Two new tax-efficient vehicles for real estate investment may soon become a reality. Legislation for the establishment of REITs may be in place by July 2006 and the FSA has already introduced regulations to enable authorised investment funds to invest all their assets in real estate or real estate-related assets.

REITs

REITs are, broadly, tax-neutral vehicles which enable investors to obtain real estate exposure without tax leakage. The principle underlying REITs is that they will be free from tax provided they distribute an agreed percentage of income and capital gains. REITs are usually income-driven products with the potential for capital growth, and are valued on an earnings rather than net asset-value basis.

A number of overseas jurisdictions have already established REIT-type vehicles, including the US (which originated the vehicle in the late 1960s) Japan, Singapore, Korea, Australia, the Netherlands, Belgium and France. Other European jurisdictions are likely to establish similar vehicles – for example, Germany has announced that it is intending to introduce a REIT vehicle sometime in 2006.

Where has been considerable discussion in the UK on the possible establishment of a REIT since the late 1980s but no real progress has been made for many years. The government itself revived the debate in 2003 and issued an initial draft consultation paper in 2004, which has led to a lengthy period of consultation.

The initial consultation paper of March 2004, although generally positive, gave rise to a number of potential concerns. These included a preference that REITs be listed, a requirement that the distribution percentage be calculated before depreciation, the absence of a clear distinction between income and capital, an exclusion of leisure-related properties such as hotels, and uncertainty as to a range of issues including whether REITs could invest in overseas properties, would they be internally or externally managed, or could they carry out developments, and the rate of stamp duty reserve tax that would be payable on the transfer of shares in REITs.

The government have now issued a further consultation paper which takes on board a number of issues raised by the industry during the consultation period. The government’s specific proposals include the following:

• 75% of gross income and 75% of gross asset-value of assets should derive from ring-fenced real estate activities. This means that REITs will be able to carry on other activities, although these will be taxable.



• 95% of net ring-fenced real estate income must be distributed to investors after deductions. This will be calculated on a post-depreciation rather than pre-depreciation basis. The treatment of capital distributions is yet to be clarified.
  
  UK companies can currently only pay dividends to the extent of their distributable profits and there is a potential inconsistency between this limitation and the requirement to distribute 95% of real estate income. The government has acknowledged that these legal constraints will need to be addressed.



• There is no limit on the type of properties in which a REIT must hold, provided this is not a ‘proxy for a financial transaction’. Accordingly it should be possible to establish hotel REITs, provided that the REIT leases the properties to the hotel operator and does not carry on the underlying hotel business itself.



• REITs will be permitted to invest in overseas properties.



• Internal and external management will be permitted.



• There will be no minimum hold period.



• There will be no requirement to invest in residential property.



• REITs will be able to undertake some development activity consistent with meeting specified income and asset tests. Development activity as a trade will not be permitted.



• REITs will be subject to specific risk requirements and therefore will not be able to hold a single asset.



• Stamp duty reserve tax will be paid on transfers of shares in REITs at 0.5%.

No decision has yet been reached on whether REITs will be required to be listed and the government has invited further representations concerning this.

Tax issues

The tax position is less clear. The government appears to accept the principle that there should be no tax leakage within the REIT and that investors should be taxed as if they own the underlying assets themselves. However, it has identified three technical issues which it wishes to resolve before any draft legislation can be issued:

(1) The treatment of REITs under double tax treaties. The government is concerned that it will not be able to impose withholding tax in relation to payments made by a REIT to non-resident investors, which would mean that non-residents would be in a better position than if they had invested directly in real estate, where withholding would apply.

(2) The government is concerned to ensure that levels of borrowing will not reduce the tax collected from investors or result in any manipulation for tax avoidance purposes.

(3) It wishes to discuss how company group structures will fit within a UK REIT regime.

Discussions are currently being held with the Revenue on these issues and it is hoped that solutions will be found to each.

The Revenue has not yet commented on the likely amount of the ‘conversion charge’, ie the tax charge that will arise on conversion to REIT status. The government has consistently stated that it does not intend to suffer a loss of tax revenue as a consequence of the establishment of the new vehicle. This will be a difficult assessment to make since there can be no certainty as to the amount of tax it would have received if REITs were not established, particularly as property companies often pay tax at a lower rate because of available reliefs and deductions. There is also a good argument that the establishment of REITs could generate additional income through increased dealings and the accelerated distribution of taxable income to investors.

At the time of the establishment of the SIIC, the French government imposed a conversion charge of 16.5%, half the usual corporation tax rate, spread over four years. A compromise based on similar principles, albeit calculated at different rates, could form the basis of a possible solution, but there would need to be considerable discussion concerning the amount and period of payment. It is, however, unclear whether the government would allow companies to set off existing deductions against any such tax charge and whether it would seek to levy a similar or reduced charge on any non-tax-paying entities – for example, exempt funds or offshore funds that are not currently subject to UK capital gains tax. The amount of the conversion charge will be fundamental to the success of the REIT Initiative, since if the figure is set too high, there will be a limited desire to convert.

COLL Initiative

REITs are not the only form of new tax-efficient property ownership veh-icle currently being proposed. The government has already introduced regulations as part of its New Collective Investment Scheme Initiative (COLL) to enable investment funds to invest all their assets in real estate subject to complying with a certain spread of risk requirements.

„uthorised investment funds can be marketed to the general public and therefore potentially have a similar investor base to REITs.

Authorised investment funds include both authorised unit trusts and OEICs (open-ended investment companies). OEICs are companies that can redeem their own shares. The following spread of risk requirements apply to these vehicles:

(1) No more than 15% in value of the scheme property may consist of one property but this may be increased to 25% once income has been included in the scheme property.

(2) The income receivable from any one group in an accounting period must not be more than 25%, or in the case of government or public body, 35%.

(3) No more than 20% of the scheme property may consist of mortgaged properties and any mortgage may not secure more than 100% of the value.

(4) No more than 50% of the value of the scheme property may consist of properties that are unoccupied or non-income producing, or in the course of substantial development, or redevelopment or refurbishment.

(5) No more than 20% of the value of the scheme property may be invested in investments in unregulated collective investment schemes or transferable securities in non-listed entities or in properties in respect of which options have been granted.

(6) No more than 20% of the scheme property may be invested in derivatives provided the derivative is an ‘approved derivative’ or complies with the rules on OTC derivatives. The underlying property of a derivative may only be of certain assets and this does not include real property.

The COLL regulations have also introduced a third category of authorised investment fund – Qualifying Investor Schemes (QIS). These are effectively expert-type funds which are subject to a more flexible regime. The principal spread of risk requirements are as follows:

• properties can be mortgaged up to 100% of their value;
• options may not be granted over properties comprising the scheme property if this would prejudice the ability to provide redemption; and
• total premiums paid for options to purchase properties may not exceed 10% of the scheme in any 12 months.

QIS can only be marketed to a more limited category of investors. These include:

• existing investors who are already invested in (or were in the last 30 months invested in) an unregulated scheme or QIS whose underlying property and risk profile are both substantially similar to those of the QIS being marketed to them;
• established or newly accepted customers of an FS-authorised firm for whom the firm has taken reasonable steps to ensure an investment in the QIS would be suitable; and
• intermediate customers and market counterparties for the purpose of the Financial Services and Markets Act 2000.

Tax issues

Authorised investment funds are tax neutral for capital purposes but are subject to tax leakage on income since they are taxed at 20%. Non-residents and investors whose effective rate of tax is less than 20% will not obtain a full credit for this. There is currently discussion concerning the possible removal of this leakage. This is part of a wider debate and it is hoped that there will be some consistency in the tax treatment of REITs and AIFs to seek to ensure that no distortion arises through the different tax treatment of the underlying vehicles.

The future

There will be further consultation in relation to each of the new vehicles but there are reasonable grounds for optimism that both will be available for investment in a tax-efficient form in 2006. The vehicles will provide an important source of new equity for the real estate market, particularly in view of the increasing desire of institutions to increase their exposure to real estate on a medium-term basis and the significant growth in the number of retail and high-net-worth individuals seeking to diversify their pension savings by making investments in real estate. © Property Law Journal