The 2019 Draft Taxation Laws Amendment Bill (Draft TLAB) proposes key amendments to the Real Estate Investment Trust (REIT) taxation regime. In particular, the proposed amendments provide clarification of the definition of “rental income” in the REIT tax regime in respect of foreign exchange differences and also clarify the interaction between the corporate reorganisation rules and the REIT tax regime.
Clarification of the definition of “rental income” in the REIT tax regime
The dedicated taxation regime provided for in the Income Tax Act, No 58 of 1962 (Act) relating to REITs, makes provision for a flow-through principle in respect of income and capital gains to be taxed solely in the hands of the investor of the REIT and not in the hands of REIT itself. In turn, a REIT may claim distributions to its investors as a deduction against its income. This deduction may only be claimed if a distribution is considered a “qualifying distribution”, which, amongst others requires more than 75 per cent of the gross income of a REIT to consist of “rental income”.
The term “rental income” is defined in s25BB(1) of the Act to mean various amounts received and/or accrued to a REIT including most importantly an amount received and/or accrued in respect of the use of immovable property (ie rental income).
Given South Africa’s stagnating economy and the desire for South African REITs to diversify their investments, many South African REITs have invested (and continue to invest) in real estate outside of South Africa. Given these investments, many REITS enter into foreign exchange derivative contracts for purposes of hedging themselves against fluctuations in the highly volatile South African Rand.
National Treasury has, however, identified that unrealised foreign exchange gains or losses arising from the foreign exchange derivative contracts of a REIT do not qualify as “rental income” of a REIT, even though they are incurred solely for the earning of such “rental income”. Instead, such gains/losses are, in terms of paragraph (n) of the definition of “gross income” in s1, read with s24I(3) of the Act, taken into account in determining the taxable income of such REIT.
In order to address this anomaly, National Treasury thus proposes that changes be made to the definition of “rental income” in s25BB of the Act to include any foreign exchange gains and deduct foreign exchange losses arising in respect of an “exchange item” relating to the “rental income” of a REIT (or its subsidiary). The proposed s31 of the Draft TLAB thus contemplates two new insertions under the definition of “rental income” namely an “exchange gain” (EG) and an “exchange loss” (EL) which will be incorporated into the formula to calculate “rental income” for any REIT’s relevant year of assessment.
Clarification of the interaction between the corporate reorganisation rules and REIT tax regime
National Treasury has further identified an issue regarding the interaction of the anti-avoidance measures contained in the corporate reorganisation rules and the provisions of s25BB(5) of the REIT tax regime.
The Explanatory Memorandum on the Draft TLAB (Memorandum) states that in certain instances, if immovable property is disposed of by a REIT within 18 months after the implementation of the relevant corporate reorganisation, the anti-avoidance measures contained in the corporate reorganisation rules require that the rolled over capital gain in respect of such immovable property be added to the taxable capital gain of the REIT for the year of assessment in which the disposal of the immovable property takes place. On the other hand, s25BB(5) of the REIT tax regime provides for a capital gains tax exemption in respect of disposals of certain immovable property by a REIT. The anti-avoidance measures contained in the corporate reorganisation rules, when read with the provisions of s25BB(5) of the REIT tax regime, create a discrepancy given that in general, corporate reorganisation rules override the provisions for the taxation of REITs in s25BB of the Act.
National Treasury thus proposes that in order to ensure that the rules for the REIT tax regime are aligned with the corporate reorganisation rules, amendments should be made in the tax legislation so that corporate reorganisation rules do not give rise to capital gains tax on disposal of assets within 18 months after their acquisition by a REIT under a corporate reorganisation rule.
The issues identified by SARS regarding the REIT tax regime and the proposed amendments aimed at clarifying the issues are likely to be welcomed in the real estate industry.