In 2007 the UK finally got its own REIT regime. Designed principally to allow large listed property companies to become REITs, it wasn’t very flexible. It wasn’t aimed at start-ups, but for UK property investors, after years of waiting, it was a start.

After recent changes to the REIT regime, it is becoming easier to set up a REIT from scratch. But barriers to accessing a retail investor base and the lack of a ‘private’ REIT regime mean we are not there yet.

What is a REIT?

‘REIT’ stands for ‘real estate investment trust’, a term well understood in the property investment world. The key to a REIT is that a large majority of its income profits must be distributed to shareholders. For UK purposes it is a property investment company which enjoys a special tax-efficient (transparent) status provided certain conditions are met. When people think of REITs in the UK, they refer only to companies like British Land or Land Securities. In the US, where REITs have been around since the 1960s, REITs comprise not only large publicly traded companies but also private REITs. In addition, there are mortgage REITs (M-REITs) and hybrid REITs (a mixture of equity and mortgage REITs).

What has changed?

The tax rules have been relaxed to make it easier to become a REIT:

  • the requirement for the company not to be a close company at day one (there is now a three year grace period and a few tweaks to the legislation to make the requirements easier to achieve by the end of the period)
  • the introduction of the concept of ‘diverse ownership’ – a recognition that many investors are themselves funds with diverse shareholders – this helps the close company test to be met
  • the abolition of the 2% ‘conversion’ charge – formerly there was a charge of 2% on the capital value of the property and assets held in the company at the time it converted to a REIT
  • the ability to list the REIT on AIM or PLUS markets – previously it had to be a full listing or a listing on CISX or Luxembourg

What are the advantages of a REIT?

The company

As a REIT, UK resident group members and non-UK resident Group members with a UK qualifying property rental business do not pay UK direct taxes on their income and capital gains from their qualifying property rental businesses in the UK and elsewhere (tax-exempt business), provided that certain conditions are satisfied. Instead, distributions in respect of the tax-exempt business will be treated for UK tax purposes as UK property income in the hands of shareholders. However, corporation tax will still be payable in the normal way in respect of income and gains from the group's business (generally including any property trading business) not included in the tax-exempt business (residual business).

The shareholders

Distributions of income profits and capital gains in respect of a REIT’s tax-exempt business (referred to as property income dividends (PIDs)) are not treated as normal company dividends but as UK property income in the hands of shareholders and will be subject to withholding tax at the rate of basic rate income tax (currently 20%) unless the REIT reasonably believes that the beneficial shareholder:

  • entitled to the distribution is subject to UK corporation tax; or
  • is exempt: e.g. a charity, pension fund or local authority.

Distributions of profits from the residual business are treated as dividends in the usual way. The Non-resident Landlords Scheme does not apply to REIT PIDs.

So in short the advantages are the removal of potential ‘double tax’ on the company’s activities as well as the ability for certain non-tax payers, such as pension funds to receive income gross.

So what are the requirements for a REIT now?

Basic conditions

The Basic Conditions for a REIT are that the REIT must:

  • be a body corporate tax resident in the UK.
  • be closed ended i.e. what we understand as a normal company not an open ended investment company such as a fund where the shareholders are entitled to have their shares redeemed based upon a net asset value calculation for example.
  • be listed on a stock exchange 'recognised' by HMRC – this includes the London Stock Exchange's market for listed securities, the Channel Islands Stock Exchange, the Luxembourg Bourse, AIM or PLUS or their ‘foreign equivalents’.
  • not be a close company (except by virtue of having as a participator a limited partnership that is a collective investment scheme). This means that the company cannot either be controlled by its directors or under the control of five or fewer members. Further exemptions apply for companies with 35% of their shares in public hands (i.e. comprising shareholders with 5% or less each) and certain pension schemes but the usual exemption for companies controlled by non-close companies is excluded. The close company test is however relaxed for new REITs during their first three accounting periods. If ‘non-close’ company status is not achieved by the end of the third accounting period, the REIT status of the Company will be removed by HMRC without any claw back of tax or penalty. This allows a closely held company to build its business over two to three years before opening up its shareholder base. As part of the relaxation of the close company test HMRC has recognised that institutional investors are themselves owned by diverse groups of investors and so has introduced a diverse ownership rule for such investors. This is a list of institutions which effectively will not be treated as a single shareholder of the REIT for the purposes of the close company test. The list will be revised from time to time.
  • have a single class of ordinary shares (the only other shares it may issue are non-voting restricted preference shares certain types of which may be convertible).
  • only enter into debt facilities where (a) the interest does not exceed a commercial rate of return; and (b) where the interest is not linked to the performance of the business or the value of the assets (this would therefore exclude certain mezzanine or equity type instruments) although this does not prevent interest reducing if company performance improves or increasing if it deteriorates.

In addition:

  • it must prepare financial statements showing information about the tax exempt business and the residual business separately.
  • a REIT can have subsidiaries – a ‘group REIT’ - of which the principal company must be UK tax resident and admitted to trading on a recognised stock exchange. The key test for the group is that the principal (parent) company has 75% subsidiaries (which may also down the chain have 75% subsidiaries but on a ‘look through’ basis each subsidiary must be a 51% subsidiary of the principal company based on the principal company’s entitlement to at least 50% of profits and assets available for distribution). Where a subsidiary is not wholly-owned, only the owned proportion of its business counts towards a group REIT’s tax-exempt business.

Conditions for the tax-exempt business

Balance of business

A REIT must satisfy at the beginning of each accounting period (that is an accounting period for tax purposes) the 'balance of business conditions'. The balance of business conditions are a good starting point for defining the essential nature of a REIT:

  • the assets test: the value of the assets in the qualifying property rental business must represent 75% of the total value of the assets held by the group (the test may be relaxed for the first accounting period so long as the balance is achieved by the end of the first accounting period) although a tax charge will be incurred equal to 2% of the market value of the property acquired during the first accounting period (less the equivalent entry charge on property disposed of during that period – see below); cash held on deposit and gilts are added for the purposes of the assets test.
  • the profits test: the income profits from the qualifying property rental business must represent at least 75% of the Group's total profits for the accounting period – profits for the group as a whole are calculated pre-tax and exclude gains or losses on the disposal or revaluation of property and certain exceptional items.

There is some flexibility in the REITs regime for these tests to be failed for a specified period after the first accounting period so long as the ratios on either case do not fall below 50% and the number of breaches is not excessive.

90% distribution test

After each tax accounting period, 90% of the income profits relating to the qualifying property rental business must be distributed to shareholders by way of a PID. This must be done before the REIT files its tax return for the period. This requirement is the key commercial element for a UK REIT.

Property requirements

The qualifying property rental business (also referred to as ‘tax-exempt business’) must throughout the tax accounting period own at least 3 properties (which may be as little as three flats in the same block) none of which represents more than 40% of the total value (fair value) of the properties in the tax-exempt business. None of the properties may be owner-occupied and there are strict anti-avoidance provisions dealing with this although there is an express provision that businesses with ‘tied premises’ such as pubs may be carrying on a property rental business.

Interest cover ratio

A tax charge will arise if, in respect of any accounting period, the ratio of (i) the income profits (before capital allowances) of the UK resident members of the group plus the UK income profits of any non-UK resident member of the group, in each case, in respect of its tax-exempt business plus the financing costs (see below) incurred in respect of the tax-exempt business of the Group, to (ii) the financing costs incurred in respect of the tax-exempt business of the group, excluding certain intra-group financing costs, is less than 1.25. This ratio is calculated by reference to the financial statements. The amount (if any) by which the financing costs exceeds the amount of those costs which would result in a ratio equal to 1.25 is chargeable to corporation tax. Put more simply

Click here to view equation.

HMRC can waive this rule in certain circumstances. ‘Financing costs’ includes only interest costs and excludes arrangement fees and certain specified costs. Additionally the corporation tax charge applies only to 20% of the profits of the tax-exempt business.

The ‘10 per cent.’ rule

The principal company of a REIT may become subject to an additional tax charge if it makes a distribution to, or in respect of, a corporate shareholder beneficially entitled, directly or indirectly, to 10 per cent. or more of the principal company's dividends or share capital or that controls, directly or indirectly, 10 per cent. or more of the voting rights in the principal company. This tax charge only applies to shareholders that are companies for the purposes of section 553 CTA 2010 and to certain entities which are deemed to be bodies corporate for the purposes of overseas jurisdictions with which the UK has a double taxation agreement or for the purposes of such double tax agreements. It does not apply to nominees.

This tax charge should not be incurred if the REIT has taken reasonable steps to avoid paying dividends to such a shareholder. One of these actions is to include restrictive provisions in the principal company's articles of association to address this requirement.

Carrying on development and trading within a REIT

The business not comprised in the tax-exempt business is generally referred to as residual business. This means that a REIT can have a development business but that this will not be its dominant business (it must be less than 25% of the group's profits and assets).

The tax-exempt business may develop property for use within the tax-exempt business but:

  • if costs of development exceed 30% of the fair value of the asset as at the date the company becomes a REIT or if later the date the asset was acquired; and
  • the developed property is sold within 3 years of completion; then the company is taxed on the profits or gains on sale as if part of the residual business. If the disposal is made to another member of the same REIT group, no tax charge will arise.

Setting up a new REIT

Who wants to set up or invest in a new REIT?

The most likely beneficiaries of REITs will be:

  • experienced property investment managers looking to create general commercial property or sector focused investment portfolios which can attract investment from the retail and institutional market
  • life and pension funds, including SIPPs which can receive distributions tax free
  • ‘inadvertent’ property investors such as banks which have acquired properties through enforcement of security and are looking for an exit or long term warehouse to hold such assets
  • companies which see the advantages of being public companies now outweighing those of being private companies because of the ability to eliminate CGT liabilities when buying other property companies – to be worthwhile such companies will need to be desiring to acquire property
  • widely held funds structured on or offshore, nervous that HMRC will want to rein in non-REIT tax transparent structures or offshore arrangements.

Main challenges

Before the recent changes, there were some significant obstacles to setting up a new REIT:

  • the need to have at least 3 properties –this one still applies;
  • the requirement that the REIT be listed on a stock exchange recognised by HMRC;
  • the requirement that the company should not be a close company; and
  • raising money through the ‘traditional’ IPO route

The relaxation of the rules on close company status and the ability to list on AIM and PLUS significantly reduce the initial burden and challenges of acquiring REIT status. AIM’s rules are significantly less onerous than the LSE’s main market and the costs of a listing would be similar to those of the CISX. However, AIM offers better (if not stunning) liquidity than CISX.

In addition the removal of the 2% entry charge makes the regime even more attractive. The three year delay to having to have a significant number of shares in public hands should also make marketing a REIT down the line easier as it has proved difficult to launch new REITs into the market through the traditional IPO route. The grace period also allows the management to build up a track record prior to having to ensure a wider distribution of the company’s shares.

Even after the changes, the UK IPO market, especially AIM, remains moribund. It has proved difficult for market participants to get IPOs of REITs away given market conditions since 2007. In part this may be blamed on the fact that the traditional UK IPO route – placing to institutional investors – is not ideal. Institutional investors can probably take advantage of their ‘sophisticated investor’ status and invest through alternative tax transparent offshore vehicles in a more tax efficient way. The idea of an ‘offer for sale’ along the lines of the BT and British Gas privatisations of the 1980’s is today largely defunct because of both the costs and perceived risks of a public offering to the retail sector.

If a way can be found more easily to access a significant class of a new REIT’s ideal target investors – individuals and their pension schemes – in a relatively low cost way, for example by positioning REITs more as an investment product to be marketed through IFAs (more akin to ‘private’ REITs in the US) then there is a chance that the retail market for UK REITs may become more accessible and a major investment allocation in that sector. Indeed the FSA’s current consultation CP12/19 (Restrictions on the retail distribution of unregulated collective investment schemes and close substitutes) may actually have the effect of making brokers more interested in marketing premium and AIM listed shares to a retail client base given the fact that the recent Retail Distribution Review will diminish the IFA’s ‘distribution’ role. However the rules proposed currently by FSA would still make it very hard for IFAs to advise retail investors who wish to acquire REIT shares in an IPO or the secondary market.

The changes to the REIT regime may take us several steps closer to that and with developments in internet marketing and investment clubs there may be new possibilities if regulatory hurdles can be overcome. If the retail market is not the way forward, then perhaps the Treasury should look at making two simple reforms which could have the effect of creating onshore private REIT ‘equivalents’ for high net worth individuals and sophisticated investors. My suggestions would be:

  • allow (with appropriate tax safeguards) the creation of a tax transparent entity (such as an LLC or indeed the current LLP) which is not at risk of falling into the definition of unregulated collective investment scheme (LLPs are potentially caught by the definition). This reform would enable property funds to operate onshore and would cut out significant operational costs and regulatory burdens; and
  • remove the bias in the financial promotions exemptions against property based collective investment schemes. ‘High net worth individuals and ‘self-certified sophisticated investors’ (who are currently blocked from the exemptions) can just as easily assess the merits of putting their money into a fund which invests directly in property as they can in investing in a fund which invests in shares or bonds. In fact property must be a much easier asset class to understand.

So the changes may well mean more new REITs will be launched on AIM. For now, however, given the state of the IPO market, unless IFAs and brokers turn their attention to marketing new REITs to retail investors and retail investors get an appetite for them, it will be some time yet before new REITs really take off.