UK REITs summary: hotel emphasis

The UK is in the process of introducing a REIT regime. Draft rules have been published in the Finance Bill 2006 and will be debated and become law at some point in July 2006. Below is a summary of the key provisions in relation to the REIT regime.

• The regime comes into force on 1 January 2007.
• The regime will be available for listed closed-ended corporate vehicles. Listing means a listing on a main market (but not necessarily the London Stock Exchange).
• The REIT must be UK tax resident and not tax resident in another jurisdiction – Query whether this is compatible with EU law?
• Broadly the REIT must not be controlled by five or fewer persons/unlisted companies or by director shareholders.
• The shares of a REIT may only comprise one class of ordinary shares together with non-voting fixed rate preference shares.
• The debt structure must comprise plain vanilla debt finance together with the possibility of convertibles. Profit linking is not available but discounted stock may be used.
• It will be possible for a single company to elect to be a REIT but also for a group of companies to elect to be a REIT with the listed company being the principal member of that group.
• Regulations are to cover joint venture companies and other vehicles in which the REIT holds an interest
• The REIT must own at least three properties – a single multi-unit property can qualify as different properties in relation to each unit provided that the units are designed and let/available for rent as separate units.
• Each property must be no more than 40% of the total qualifying properties – this might be problematic for small portfolios with trophy assets.
• Qualifying property must not be owner occupied as defined under GAAP (viewed on a group basis where there is a group REIT). This is the issue that causes problems for hotel REITs together with the next point.
• The REIT must receive investment income taxable under Schedule A in relation to UK properties and Schedule D V in relation to overseas properties. The provision of goods/services at the property often means that the whole activity is taxed under Schedule D I as a trade. This prejudices REIT status in those cases – again a threat to hotel REITs.
• The REIT must distribute 90% of its rental profits after capital allowances but subject to any provisions of corporate law that prevent it from doing so.
• At least 75% of the assets and income (for accounts purposes) of the REIT must comprise qualifying real estate investments or qualifying real estate income. Therefore take care with non real estate investment activities.
• The financing ratio of REITs is calculated as rental profit before interest and capital allowances against finance costs. The maximum permitted ratio is 1.25:1. This means that on the basis of average yields of, say, 5% and interest rate of 6% leverage of at least 60% may be permitted.
• Some property development is permitted – for own occupation.
• Qualifying properties must be held for, say, 4-5 years.
• Notice is given to join the regime – however setting up a new REIT from scratch will normally require listing as a property company initially with conversion into REIT once the three properties have been acquired. If you have a portfolio identified it may be possible to acquire that at day 1 and elect for REIT status i.e. make the transaction, fund raising and listing on the stock exchange inter-conditional. The cost of that could be higher, i.e. SDLT at 4% plus entry charge at 2% - see 21 below. This is a disadvantage against existing property companies converting to REIT status or existing REITs acquiring portfolios.
• Membership of the regime lasts until notice is given to leave or certain forms of breach of the rules occur.
• REIT status means that a separate property rental business is deemed to be commenced in relation to the exempt real estate business – ring-fencing of profits/losses applies.
• Upon entry there is a charge equal to 2% of the gross value of the exempt real estate assets. This can be spread over three years at an interest cost (about 6% p.a.).
• The entry charge is treated as Schedule D VI income and thus cannot be offset against other losses or reliefs.
• A REIT will incur a 4% SDLT charge on the acquisition of UK properties unless avoidance mechanisms are used – see next point.
• It may be possible to acquire on a tax efficient basis properties in offshore vehicles such as SPVs or unit trusts – e.g. the JPUTs that have in recent years been set up to hold a number of UK property investments in an SDLT efficient manner. It is possible that neither SDLT nor entry charge will apply.
• Where the REIT distributes profits to investors holding more than 10% of the share capital, tax is imposed on the REIT in respect of the profits so distributed – query whether this applies to the excess distribution received by the 10% plus shareholders? Draft regulations are awaited.
• The above tax charge/penalty may be avoided by the REIT taking appropriate enforcement steps e.g. by stipulating in its memorandum and articles that 10% plus shareholders must dispose of their dividend rights.
• There are various administrative rules including anti-avoidance rules specially designed for REITs.
• The calculation of REIT profits is carried out under normal UK Schedule A rental business methods. However, capital allowances must be claimed in full in calculating the amount of profits, 90% of which must then be distributed. On sale into the REIT capital allowances elections should be available (and possibly also on a sale out of the REIT) to allow tax planning with a non-REIT purchaser or vendor.
• Whilst no tax applies to REITs in relation to their real estate profits and gains, distributions are taxable as property receipts in the hands of the shareholders with a rate of 40% for UK individuals, 30% for UK corporates, 22% for foreign individuals and again 22% for most foreign corporates. The profits received from REITs are separate from other property businesses and thus cannot be offset by losses e.g. on a direct property investment holding.
• Withholding tax at 22% will be levied on distributions except where to exempt bodies such as charities, local authorities and pension funds. Double tax treaties may reduce the WHT but the 10% shareholding rule (see 25 above) should limit the benefit of that.
• Whilst capital gains are exempt in relation to the REIT qualifying properties the distribution of gains will be taxable.
• There is an order of attribution of distributions to different forms of profits. The first profit distribution must be so as to comply with the 90% qualifying distribution requirement.
• Overseas properties can be held direct by the REIT on a UK tax free basis. However, profits will be subject to local taxes. At the moment there is no exemption for profits derived from the REIT holding shares in an overseas SPV holding local real estate – this would be the normal structure for cross-border investment to reduce local taxes.
• It is expected that several sizeable listed UK property companies will elect for REIT status. The position is not so easy for start up REITs but generally sizeable take up is expected.
• Hotel REITs are expected but there are significant doubts as to whether a Propco/Opco structure is available. Existing UK and overseas property investment vehicles will be attractive targets for REITs and considerable consolidation is expected in the sector.