The booming global property investment market has made Real Estate Investment Trusts (REITs) one of the fastest expanding areas of stock markets since 2000, particularly in the United States, but also in Japan and France where they were launched in 2001 and 2003 respectively. The UK Government has now committed to introducing UK REITs in the Finance Bill of 2006 and they are the most hotly anticipated investment vehicle in the UK property sector.
However, GREITs have always been available to UK investors and it is estimated that there is more than 3 billion pounds in listed property companies in Guernsey. These companies are readily available to UK investors and provide most of the benefits of a REIT not only from a taxation perspective but also from an investment diversification perspective.
The considerable increase in GREITs illustrates the potential for an onshore equivalent structure. We shall look at the conditions a company must satisfy in order to become a UK REIT; the problems with the current draft legislation and the issues affecting a conversion of a GREIT to a UK REIT; and the continued advantages of establishing GREITS in Guernsey.
To qualify as a UK REIT an entity must:
- be a closed-ended, but not a closely held company, resident in the UK, that is publicly listed on a Recognised Stock Exchange;
- separate out its income between taxable and non-taxable portions, referred to as ‘ring-fenced’ (non-taxable) and ‘non ring-fenced’ (fully taxable); and
- distribute at least 95% of its ring-fenced profits to investors and to withhold basic rate tax on these distributions to all shareholders whether UK resident or not.
- The ring-fenced part of the UK REIT should represent at least 75% of the entity’s activity by income and assets.
- UK REITs will be subject to an interest cover test on the ring-fenced part of their business.
- No person (including an individual or body corporate) will be allowed to control (either directly or indirectly) 10% or more of the UK REIT’s share capital or voting rights.
The draft legislation has been welcomed as a great step forward in the UK. However, there are still a number of important questions that remain unanswered.
The UK Government is keen to ensure that the switch to UK REITs is revenue neutral for the Exchequer but that the tax effect of the regime should replicate, so far as possible at shareholder level, direct investment in UK property. Consequently a conversion charge will be imposed on property companies wishing to convert to UK REITs.
The cost of entry is likely to be the key consideration for most UK companies and any existing offshore property funds in the short term but the government has not given any indication how the conversion charge will work in practice. For companies wishing to convert to UK REIT status the cost will need to be measured against the benefits of the new regime.
A UK REIT will treat all distributed income and capital gains from property investment as income and shall withhold basic rate tax of 22% on distributions made to shareholders including non UK residents. This is unlikely to be attractive to non UK residents as they currently pay no tax on gains. It is also not clear how this condition relates to the UK’s obligations under certain double taxation treaties.
In the past, success for property companies has been demonstrated by increased net asset values and, as such, companies have tended not to pay significant amounts of dividends. However, in other countries REIT shares are held as an income stock and investors expect a high dividend flow from them. Property companies that want to convert into UK REITs will therefore have to adopt a significantly different business model. The costs of doing so could be prohibitive.
The Government has opted not to specify mandatory gearing requirements. Instead, in relation to its ring fenced business the UK REIT will be subject to tax in respect of any amount by which the interest payable in respect of its ring-fenced business exceeds an interest cover ratio of 2.5.
It is not clear how or why shareholders holding more than 10% of current UK property companies would want to reduce their holdings so that the company in question could convert to a UK REIT.
Given the problems with UK REITs Guernsey continues to be attractive to promoters of real estate funds.
Over the years Guernsey’s administrators have developed a sophisticated infrastructure for the administration of GREITs and have developed considerable expertise in this area. The regulatory process for the establishment of a GREIT is well understood and clear. There is a fast track process for the approval of funds with the recent introduction of "qualifying investor funds" which enables funds to be self-certified by the Guernsey administrator.
The Channel Islands Stock Exchange (CISX) also provides a listing route for GREITs, which means Guernsey can act as a one-stop-shop for their establishment and admission to listing. The CISX is recognised by the FSA and the Inland Revenue which means that SIPPs and ISAs can invest in CISX listed GREITs. There are already over 20 property vehicles listed on the CISX.
GREITs can also be listed on the London Stock Exchange or the Alternative Investment Market.
GREITs can be established as closed ended companies or open ended investment companies and qualify for tax exempt status. Any income from dividends is paid gross and any capital disposal within it is free from capital gains tax.
There is no restriction on the diversification of a portfolio of a GREIT provided there is an adequate spread of risk and there is also no restriction on the type of property business which a GREIT can undertake.
The CISX listing rules and Guernsey law and regulations do not impose any requirement on gearing levels for GREITS. Indeed the CISX is generally not prescriptive in terms of its listing requirements for GREITs.
On admission GREITs listed on the London Stock Exchange cannot borrow more than 65% of the company’s gross assets. However, the UKLA listing rules do not preclude a company from seeking shareholder consent to alter its articles of association after admission. Therefore the shareholders can, in theory, set whatever level of gearing they feel is prudent.
There is no requirement under Guernsey law or regulations for a shareholder in a GREIT to be limited to only a 10% holding.
GREITs which are already readily available to UK investors provide most of the benefits of a REIT not only from a taxation perspective but also from an investment diversification perspective. For this reason, in our view, it is unlikely that the introduction of UK REITs will have any significant effect on the number of GREITs coming into Guernsey, given that to date many of them have been established for institutional investors only. Even if the legal framework for UK REITs goes as far as the UK funds industry wants it to, it is likely that UK REITs and GREITs will happily coexist alongside each other. Indeed there is nothing to stop clients formulating their own plans for UK REITs by setting up GREITs that closely mirror the conditions laid down in the draft legislation in preparation for converting them into a UK REIT in the future.
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.