Summary and implications
The Government introduced tax breaks for UK property funds in 2008. It has taken five years for the industry to start responding. Now we are seeing authorised investment funds being launched as property authorised investment funds (PAIFs). Why the delay? Market conditions have played a large part in the lack of action. However, there are still practical and tax issues to be resolved.
Combining the flexible regulations of qualified investor schemes (QIS) and tax efficiency may give business opportunities to fund managers to offer new vehicles to the market.
Types of authorised funds
Before a fund can become a PAIF it must be authorised. The real estate authorised fund market is relatively small in the UK, at about £8.5bn.
Authorised funds are of two legal types:
- an open-ended investment company (OEIC), where the investor holds shares in a company; or
- a unit trust, where the investor holds units in a trust.
Until 2007 all authorised funds investing in real estate were established as unit trusts. This was driven by the familiarity of unit trusts in the real estate sector. Now a few have emerged in OEIC form. In order to qualify as a PAIF, an authorised fund must be an OEIC. This will be a change that fund managers must take on board.
Forms of authorised funds
While there are two legal types, there are various regulatory classifications, regardless of the legal form taken.
Real estate is not an eligible asset for a UCITS fund or a tax exempt fund. In the UK non-UCITS retail schemes (NURS) are funds outside the UCITS framework and can include real estate as an asset.
In the UK there are, in addition to NURSs, QISs. These are aimed at sophisticated investors, being institutions or individuals with sufficient expertise to understand the risks. QISs are subject to lighter product regulation than NURSs. NURSs and QISs are regulated under the FSA
Handbook on Collective Investment Schemes (COLL). For a comparison of the differences see the table below.
We see fund managers using the QISs with the PAIF tax status. This may create a product suitable for institutional and professional investors, which is taxed like a REIT.
Exit and pricing
OEICs are open-ended. This means that on notice an investor can get his investment back from the OEIC rather than having to sell his shares to a third party to achieve an exit.
A fund manager will have to be prepared to manage an open-ended vehicle to take advantage of the PAIF regime. Retail investors in authorised funds are used to daily dealing. This can be a challenge when most real estate funds aimed at institutional investors are unauthorised and closed-ended.
The pricing of redemptions is based on net asset value, but a bid offer spread will apply to deal with the costs of entry and exit into the real estate market. Fund managers do retain cash in liquid assets such as REITs to meet liquidity provisions.
Click here to view table.
A big impediment to the growth of PAIFs is operational issues. Authorised funds are transacted and administered on supermarket platforms. Few fund platforms and administrators have implemented system changes required to stream different types of distributions and provide a consolidated tax voucher. The cost of doing this manually has put off many fund managers. The impetus to change has arrived as a few PAIFs have launched and tax elected funds are on the horizon, which also require a multiple distribution stream capability from administrating and platforms.
The European Union has been assessing if the current law deprives private investors of real estate product choices.
Today, fund managers cannot market a NURS to investors living in other EU countries. This is unless the fund is approved by the regulators in each country and complies with the terms for regulated funds in each country. This is a near impossible task. Apart from the huge amount of time and cost incurred to achieve this, each country has different requirements, some of which conflict.
To examine the discriminating issue for real estate funds, the EU commission set up an expert group. Nabarro partner Deborah Lloyd was a member of the expert group. The expert group looked at the current barriers to passporting, the existing national laws and the options for an EU passporting regime for real estate funds.
Germany is the biggest market for real estate open-ended retail funds and it has been discredited following liquidity issues and pricing. The German government is proposing to prohibit the launch of new open-ended funds.
Given this, it is unlikely that change at EU level will come fast.
The authorised funds taxation model was designed to deal with funds investing in equities and bonds rather than property. Generally, an authorised fund is taxed at a rate of 20 per cent on income, but is exempt in respect of capital gains.
Authorised funds may make two different types of distributions depending on the type of income they earn. Where 60 per cent or more of a fund is invested in bonds then interest distributions can be made. These are allowable as deductions in computing taxable income but, due to the 60 per cent test, are not likely to be relevant to authorised funds holding property. Where the 60 per cent test is not met, then only dividend distributions can be paid out. As with any corporate, dividend distributions paid out by an authorised fund are not deductible in computing the amount of taxable profits.
Direct property holdings by the authorised fund would generate rental income, which would be taxed at 20 per cent.
The only UK investors for whom the system is inefficient are lower rate taxpayers or non-taxpayers which includes charities, pension funds and life companies who cannot claim back the tax credit and so the tax paid by the authorised fund is an actual cost.
Authorised funds holding property can elect to be taxed in a similar way to REITs.
PAIF has become the new acronym to describe the property authorised investment funds that elect into this tax regime.
The framework, introduced in April 2008, moves the point of taxation from the PAIF to the investor for the “ring-fenced” property investment business. The result is that investors face broadly the same tax treatment as they would have had they owned real property or REIT shares directly. This means low or non-taxpayers are not disadvantaged.
There will be costs of converting existing structures into PAIFs. Stamp duty land tax is a big hurdle. Whilst existing authorised funds can convert SDLT-free, there is no exemption for unauthorised unit trusts to convert and not pay SDLT. This in itself will be an impediment to the idea some have that PAIFs are the catalyst to bring the offshore funds back onshore.
Another deterrent is that no corporate shareholder can be directly entitled to more than 10 per cent of the net asset value of the fund. This could be overcome with an authorised unit trust acting as a feeder. There is SDRT exemption for feeder funds and simplified regulation regarding distributions to feeder funds. However it adds to the complexity of the structure.
The highlights of the PAIF regime
- OEICs (but not unit trusts) have the benefit of REIT-style taxation. This is why OEICs are the vehicle of choice going forward.
- There is no entry or conversion charge.
- The regime is elective not mandatory.
- SDLT is not triggered for funds transferring from an authorised unit trust to OEIC form.
- The funds need to have a wide shareholder base and “genuine diversity of ownership”.
- The property portfolio must comprise property holdings of 60 per cent or more (40 per cent in first year).
- 60 per cent of income must come from property investment business (40 per cent in first year).
- Listed REITs count as property holdings.
- Foreign property held in an SPV counts as a property holding.
- Breach of the conditions is not fatal. It is recognised that redemptions may cause breaches.
In light of the new regime, all fund managers have been considering whether existing unit trusts should be converted to OEICs to benefit from the new tax regime. M&G has led the way and converted its authorised fund to a PAIF. Others will follow but it will depend on whether the costs of conversion outweigh the benefits to investors. Certainly we see all new property authorised funds being established as OEICs with a view to electing to be a PAIF.
It is unlikely offshore funds will come back onshore.