In Germany, with the largest real estate market in Europe, the introduction of REITs has generated significant controversy. On 2 November 2006 the German government approved the draft law on German Real Estate Investment Trusts (G-REITs). On 15 December 2006 the German Lower House (Bundesrat) rendered a list of many suggestions for amendments. It is expected that the legislative process will be finalised by the end of March 2007, but nevertheless the Ministry of Finance announced that the law will become effective with retroactive effect as of 1 January 2007. The most exiting question: Will the final G REIT law exclude residential portfolios (as the current draft of the government does) or not (as the Lower House (and all important German real estate market participants) suggests). Residential portfolios account for a significant part of the German real estate market. In particular, private equity funds that are heavily invested in flats and residential housing portfolios had hoped for a successful exit using the G-REIT vehicle. Public authorities (cities and federal states (Bundesländer)) who have large portfolios had also hoped to be bale to enhance their cash position by sale through a G-REIT. Germany would be the only jurisdiction with such an exclusion, and thus partially lose the international competition for capital.
Due to uncertainty regarding timing, some other open legal questions and details in the structure realistically Germany will see the first G REIT IPOs after the summer break.
"Normal" Limited Stock Corporation
A REIT is a vehicle that invests in property and enjoys a measure of protection from corporate and trade tax. In return, the REIT has an obligation to distribute a significant amount of its cash flows to shareholders.
According to the government draft, German REIT stock corporations (REIT AG) will generally be unregulated stock corporations. Their business purpose is limited to the purchase, holding and sale of title of ownership and rights of use in rem to real estate in Germany and foreign countries, as well as the management relating to renting and leasing of such real estate and necessary ancillary services. All shares in the REIT AG must constitute a single class of ordinary shares with voting rights, issued against full payment of the issue price. The minimum nominal amount of stated capital is € 15 million.
At least 75 per cent of the total assets (valued at market value in the compulsory IFRS group accounts) of the REIT AG must be real property. Accordingly, the REIT AG may not hold more than 25 per cent of its assets in the form of participating interests. If these requirements are not fulfilled, or if the REIT AG will purchase a participating interest that will bring its total participating interests above the 25 per cent threshold, consideration must be given to sales or mergers within the group in order to achieve REIT status. However, such sales and mergers will generally trigger income and real estate transfer taxes. A further specified requirement is admission of the REIT shares to trading in an organised market on a stock exchange within the EU or the EEA. There will be no private REITs in Germany, a fact that greatly pleases the open-end and closed-end real estate investment funds.
Restricted Shareholder Structure
Direct shareholding of 10 per cent or more of the shares of a REIT AG is not permitted. This rule is designed to avoid the application of reduced withholding tax rates for foreign investors under many double-taxation treaties. The REIT AG’s free float must be 25 per cent initially and at least 15 per cent thereafter. For the first time, "free float" has been legally defined as the shares of shareholders who each hold less than 3 per cent of the shares . Contrary to preliminary deliberations, the current draft law does not provide for corporate-law sanctions and only tax sanctions are imposed. The shareholder-structure limitation is therefore regulated on a pragmatic basis. One interesting aspect of the law is the future economic significance of G-REIT free-float shareholders: they are the prerequisite for maintaining REIT status and will therefore not be disappointed to have been granted such a relevant position.
New Exit Tax Regulation
As a related measure, an exit-tax provision will be incorporated into income tax law. This provision will be applicable only during a three-year period ending 1 January 2010. Under this provision, a tax privilege will result if hidden reserves are realised for real estate assets held over a period of more than ten years as fixed assets of German property upon conversion into a G-REIT or upon sale to REITs, to preliminary REITs and (for reasons of equal treatment) to open-end real estate investment funds with private unitholders. In essence, only 50 per cent of the hidden reserves will be subject to taxation.
Fortunately, this privileged taxation also applies to sale-and-leaseback structures. This makes the G-REIT interesting for hotels, department stores and hospitals, infrastructure projects, etc. Sellers are likely to favour G-REITs and open-end real estate funds for future real estate transactions over foreign REITs, foreign investment funds and German companies without REIT or preliminary REIT status, for example, closed-end real estate investment funds. It may be argued that the ten-year time limit is too long or the three year time limit too short and that the group of privileged purchasers is too narrow. However, the new law’s exit tax provison is very likely to give significant impulse to the German real estate market.
The REIT AG itself will be completely exempt from corporate tax (Körperschaftsteuer) and trade tax (Gewerbesteuer). No privileges at all are envisaged with respect to property tax (Grundsteuer) and real estate transfer tax (Grunderwerbsteuer). Fortunately, beside the exit tax in case of existing hidden reserves there will be no entry charge on the fair market value of the REIT real estate assets like in the UK.
Taxation at Shareholder Level
As opposed to taxable stock corporations, the REIT shareholders must pay the full amount of tax on the high distributions (distribution of 90 per cent of the profit of the REIT AG is compulsory). Profits will be calculated on the basis of the individual accounts to be drawn up according to the German Commercial Code (Handelsgesetzbuch - HGB). Optionally, straight-line depreciation may be excluded.
An important aspect for foreign shareholders is a withholding tax of 25 per cent on the distributions, which can be reduced to 15 per cent in accordance with many double-taxation treaties. The latest amendment to the double-taxation treaty with Ireland even grants a reduction to 10 per cent; Ireland will probably become a very interesting holding jurisdiction for G-REIT investors. This shows that amendments to important double-taxation treaties are part of a functioning G-REIT system. Unfortunately, this has been neglected in past years. This is not changed by the equal standing with non-German REITs that the draft statute surprisingly envisages for reasons of equality of opportunity. In any event, German investors in non-German REITs must expect considerable tax increases on their investment returns.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.