This quote promoting real estate investments above all others is often attributed to the 20th-century real estate investor Louis Glickman. The second-best investment for a real estate business, however, may well be a good tax advisor to consider and mitigate the numerous taxes associated with real estate investments. This article serves as a high-level roadmap, setting out different types of taxes that should be taken into consideration when setting up and growing a real estate business.
The owner of real estate would generally be qualified by tax authorities as the (principal) taxpayer, although users of the real estate (eg, tenant or usufruct holder) may also be qualified as such. The development of a tax-efficient property ownership structure ensures that significant value is preserved in that investment’s lifetime. The most notable levies in this respect are corporate income tax (CIT) and capital gains tax (CGT).
Local CIT may be levied on the profits generated with the real estate, generally the operating earnings minus the deductible expenses. Important aspects to consider include the CIT rate(s), depreciation rules as well as potential deduction restrictions.
In most countries, CGT is levied on the capital gains (profits) made on the sale of an asset that increased in value, such as real estate or a shareholding in a local (real estate) subsidiary. As a general rule of thumb, capital gains derived from real estate are taxed in the country where the asset is located (known as the situs principle). Many jurisdictions have (domestic) rules which also subject the sale of shares in a real estate subsidiary to CGT. In order to prevent double taxation, tax treaties are routinely concluded between jurisdictions to solidify this principle and to allocate taxing rights. A tax treaty may dictate that only one of the countries may levy CGT. Some tax treaties for example stipulate that a jurisdiction is not allowed to levy tax on the sale of shares in a real estate (rich) company, established in that jurisdiction. Spearheaded by the Organisation for Economic Co-operation and Development (OECD) with its anti-Base erosion and profit shifting (BEPS) project, the international community is in an ongoing process to avoid exploitation of gaps and mismatches between jurisdictions, including with respect to the (improper) use of the tax treaties. In some cases, this also concerns CGT on the alienation of real estate rich company’s shares.
While technically not a tax topic, bilateral investment treaties can also be important for international investors. In broad terms, the nationalization or expropriation of investments is typically prohibited under the BITs, unless such measures are taken in the public interest and the host state pays prompt, adequate and effective compensation to the investor. As such, particular attention should be paid to these treaties when envisaging investing in certain high-risk source countries.
Funding and treasury
In addition to the ownership structure, the financing structure can be equally important. Payments of dividend and interest may be subject to withholding taxes (WHT). As with the CGT, tax treaties may provide mitigation of WHT by allocating taxing rights to the investor and/or source country.
Returns from your target investment may also impacted by interest expenses deduction rules. Deduction of interest expenses may be restricted to a certain percentage by means of the “thin capitalization rule” (or “thin cap rule” for short). Such a thin cap rule may for example result in interest on debt in excess of four times the equity to be non-deductible. The restriction of deductions would result in a higher CIT taxable base.
Deductibility of interest expenses can also be (further) restricted by formal transfer pricing rules and/or the general at arm’s length principle. This principle requires related parties to conclude transactions on an independent basis, ideally resulting in fair market prices. Some jurisdictions have formal transfer pricing rules in place, which may require detailed reports to be kept substantiating that transactions with related parties are in line with the at arm’s length principle.
Local tax planning
Different tax aspects and incentives of the target source country should be closely reviewed. The acquisition of real estate (entities) may be subject to real estate (transfer) tax and/or stamp duties. Some jurisdictions apply different real estate (transfer) tax rates depending on the type of real estate (eg, a lower tax rate for residential real estate).
The acquisition of real estate may also be subject to value added tax (VAT) which may, or may not, be recoverable. In certain jurisdictions, a special VAT exception applies in case the acquired real estate is considered to be (part of) a business (the “transfer of going concern”), in which case the transaction would normally not be liable to VAT. Some countries may provide tax credits, capital allowances (similar to a tax credit) or certain environmentally driven depreciations/ incentives. Depending on the target jurisdictions, all three categories might be considered and could result in a lower domestic CIT basis.
Intellectual property planning
Certain types of real estate, such as hotels and restaurants, require a particular brand or formula in order to operate. For tax purposes, such as a brand or formula is typically referred to as intellectual property (IP)It is not uncommon to assign IP rights to a designated special purpose vehicle which sole purpose would be to license the IP to the real estate operator/owner. IP rights may provide for tax efficient structuring possibilities.
Countries may have transfer pricing and/or at arm’s length rules in place requiring licensing fees paid by group entities to reflect the fair market value. In order to ensure an appropriate allocation of the returns from the exploitation of IP, and also the costs related to the IP, it is a globally acknowledged principle to look at the functions of the entities involved, the assets used and the risks assumed in the “development, enhancement, maintenance, protection and exploitation” (DEMPE) functions of the IP. IP, being a relatively easy transferred asset across borders, is one of the OECD’s main focus areas. The OECD introduced the DEMPE functions for IP as part of its BEPS project.
Sustainability and growth
Once the ownership, financing and/or IP structure is in place, it is important that the day-to-day operations are optimally managed, also from a tax perspective. Taking into account liquidity requirements and internal fund flows, certain arrangements can be designed to achieve full tax efficiency in cash management. This is particularly important for the avoidance of any trapped cash, local expense deduction restriction rules and WHT.
VAT exposure is often hidden in organizations, but can have a major impact on the cash flow, particularly when unrecoverable. It is not uncommon for countries to have long-term revision rules for, among others, real estate. Such revision rules may require taxpayers to keep track of the use of the real estate and, under particular circumstances, repay previously recovered VAT.
Furthermore, some countries may have special incentive schemes for sustainable energy production, environmental investment rebates or arbitrary (or accelerated) depreciation of environmental investments.
Compliance and reporting
Operating real estate often triggers registration and filing obligations on both a national level (eg, CIT and VAT) and on a local level (eg, municipality tax). These various obligations may involve time-consuming and complex exercises, in particular for real estate investors active in multiple jurisdictions. Tax reporting policies and/or models should therefore be set up and ongoing compliance should be monitored.
Acquisitions and exits
Assets and businesses may be acquired by means of an asset deal and/or share deal. The chosen route generally depends on a mix of commercial, legal and tax considerations. In any scenario, due diligence should be conducted to determine historic tax risks and liabilities. Such risks and liabilities, and the integration of newly acquired assets and businesses in existing structures, need appropriate attention.
Based on the location of the target asset and/or the target entity, analysis should be undertaken to determine the most tax efficient acquisition structure, also taking into consideration a potential future exit. A proper exit from an investment should always ensure that tax does not wipe out significant returns on investment.
From the acquisition up to the sale of real estate, a myriad of taxes may be applicable to “earth’s best investment.” All real estate transactions should therefore be carefully examined and planned, including from a tax perspective to ensure tax efficiency