Finance and Tax Blog for individuals and companies

The Government is about to relax its rules on the treatment of UK Real Investment Trusts (REITs) in particular to rejuvenate the tarnished credit melt down buy-to-let market for residential investment:

The Government is keen to encourage new and affordable housing stock and encourage private investors who want residential property investment to obtain it through a commingled investment vehicle rather than on their own. REITs are able to borrow mortgage funds more tax efficiently than private investors as REITs would be perceived to have greater diversification of properties held and spread of tenant risk to voids and bad debts through non-payment of rent.

The advantages to private investors are:

(a) receive dividends from the underlying net rental stream;
(b) have no personal mortgage debt to manage;
(c) and have the same capital gains tax breaks as with direct investment.

There is also better liquidity for such investors as they would be able to dispose of all or part of the investment quickly and on a piecemeal breakup basis if it so suited exit and efficient capital gains tax planning.

There are other more technical changes afoot to enable pension funds and insurance company’s spin-off their commercial property portfolios into public ownership while at the same time retaining a stake for the benefit of their pension and policy holders.

We have been following proposed changes to REITs from the budget 2011 onwards. These are noted and explained in our earlier Posts on the subject:

• Real Estate Investment Trusts (UK REITs) (March 31 2011)
• Real Estate Investment Trusts (UK REITs) – Update on Proposed Changes (Nov 2 2011)

In an earlier article in March 2011 following Budget 2011 we outlined a number of proposed changes to the rules for UK REITs to encourage investment in real estate including residential property and make them more structurally attractive to institutional investors. The proposed modification to the rules should encourage seeding of a REIT by institutional investors.

The UK Government has now given its initial response to the above Budget REITs consultation and proposes the following:

• The REIT conversion charge being 2% of gross assets payable on entry into the regime will be abolished. This rule had been introduced to extract a tax levy on property assets otherwise subject to corporation tax on chargeable gains being transferred into the new REIT regime. A number of institutional investors and overseas property companies are however exempt from UK capital gains tax e.g. pension funds and there is a separate tax regime for the taxation of life unit linked funds.
• The Listing requirement will be relaxed to allow REITs to list on AIM and PLUS markets together with their foreign equivalents. However, the Government has reiterated that these changes are not intended to allow private REITs.
• Close company requirement: the current closed-company rules applying to UK REITs do not recognise the underlying diverse ownership that pension funds and life insurance funds have in terms of beneficiaries and policy holders. This meant that the top five shareholders being those each having 5% or more of the votes of the REIT cannot collectively hold more than 85% of such votes.
• The above rule is to be replaced by a new “widely held” condition. A fixed three year grace period will be introduced for a REIT to meet the restrictive close company condition. If at the end of the three year period the close company condition is not satisfied REIT status will be lost but there will be no penalty for the failed REIT provided there are legitimate reasons for such failure.
• Diverse institutional investors: certain types of institutional investor (now awaiting draft legislation from the Government in December 2011 for a definition of such type of investors) will be able to hold shares in a REIT without causing a breach of the close company votes condition mentioned above if they are diversely owned.
• Finally there will be some housekeeping type changes to deal with cash being treated as a “good” asset in the balance of business asset test; profits/financing ratios; and an extension from three to six months to the time limit for meeting the distribution requirement.

It is expected that the Government will introduce the changes in Finance Bill 2012.

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.

Our previous briefing on property authorised investment funds (PAIFs) outlined some of the legal and commercial obstacles preventing a successfully launch of such investment fund vehicles. There is another major commercial issue around capital seeding of new PAIFs. Broadly, the tax rules state that PAIFs must have at least 60% of their assets in eligible property assets which include ownership of Commercial Property, Shares in Real Estate Investment Trusts (REITs) and certain offshore funds with similar attributes.

A number of property fund managers have funds based offshore in Jersey or Guernsey Channel Islands commonly known as JPUTs or GPUTs. Historically theses funds had been set up to enable managers to co-mingle onshore UK approved pension funds and overseas investors without tax sticking at the fund level. Where such funds wanted to attract UK SIPP investors a listing of the fund units on the Channel Islands Stock Exchange (CISX) broadly such funds had been structured as tax look through for income such that any UK tax attributable to net rental income could be recovered by UK tax exempt investors. The onshore equivalent to these funds was Exempt Unauthorised Units Trusts (EPUTs).

A way to tackle this seed capital issue would be to bring JPUTs or GPUTs onshore as first UK authorised unit trusts followed by a conversion to PAIFs. In general there are a number of UK tax breaks to facilitate this process with the exception of an immediate relief for Stamp Duty Land Tax (SDLT) on the first step of the migration process. Potentially SDLT at the rate of 4% on the underlying property portfolio could be triggered on migration of the PUTs onshore. However, there are legal aspects which could be addressed to mitigate this problem. Careful drafting of the PUTs trust deed of variation and changes to appointment of UK Trustees and retirement of offshore trustees could prove helpful to the fact pattern.

In addition to SDLT above there is a cash flow position to manage on UK VAT since for VAT purposes the first and succeeding steps in the on shoring process triggers a change of ownership. Again this matter can be addressed by careful planning. Government authorities are aware of these matters and are usually helpful in accommodating a commercial project plan.

During the last 5 years or so the UK Government has introduced a number of welcome initiatives to promote the UK as a Fund domicile of choice. To their credit they have engaged in extensive consultation with the Funds’ industry to meet its objectives.

Apart from the apparent success of the UK reporting fund regime (judged by number of new funds that have recently joined ). Why have some initiatives not succeeded so far?

In the first of these briefings we look at Property Authorised Investment Funds (PAIFs).

PAIFs had been introduced to cater for industry demands for an onshore equivalent of offshore property unit trusts e.g. JPUTs. Prior to their introduction tax stuck within a UK property fund for exempt UK pension funds including SIPPs and ISAs: Why? Because such investors could not obtain repayment of the UK tax credit on distributions paid out of net rental income subject to UK tax at 21%. Notwithstanding rectifying this potential tax leakage PAIFs are slow to gain momentum.

Clearly the economic downturn in property asset class where most fund managers were grappling with redemptions and management of liquidity has been a significant reason. There are, however, other issues:

First, the tax withholding treatment of net rental income paid to non-UK investors. This WHT can be reduced under applicable tax treaties with the UK. But in the case of an overseas exempt investor this can lead to a final tax and means they are not on par with UK exempt investors. In the case of an overseas investor subject to tax the amount withheld can be in most cases be set against local tax. It is difficult therefore to market an offering to both UK and overseas investors who want UK commercial property exposure.

Secondly, the tax avoidance measure on corporate investor holdings of 10% or more. HMRC have helpfully allowed a carve out from this rule enabling a corporate investor to structure their holding through a UK authorised unit trust but commercially this gives compatibility issues for a number of investors including fund supermarkets. While in the latter case we understand market developments are being taken forward to combat this obstacle to effective marketing it has nevertheless a 12-18 months lag on new possible launches.