Summary and implications
In December 2012 HMRC responded to the earlier consultation on the tax treatment of REITs investing in REITs. They announced that they would introduce measures to allow the income of UK REITs investing in other UK REITs to be treated as exempt. The consequences of this are as follows:
- The property income distribution (PID) that a UK REIT receives from another UK REIT would be tax exempt.
- For the purpose of the balance of business (BoB) test the investment by a REIT in another REIT will be included as an asset of the investing REIT’s property rental business.
- The investing REIT must distribute 100 per cent of the PID it receives to its investors within 12 months of the accounting period in which it was received.
The current problem
If a REIT invests in another REIT then the PID received by the investor REIT is at present treated as income from property but is not treated as part of the investor REITs tax exempt rental business. An investment in another REIT is also treated as not within the tax exempt property rental business of the investor REIT for the purposes of the BoB. The REIT regime requires 75 per cent of a REITs asset to comprise assets used in their property rental business.
Why the need for change?
HMRC intends that the measures will provide three benefits to the REIT sector. These benefits were identified by respondents to the original consultation. They are as follows:
- Investment diversification. It was suggested that an existing REIT might seek to divest itself of part of its property rental business by separately listing a new REIT whilst retaining a stake.
- Better cash management. If a REIT has surplus cash, perhaps following a sale, it is currently unable to take a short term stake in another REIT so as to get a better return than that offered by leaving the cash on a short-term interest bearing deposit.
Tax implications. There is a certain illogicality in a REIT being able to avoid tax on an investment in another company if it can enter into a REIT joint venture election provided it holds a stake of more than 40 per cent but to suffer tax if it holds a lesser shareholding in a REIT.
Why a 100 per cent distribution requirement?
Without the requirement for an investor REIT to distribute 100 per cent of any PID received it would be possible for the investor REIT to act as a money box company to accumulate untaxed income. This would lead to a loss of revenue for HMRC.
What has not changed?
Several of those who responded to the consultation wanted HMRC both to relax the “holder of excessive rights” rule and to include REITs within the definition of “institutional investor”.
The “holder of excessive rights” rule effectively limits a REIT investor to a holding of 10 per cent in another REIT. The definition of “institutional investor” is used when assessing whether or not a REIT is close. A close company would fail one of the REIT rules. An “institutional investor” does not make a REIT close. Thus if these two rules did not apply to an investor REIT they could hold more than 10 per cent and would not be counted in deciding whether a REIT was close.
Unsurprisingly HMRC declined to adopt the suggestions, citing the possible loss of revenue as their reason.
Likely effects of the change?
The proposed reforms in legislation are likely to have a positive impact on the REIT sector and will be welcomed by the property industry. The key effects of the changes are likely to be as follows:
- Since they offer the potential for REITs to set up “Sub-REITs”, these Sub-REITs may have differing exposures to property risk and property types which may be attractive to different classes of investor.
- New entrants, such as sovereign wealth funds, may be encouraged to enter the REITs sector. New entrants can establish UK REIT vehicles to joint venture with existing REITs and benefit from increased tax efficiency.
- The reforms to the tax treatment of REIT in REIT investment may encourage offshore unit trusts to move onshore. Whether in fact this will happen in practice is difficult to judge. To date no offshore unit trust has specifically stated that it will do so.
The elephant in the room
Despite the strength of the arguments for change no-one has mentioned the possibility of an existing REIT using the proposed changes when looking to take over another REIT. As one REIT built a stake in another it would no longer suffer the tax disadvantage it would have in the past. Whether the introduction of these changes would hasten the takeover activity long suggested in the sector remains to be seen.
On 11 December 2012 HMRC released the draft clauses and explanatory notes for the Finance Bill 2013. These have been exposed for eight weeks of consultation and include the draft legislative changes necessary to bring in the changes outlined above. The draft clauses introduce the concept of “UK REIT investment profits” as the term for PIDs received by an investor REIT who will separate out this income from their other tax exempt property rental business income. It is this property rental business income that will be treated as distributed first when an investor REIT itself makes a distribution and in determining whether 100 per cent of any PID received is itself distributed.