Finance and Tax Blog for individuals and companies

It has been reported that there is circa £213bn secured against property in the UK of which £153bn has to be refinanced by the end of year 2016 (source Financial Times 5th June 2012). New financial products are being introduced into this sector of the debt finance market.

Many UK banks are locked into rebuilding their balance sheets following recent financial market turmoil. This appears to be affecting available finance for the UK mortgage market. However, it is apparent that the gap left by banks is being addressed by institutional finance from pension funds, insurance companies and specialist investment funds. These investors are looking to generate a premium on cash investment like products compared to the current low yield on UK gilts.

Professional investors look more closely at the quality and covenant of the underlying borrowers and/or tenants. The mortgage bonds are structured to match the liability profile of the lending institution and in effect create a sound base for funding long term debt compared to banks who typically fund their mortgage liabilities with retail deposits with on demand withdrawals and the inter-bank market with periodic roll over’s.

A UK approved investment trusts could be used to facilitate mortgage finance. The Trust concerned would raise money from retail and institutional inventors. The shares could be listed on the UK stock exchange. Under the Interest Streaming Regulations an investment trust is allowed to make certain distributions as interest distributions instead of normal dividend distributions. This enables UK pension funds, ISAs and other tax exempt investors to receive the interest from the underlying investment trust without deduction of UK withholding tax.

An approved UK investment trust could also be used for infrastructure finance and another article will be published on this topic.

Following a consultation last October the government last week published a draft of the first revision since 1965 of rules governing UK approved investment trusts, which could make these closed-ended vehicles more competitive with open-ended funds. It will give fund managers and fund sponsors effective alternative fund product strategies to market. In particular the new vehicles will be able to design and implement strategies to give investors a higher income yield as they can pay out part of the overall return from capital.

“The Association of Investment Companies (AIC) says the new rules will increase flexibility in the trusts’ investments, reduce their administrative burden in complying with the tax code and lessen the risk that they will lose their investment trust status After negotiations, Ian Sayers, the director general of the AIC, says investment trust managers got everything they had asked for, and more within the new set of rules.”

Approved investment trusts which must be UK tax resident do not pay UK corporation tax on net realised/unrealised capital gains or losses. This makes them a particularly attractive vehicle for retail investors who can select particular investment trust strategies say, international or commodities and not pay CGT until disposal of their holding of shares subject to the annual exempt CGT amount. Dividends, however, are subject to additional tax for higher rate or additional rate taxpayers.

In particular, the FSA’s retail distribution review forces financial advisers to consider investment trusts for their clients along with other types of investment product.

In summary the proposed changes are:

• Regulators would test the spread of risk within investment trusts, which would be able to invest 20% of their portfolio in a single issuer rather than 15% currently;
• The new rules will also provide more certainty on which transactions are treated as investments for tax purposes. This will bring trusts in line with open-ended funds who have had access to the so-called HMRC white list on financial strategies treated as trading or investment;
• Remove the annual retrospective approval process whereby upon filing the annual corporation tax self assessment return a trust would apply for approval status that it had met the eligible conditions under Section 842 ICTA 1988;
• It is thought that although the EU also regulates the sector under its Alternative Investment Fund Managers Directive (AIFMD) recent changes in regulation will be beneficial;
• Rules are introduced to enable a trust to pay out part of its income yield from capital;

In conclusion the new draft regulation is implemented in its present form, fund managers will have greater flexibility in how they can invest.

Real Estate Investment Trusts (REITs) were introduced in the UK with effect from 1 January 2007. They are structured as listed closed-ended investment trusts. The regime allows companies carrying on a property rental business to benefit from exemptions from UK corporation tax on property related income and gains, provided they meet certain conditions. Under current law, the holding company of a REIT group must be UK resident and listed on a recognised stock exchange. REITs are required to distribute at least 90 percent of their tax exempt income profits to investors. A conversion charge applies to companies adopting REIT status, equal to 2 percent of the market value of their investment properties at the date of conversion. There are about 20 or so REITs established so far.

One of the social aims at the time had been to encourage a professionally managed private rented sector to provide more flexible housing options.

In the 2011 Budget the Government announced proposals to simplify the REITs regime in particular dealing with the close-company provision together with a disaggregation of Stamp Duty from up to 4% to around 1% on bulk house purchasing by large investors. This should make REITs more commercially attractive to institutional, retail and other investors who want to invest in, and/or restructure their current holdings in residential and commercial property.

The Government said informal consultation on such proposals will start immediately with legislation promised in 2012. Subject to the responses the Government will make changes both to reduce the barriers to entry and investment and to reduce the regulatory burden for existing and future REITs.

In summary the key 2011 Budget proposals are:

1. Changes to the ownership requirements to allow a narrower group of investors
2. Changes to the listing regime enabling listing on other exchanges such as AIM
3. Abolition of the 2% entry charge on conversion of a property portfolio into a REIT
4. Allow cash to be a ‘good asset’ which in turn also enables seeding a new property portfolio and enhances ongoing liquidity requirements
5. Seek views on the introduction of a diverse ownership rule for institutional investors which will enable them to meet the non-close company rule. The rule catches the top five shareholders being those each having 5 percent or more of the votes who cannot collectively hold more than 85 percent of the votes. This rule precludes most insurance and pension funds from forming REITs.
6. As it stands, the closed-company rules applying to UK REITs do not recognise the underlying diverse ownership that pension funds and life funds have.
7. Look at extending the time limit for complying with the distribution requirement in particular circumstances involving stock dividends to reduce the administrative burden on those REITs that pay out dividends on a six monthly basis.

The Government issued a consultation document earlier this year which proposed the modernisation of the tax treatment of UK resident investment trust companies (‘ITCs’). ITCs are closed-ended investment funds whose shares are listed on the stock exchange. A number of ITCs are established in Guernsey as UK tax resident to enable them to return capital to shareholders in certain circumstances. Company law in Guernsey is more flexible than the UK but this has given some concern to HMRC on whether such funds fall within the definition of offshore funds and in scope of the UK Reporting Fund Regime applicable to open-ended investment funds.

Following public consultation, HM Treasury now publish revised proposals amended in a number of key areas to take into account some of the representations made by industry. This update examines such proposals.

• Responses were generally positive but in the main two particular areas of concern emerged: First, HMRC had proposed to remove the 35% voting exclusion where an ITC would meet one of its eligible conditions if at least 35% of its voting shares are held by the public. This meant an ITC could not be treated as a close company and in turn loss its exemption from capital gains tax on net realised gains on its underlying investment portfolio. HMRC have decided to adopt a grandfathering approach by retaining the above exclusion in its current form for all ITCs approved by HMRC before the new provisions take effect. However, it is clear that HMRC had concerns about a small group of investors who had been seen to exploit the favourable ITC CGT exemption.
• Secondly, a proposed reduction from 15% to 10% in the amount of gross income from its shares and securities that can be retained. In contrast a UK reporting fund has to report 90% of its income attributable to investors in open-ended offshore funds.
• Currently an ITC can retain 15% of such income. It was proposed to alter this test to 10%. Industry wanted to retain the 15% test since in their view it gives flexibility to maintain dividend levels to its shareholders. A reduction could make ITCs less commercially attractive. Government has confirmed that an ITC may retain 15% of its total gross income from all sources rather than solely shares and securities.
• A further article will be published on the new characteristics based definition of a closed-ended investment fund.