On 1 January 2007, the UK launched its new investment vehicle: the UK real estate investment trust (UK-REIT). The vehicle is intended to introduce greater flexibility, liquidity and tax efficiency into the UK commercial property sector.
Although it has been a long and tortuous path, the expectation is that experience will show the property industry has a flexible vehicle that largely meets the original, ambitious, objectives. The UK Government published draft legislation in December 2005 as part of the consultation process. This was based on a single company structure. It was followed by the publication of draft clauses designed to accommodate groups within the UK-REIT model, together with some ancillary amendments to the draft legislation published in December 2005. The 2006 Budget addressed many important technical and commercial issues raised by the property industry and the profession on the original proposals that have been reflected in the Finance Act 2006 (“Finance Act”). A number of important aspects of the UK-REIT were dealt with by regulations, laid on 1 November 2006. HMRC also issued draft guidance (“HMRC Guidance”) to the regime on 29 November 2006; the final form guidance should be available in early 2007. In addition, the prebudget report on 6 December 2006 has announced changes to the regime, including making it easier for newly-established companies to become a UK-REIT.
With the costs of entry into the UK-REIT regime, referred to as the conversion charge, set at 2% of the gross market value of the properties and a more flexible structure than that originally proposed, it is anticipated that many listed UK property companies will convert to UK-REIT status. On 1 January 2007 nine companies, including many of the largest property companies in the industry, converted.
On 1 January 2007 nine companies including many of the largest property companies in the industry converted.
SUMMARY OF THE UK-REIT REGIME
This summary outlines the key features of the regime, as set out in the Finance Act, and the conditions that UK companies are required to meet in order to join the UK-REIT regime for accounting periods beginning on or after 1 January 2007. A company (or group) that meets the conditions will not automatically become a UK-REIT. The company (or principal company if part of group) must serve written notice on HM Revenue and Customs (“HMRC”) before the beginning of the accounting period for which it wants to be treated as a UK-REIT.
A single company UK-REIT (or the principal company of a Group UKREIT) must be a body corporate solely resident in the UK for tax purposes and listed on a “recognised stock exchange”. Trusts, private vehicles and companies listed on the Alternative Investment Market (unless a secondary listing on a recognised stock exchange is obtained) are therefore excluded from joining the regime. The company must not be a close company for tax purposes, basically being controlled by 5 or fewer participators, other than solely by reason of having as a participator a limited partnership that is a collective investment scheme. The company must not be an open-ended investment company (“OEIC”) or an insurance company.
To enter the regime the company need not initially fulfil all of the qualifying conditions: at the point of giving notice it must be UK resident, and it cannot be an OEIC. The pre-budget report on 6 December proposes to relax the condition on listing so that a UKREIT no longer has to have listed shares on the date it gives notice. Instead it must confirm that it reasonably believes it will meet the condition on the day it joins the regime.
A Group UK-REIT will comprise a principal company and all of its 75% subsidiaries (other than OEICs and insurance companies). In broad terms, one company is a 75% subsidiary of another if the parent company is the beneficial owner (directly or indirectly) of at least 75% of its ordinary share capital.
Each subsidiary must also be an effective 51% subsidiary, adopting the statutory test used to determine a corporate group for chargeable gains purposes. Therefore, a company will be an effective 51% subsidiary of a principal company that is beneficially entitled to more than 50% of any profits of that company which are available for distribution to “equity holders” and to more than 50% of any assets available for distribution to those equity holders on a winding up. A company’s equity holders broadly include most shareholders and also loan creditors in respect of loans which are not “normal commercial loans”.
Originally, the draft legislation permitted a UK-REIT only to have ordinary shares of one class in issue. Reflecting the 2006 Budget changes, the Finance Act permits UK-REITs to issue different classes of non-voting fixed rate preference shares. A UK-REIT must not be party, as debtor or creditor, to a loan that is not a “normal commercial loan” (as defined under the loan relationship rules). Therefore, in broad terms, a UK-REIT must not be party to a loan that carries profit-linked, asset-linked or excessive interest or that provides for repayment of an excessive amount. It may, however, issue debt instruments that are convertible into a single class of ordinary share or into fixed rate non-voting preference shares.
Balance of Business The UK property rental business of a UK-REIT is tax-exempt. The regime requires that the majority (at least 75%) of the UK-REIT’s activities relate to the property rental business by reference both to its total income profits and to the value of its assets (the “Balance of Business test”). In a Group UK-REIT, this is applied on a consolidated basis.
Provided they do not exceed 25% of the company’s activities, a UKREIT can still undertake other activities. These would include income-generating activities from ancillary services associated with the property rental business and development undertaken with the purpose of generating a trading profit.
Under the Real Estate Investment Trusts (Breach of Conditions) Regulations 2006 (SI 2006/2864), in certain circumstances the value of the assets may temporarily drop to 50% without breaching the Balance of Business test.
The income and assets tests use International Accounting Standards (“IAS”) principles. Profits are calculated before deduction of tax and exclude realised and unrealised gains and losses on the disposal of property. The legislation makes clear that where IAS offers a choice of valuation between cost basis and fair value for assets, fair value must be used and that liabilities secured against or otherwise relating to assets are disregarded.
In addition to the exclusion of certain classes of business and activities (such as property development) that do not normally form part of a property rental business, certain classes of income and profits are expressly excluded from being within the property rental business. These include certain income currently not treated as property income, receipts from transactions falling within the rent factoring tax provisions and dividends from other UK-REITs.
In a Group UK-REIT, when determining the 75/25 Balance of Business split between property rental business and taxable activities, UK and non-UK property rental activities of a UK resident company are included within its property rental business together with the UK property rental business of a non-UK company. However, non-UK activities of non-UK resident companies are not treated as part of the property rental business. In addition, where a company in a Group UK-REIT is not wholly owned, only the appropriate proportion of its activities form part of the property rental business.
Under the pre-budget report it is proposed that a new UK-REIT does not have to satisfy the assets test on joining the regime. It can acquire its property assets over its first accounting period and pay the 2% conversion charge on the excess of the market value of its investment property at the end of the first accounting period over its market value at the start.
The property rental business must include at least three commercial or residential properties. Properties, for these purposes, include separately rented units. Therefore, the property rental business could consist of a single shopping centre or other multi-let property used for qualifying purposes. No single property can represent more than 40% of the total value of the properties of the business. Breach of this 40% limit will not usually result in expulsion from the regime provided the breach is minor and not part of a series of breaches. As noted above, this 40% test is now based on the fair value of those property assets and not historic cost where IAS offers a choice in the method of valuation. However, the property rental business cannot include any properties that are owner occupied. This exclusion from the property rental business includes occupation by the UKREIT, occupation by any other Group UK-REIT company or by any company whose shares are stapled to those of the UK-REIT (such that the shares of the occupying company and of the UK-REIT are traded together).
The potential impact on hotel groups and certain retailers wishing to enter the regime is clear: unless they are prepared for their shares to trade separately from their associated operating businesses, this rule will bar their entry to the regime.
Unless prohibited from doing so under corporate law, the UK-REIT will have to distribute, as a minimum, 90% of the net taxable profits of the property rental business to investors. This required percentage only applies to income profits which are, broadly, calculated using tax rules. Subject to any applicable exemptions or reliefs, all such property income distributions (commonly referred to as “PIDs”) will suffer withholding tax at 22%.
If chargeable gains within the property rental business are distributed, these are treated the same way as income distributions from within the property rental business in that they are subject to the tax withholding provisions but do not count towards the 90% distribution requirement.
The 2006 Budget increased the period for the UK-REIT to make the necessary distributions from 6 to 12 months from the end of the accounting period, which is to be welcomed from both a cash flow and tax compliance perspective. Further, breaches of the distribution requirement will not result in removal from the regime but instead, the imposition of an additional tax charge on the UKREIT. If a UK-REIT is impeded by virtue of law from meeting the 90% distribution requirement then the UK-REIT is treated as meeting the condition as long as it distributes as much as it legally can. A contract between a UKREIT and its shareholders (eg a provision in the UK-REIT’s Memorandum and Articles of Association) will not constitute a legal impediment for these purposes.
The legislation uses a Profit: Financing Cost ratio rather than a conventional gearing ratio in setting the limit on how much a UK-REIT will be able to borrow. The purpose of the ratio is to prevent a UK-REIT being highly geared or at least subject to finance costs that reduce the amount of profits available for distribution to the shareholders. This ratio is applied to a Group UK-REIT on a consolidated basis. The ratio (now based on taxable profits before interest costs and capital allowances) must not be lower than 1.25. This figure is relatively modest when compared to the 2.5 ratio that was included in the draft legislation back in December 2005 and is below the industry average.
Compliance with the 1.25 ratio is not a condition for remaining within the regime. Instead, a UKREIT that breaches the ratio will be taxed on the amount of interest that causes the 1.25 ratio to be breached. The charge will be by reference to the excess financing costs.
Under numerous Double Tax Agreements the corporate holder of 10% or more of the shares in another company is entitled to a reduced or nil withholding. To avoid this cost to the UK Exchequer REIT holdings of 10% or more are discouraged by the legislation. UK-REIT status will not be lost if any person obtains control of 10% or more of the UKREIT’s shares or voting rights. Instead, a tax charge will be levied on the UK-REIT in the event that it makes a distribution to or in respect of a shareholder who holds or is beneficially entitled to 10% or more of dividends, the shares or the votes in the UK-REIT unless the UK-REIT has taken “reasonable steps” to avoid the payment of such a distribution. The Real Estate Investment Trusts (Breach of Conditions) Regulations (SI2006/2864) laid on 1 November 2006 clarified that this tax charge is only levied if the 10% shareholder is a company.
Reasonable steps would include a provision in the UK-REIT’s Memorandum and Articles of Association requiring a corporate shareholder whose shareholding or voting power exceeds the 10% threshold (referred to as a “Substantial Shareholder”) to enter into a transaction designed to remove the entitlement to that dividend. This might be achieved by a dividend strip transaction where the counter-party would not be beneficially entitled to 10% or more of the dividends or by the establishment of a trust to hold the dividends unless or until the shareholder ceased to be a Substantial Shareholder. As regards dividend strips, HMRC Guidance states that the range of anti-avoidance rules that apply to dividend stripping is not disapplied solely because the purpose of the strip is to achieve compliance with the UK-REIT conditions. It should be noted that, as well as developing a template Stock Exchange circular for companies to use in their conversion process, the British Property Federation has released a draft article dealing with the 10% threshold.
UK-REITs can undertake development activities within their property rental business provided that they are undertaken with a view to generating future rental income. However, where a UK-REIT develops a property held within its property rental business and then disposes of it in the course of a trade within three years of completion of the construction, the disposal may be treated as falling outside the UKREIT’s property rental business. This will be the case if the cost of construction exceeds 30% of the fair value of the land and buildings on entry into the regime or acquisition (whichever is the earlier). In such cases, the proceeds will fall into charge to tax as either trading or realisation of an investment. This may be the case even if the original intention was to develop and hold the property long term. The 2% entry charge relating to the asset that has been redeveloped will, however, be refunded.
Companies or groups wanting to become UK-REITs will pay an entry charge of 2% of the gross market value of their UK investment properties at the date on which the company or group joins the regime held in either a UK or non-UK company. On entering the regime, companies will be deemed to dispose of and reacquire at market value properties to be used in the property rental business. Any chargeable gain or loss arising on the deemed disposal will not be brought into account for tax purposes.
The entry charge will be collected at the same time as any corporation tax that is due for the first accounting period the regime applies (i.e. in four quarterly instalments, generally commencing six months after entry into the regime). Alternatively, companies or groups will be able to spread the charge over four years, in instalments of 0.5%, 0.53%, 0.56% and 0.6% (2.19% in aggregate) if they prefer, at an effective rate of interest of about 6%.
Breaches of the UK-REIT conditions
Breaches of certain conditions will result in automatic expulsion from the regime. For example if the UK-REIT ceases to be UK resident or becomes an openended investment company. A UK-REIT that ceases to be listed on a recognised stock exchange or becomes a close company may avoid automatic expulsion if the breach arises as a result of the actions of others. There are specific provisions dealing with breaches as a result of takeovers.
A UK-REIT will now be able to stay within the regime provided that any minor breaches are rectified quickly. However, HMRC will have the power to issue a notice disapplying UK-REIT status from the end of a previous accounting period where the UK-REIT has exceeded a maximum limit on the number of acceptable breaches, the limit varying according to the condition. Generally a REIT cannot have 4 breaches within 10 years and remain in the regime.
Two separate groups The tax-exempt parts and the non-tax-exempt parts of UK-REITs and the members of Group UKREITs form two separate deemed groups (“tax-exempt” and “residual”), which will also be separate from any group before and after UK-REIT regime status.
Transfers of assets between the tax-exempt part and the residual part will take place for tax purposes as though between third parties. In addition, losses arising in the tax-exempt part will not be available for offset against the profits of the taxable part and vice versa.
Neither small company nor marginal rate is available to companies within a Group UKREIT in respect of taxable profits.
Intra-group transactions, including payments of intra-group interest, are not to be included in the Group UK-REIT’s financial statements unless they relate to the interest of a minority shareholder.
The Real Estate Investment Trusts (Joint Ventures) Regulations 2006 (SI 2006/2866) allow a UK-REIT and its joint venture company to elect for the assets and income of the joint venture company to be included in the UK-REIT’s business if, amongst other conditions, the UK-REIT is beneficially entitled to 40% or more of the joint venture profits that are available for distribution to shareholders and the UK-REIT is beneficially entitled to 40% or more of the assets of the joint venture in the event of a winding up.
The joint venture company will have the same kind of tax-exempt business and residual business as a company that is a 75% subsidiary and a 51% subsidiary of the principal company of a Group UK-REIT. The tax-exempt profits of the joint venture company will be included in the profits of the tax-exempt business for the purposes of the distribution test. However, neither the joint venture company itself nor its tax-exempt and residual parts are treated as part of a group for any other purposes of the Taxes Acts. Unlike a tax transparent vehicle, the benefit of the tax-exemption accrues to the joint venture company and not to the UK-REIT directly. Further, the UK-REIT will not necessarily be able to ensure that dividends are paid by that joint venture company, which could impact on its ability to meet the distribution test. For this reason there will need to be a shareholders’ agreement between the UK-REIT and the other shareholders within the joint venture company.
On electing to include the assets and income of the joint venture company in the business of the UK-REIT, the joint venture company is required to pay the Entry Charge equal to 2% of the value of its assets in the property rental business at the date the election becomes effective. The pre-budget report proposes to extend the joint venture company to more complex group structures as the original legislation only applies to a single company structure.
Tax transparent vehicles
If a UK-REIT holds property through a tax transparent vehicle for UK tax purposes, such as a partnership, its share of the property and income will also qualify for the Balance of Business test. The draft HMRC guidance indicates that, for the purposes of applying the Balance of Business test to a Group UK-REIT, they will treat a Partnership interest of 20% or less as opaque and so will not look through to the underlying assets. Although ignored for the Balance of Business test, any income or gains will benefit from exemption. [The statutory justification for this approach is unclear and likely to be vulnerable to challenge]. At present the treatment of Offshore Unit Trusts, such as Jersey property unit trusts (“JPUTs”), is unclear. HMRC are presently consulting on this issue. The property owned by the partnership or JPUT is not counted to satisfy either the condition that the property rental business must involve at least 3 separate rental properties, or the condition that no one property can be more that 40% of the total value of the property assets in the business. HMRC argue that the reason that this property is so excluded is that the part of the property owned by the UK-REIT cannot be let out separately from the parts of that property owned by the other unitholders.
Prior to the changes announced in the 2006 Budget, a UK-REIT that participated in any tax avoidance was liable to expulsion by HMRC from the regime. The legislation now allows for HMRC to issue a notice to such a UK-REIT setting out the advantage they believe is being sought and cancel that advantage by assessment or repayment. If the UK-REIT receives two notices as a result of trying to obtain an unfair tax advantage, it can be removed from the regime.
It is thought that as a consequence of this aspect of the regime UK-REITs will be cautious in terms of any tax planning undertaken.
TAX TREATMENT OF A UKREIT
UK-REITs will not pay corporation tax on property rental income or chargeable gains that relates to the tax-exempt business. However, the exemption from tax does not extend to distributions and interest receivable from non- UK resident companies or to the residual business.
Care needs to be taken where property is held in a subsidiary of the UK-REIT or a JPUT. Under the new regime, a gain on the disposal of shares in a subsidiary or units in a JPUT will be treated as profits of the UK-REIT’s residual business and accordingly, taxed at 30%.
The UK-REIT will not need to claim capital allowances. Instead, it will automatically be deemed to have claimed full capital allowances in calculating the profits of its tax-exempt business. HMRC Guidance clarifies that on entry to the regime elections under section 198 and section 199 of the Capital Allowances Act 2001 cannot be made. Similarly, these elections cannot be made on a transfer of a property from the tax-exempt business to the non tax-exempt business. However, apart from on joining and leaving the regime and on transfers between exempt and residual businesses, section 198 and 199 elections can be made, subject to satisfying the normal conditions.
As described above, in addition to the tax charge on entry, a tax charge may be levied on a UKREIT if it makes a distribution to a Substantial Shareholder, breaches the Profit: Finance Cost ratio and/ or breaches the 90% distribution requirement. No loss, deficit, expense or other allowance may be set off against these tax charges if they arise.
Distributions by a UK-REIT in respect of income profits and chargeable gains of its tax-exempt business will generally be treated as UK property income in the hands of the shareholders for UK corporation tax and income tax purposes. These distributions will generally, subject to exceptions for UK corporates and Pension Funds, be subject to withholding tax at the basic rate (currently 22%). Full details of the withholding tax regime and the exceptions thereto are set out in the Real Estate Investment Trusts (Assessment and Recovery of Tax) Regulations 2006 (SI 2006/2867).
UK resident taxpayers
On current rates, PIDs from a UKREIT will be subject to tax at 30% in the hands of UK corporates and 40% when received by higher rate income tax payers but allowance will be given for withholding tax. This broadly equates to the rates which would apply if a direct property investment in the UK had been made by the investors in the UK-REIT.
The Effect of Capital Allowances
The 90% minimum PID distribution is calculated by reference to the taxable profits of the exempt business after deducting capital allowances. This means that an amount equal to the capital allowances deducted can be paid as a normal dividend, without any withholding, and taxed only at the shareholders marginal rate. Whilst this is a benefit to the shareholder, a basic rate shareholder would receive untaxed income, it is of no direct benefit to the UK-REIT.
Non-UK residents and Double Tax Agreements
Non-UK tax resident investors will potentially be subject to withholding tax at source at 22% on PIDs. However, it may be possible for some non-UK tax resident investors, depending on their status, to obtain a measure of relief under the appropriate Double Tax Agreement. Most UK Double Tax Agreements reduce the rate of withholding on dividends from UK resident companies to 15%. However, the taxation of distributed capital gains as income is particularly disadvantageous for non-UK tax resident investors when compared with a direct UK property holding as they do not generally pay UK tax on gains realised from such property.
Exempt bodies like pension funds are not subject to withholding tax in respect of PIDs. As UK-REITs will not be subject to tax on the profits of their tax-exempt business, such exempt bodies will not suffer the “indirect” tax cost of not being able to reclaim the tax credit normally associated with distributions by UK resident companies. This is broadly the same position as investing via a tax transparent vehicle, such as a limited partnership or a Jersey unit trust which is transparent in respect of its income profits. The pre-budget report also proposes to revise the legislation to ensure charities are exempt from tax on distributions from UK-REITs in the same circumstances that are exempt from tax on UK dividends.
The pre-budget report also proposes to change the legislation to permit investment-regulated pension schemes (which include self invested pension schemes) to hold an interest of 10% or more in a UK-REIT without incurring an additional tax charge for the UKREIT which can apply to other corporate holdings of such a size.
Charge on a voluntary early exit from the regime Where a company elects to leave the UK-REIT regime within ten years of joining and disposes of any property that was involved in its tax-exempt business within two years of so leaving, broadly, any uplift in the base cost of that property which occurred on entering the regime will be disregarded. This will potentially result in a higher chargeable gain or lower allowable loss than would otherwise be the case. If a UK REIT were to leave the regime involuntarily, say it were taken over by a non-REIT, this charge would not arise on any subsequent sale of the property.
UK-REITs will be subject to the usual stamp duty land tax rules in relation to their UK real estate transactions and investors will be subject to stamp duty or stamp duty reserve tax at 0.5% on their dealings in their shares. This compares favourably with the maximum 4% charge to stamp duty land tax applicable to purchases of UK real estates that are held directly by the investor or via a partnership.
Value Added Tax
Electing for UK-REIT status has no effect on the VAT treatment applied to a company.
ISAs, PEPs and CTFs
Shares in UK-REITs may be held in an Individual Savings Account (“ISA”), a Personal Equity Plan (“PEP”) or a Child Trust Fund (“CTF”) subject to the existing limits and rules. The UK-REIT will be the only vehicle available for sheltering rental income in this way.
The concept of the UK-REIT has been well received and many major property companies converted on 1 January 2007.
As more and more property companies convert during the course of 2007, the property industry will no doubt evaluate whether UK-REITs do in fact create greater flexibility, liquidity and tax efficiency in the UK property markets. The outlook so far is very promising.
Nabarro has been closely involved in the development of UK-REITs both at a company and sector level. It is currently advising leading names in the sector on UK-REIT issues and has been involved in the conversion of a number of clients to REIT status.
Recognising the tremendous potential the UK-REIT has for the real estate sector, it has assembled a dedicated team to advise clients on these opportunities. This group includes specialists in Real Estate, Corporate Finance, Tax and Banking.