After an extended political discussion about the fiscal and economic impact of real estate investment trusts (“REITs”) in Germany, in November 2006 the German government adopted its proposal for the Law on the Introduction of Real Estate Investment Trusts in Germany (the “REIT-Act”). The new law shall allow the establishment of German Estate Investment Trusts (“G-REITs”) in the form of stock corporations with publicly traded shares. The finalizing legislative procedure is expected to commence in January 2007 and will probably last more than two months. From previous experience it is likely that the German parliament will accept the draft as adopted by the government. The new law shall become effective on January 1, 2007, retroactively.
The following summary outlines (1) the reasons for introducing G-REITs to the German real estate investment market, (2) the corporate structure and the G-REIT requirements, (3) the tax treatment and concludes with an outlook for the future of G-REITs.
1. Reasons for introducing G-REITs
By introducing G-REITS the German government seeks to close an existing gap of indirect real estate investments in Germany. Prior to January 1, 2007 investors could only invest indirectly in real estate through open-ended or closed-end investment funds. Foreign investors, especially, viewed these investment vehicles as too complex and restrictive. The internationally well-known vehicle of a publicly traded REIT shall enhance the range of available indirect real estate investments in Germany and be more attractive to investors, especially foreign investors. The German government has been forced to introduce G-REITs as numerous economically important European countries recently introduced REITs or similar schemes (e.g. Luxemburg in 1988/ 2002, France in 2003, Spain in 2004 and Bulgaria in 2004) and the UK and Finland plan to introduce REITs soon.
Through the introduction of G-REITs the legislature furthermore intends to enable German corporations to mobilize their real estate. In Germany, approximately 73% of the real estate used by corporations is held in direct ownership (USA: 25%, England: 54%). The real estate assets of the 65 largest listed German companies bear hidden reserves of approximately 80 billion Euros. Under the REIT-Act German corporations have the opportunity to sell or contribute their real estate to G-REITs on a tax-privileged basis (so called “Exit Tax”) which may prove an incentive for the German industry to realize hidden reserves by disposing of real estate assets.
2. Corporate structure and G-REIT requirements
(a) Legal Framework
The G-REIT can either be a newly formed corporation or created by transformation of an already existing company (e.g. conversion, de-merger, or reorganization). The G-REIT, however, must be a public stock corporation (Aktiengesellschaft) on an exchange either in Germany or in another member state of the European Union within three years following its establishment. It is subject to the German Stock Corporation Act (Aktiengesetz), but will not be subject to supervision of the German Financial Supervisory Authority (“BaFin”). The statutory and actual seat of the G-REIT must be in Germany. The minimum share capital must amount to 15 million Euros.
(b) Shareholder’s structure
In order to open the G-REIT to retail investors, a minimum initial free float of 25% of the shares is required. Thereafter, at least 15% of the G-REIT shares must be free float on a sustainable basis (so-called “minimum free float”). No investor is allowed to hold directly 10% or more of the G-REIT’s shares (so-called “maximum amount of holding”). Participation of less than 3% count as free float. Accordingly, an investor may also hold indirectly shares in a G-REIT without reducing its possibilities for direct investments.
The reporting requirements under the German Security Trading Act (Wertpapierhandelsgesetz) allow the BaFin to monitor, if the minimum free float and maximum amount of holding requirements are complied with.
(c) Investment restrictions
Generally, the G-REIT must invest at least 75% of its capital in real property and at least 75% of its gross profits have to be generated from the leasing and disposition of real property. The assets of all GREIT service companies which have to be subsidiaries of the G-REIT (REIT-Dienstleistungsgesellschaften) may not exceed 20% of the GREIT’s asset value.
Any real estate portfolio – with one exception – is a permitted asset class for the G-REIT. That exception is real estate which predominantly serves residential purposes and which was erected before January 1, 2007. Such property may not be acquired by the G-REIT. The government’s reasoning for establishing this exception is the negative impacts on the real estate rental market to the detriment of tenants and public authorities as well as on urban development and social protection. It can be expected, however, that during the legislative procedure, this issue will be reexamined. Opponents argue that, if a G-REIT is prohibited from acquiring residential real estate, a foreign REIT will acquire them.
(d) Profit Distribution
A G-REIT is obliged to distribute at least 90% of its “distributable profits” until the end of the business year following the realization of profits. The calculation of the distributable profits is determined in accordance with the German accounting standard as set forth in the German Commercial Code (Handelsgesetzbuch). According to the legislator’s reasoning, the International Financial Reporting Standards (IFRS) cannot be regarded as adequate to calculate the distributable profit since a distribution of mere book profits might jeopardize the GREIT’s financial situation.
For determining the amount of the profit distribution only a straightline depreciation is permitted. Up to an amount of 50%, profits from dispositions may be allocated as reserves for a maximum period of three years.
(e) Debt financing
Debt financing is restricted to 60% of the value of the G-REIT’s assets which respective value is to be determined by a fair market value approach.
(f) Holding period
The G-REIT may not engage in real estate trading. This is considered to be the case if within any five year period the G-REIT generates gross proceeds from the disposition of real estate of more than 50% of the value of the real estate assets held by the G-REIT during such five year period. Conclusively, within five years the G-REIT may dispose of a maximum of half of its portfolio.
3. Tax treatment
(a) Tax privilege of G-REITS
Once the G-REIT has been listed on the stock exchange and meets all other G-REIT requirements, it is exempt from German corporate and trade tax (Körperschafts- und Gewerbesteuer). The tax exemption ceases only, if the G-REIT does not comply with the requirements outlined above, such as conducting prohibited real estate trading or non-compliance with the free-float requirements or debt regulations. Furthermore, the G-REIT may be obliged to pay tax penalties and ultimately lose its tax-exempt status, if it has not invested 75% or more gross profits in real estate, generated 75% or more gross profits from real estate or distributed 90% or more of the distributable profits to its shareholders.
(b) Taxation of the shareholders
On the shareholder level, distributions to investors are fully taxable. German tax residents are fully subject to German income tax, i.e. the regular tax privilege for dividends does not apply (no half income method for private shareholders, no 95% tax exemption for dividends for corporations). Profit distributions are subject to withholding tax at a rate of 25% (excluding solidarity surcharge). German resident shareholders basically are entitled to get credits or refunds for the withholding tax. For non-German resident shareholders the applicable double taxation treaties might provide for reductions or exemptions.
The sale of shares in the G-REIT is subject to the general taxation rules. Accordingly, capital gains of private investors holding less than 1% of the G-REIT’s share capital during the last five years prior to the sales of shares, will not be subject to German income tax unless the shares are sold within a one-year-holding period. Capital gains realized by nonprivate German investors are fully taxable. Also, capital gains realized by foreign investors are subject to German income tax; however, double taxation treaties regularly provide for a tax exemption or reduction.
(c) Exit Tax
In order to promote G-REITs, certain tax incentives apply to German real estate transferred into a G-REIT. For a period of 3 years – i.e. until January 1, 2010 – only 50% of the mobilized hidden reserves of German real estate to be transferred to G-REITs, Pre-G-REITS (stock corporations not yet meeting all G-REIT requirements) or open ended real estate funds are subject to income tax provided that the respective real estate has been a German business asset for more than 10 years.
This “Exit Tax” privilege will not apply retroactively (i) if the G-REIT sells the acquired real property within a period of four years following the purchase agreement, or (ii) if the real estate was transferred to a Pre-GREIT and the Pre-G-REIT is not registered as a G-REIT stock corporation within four years following the purchase agreement.
The introduction of the G-REIT to the German market is an important step to provide domestic and foreign investors a vehicle for indirect real estate investments. Due to the tax privileges for transferring real estate into a G-REIT (“Exit Tax”) it is very likely that the G-REIT will become an integral part of Germany’s real estate investment vehicles. Since it can be observed that foreign investors consider German real estate to be modestly valued in comparison to real estate in other countries, in particular European countries, and the G-REIT offers them a familiar investment vehicle, the chances are high that G-REITs will fuel the German real estate market after their introduction on January 1, 2007.