National Treasury released the Draft Taxations Laws Amendment Bill, 2012 ("DTLAB") on 5 July 2012 for public comment. One of the significant new proposals of the DTLAB is the introduction of a South African Real Estate Investment Trust ("REIT") tax dispensation which will consolidate the existing property loan stock ("PLS") and property unit trust ("PUT") structures. The REIT regime is set to provide certainty in respect of the taxation of the current South African property investment structures and to bring such structures on par with leading international norms.
Vehicles for property portfolio investments
The PUT and PLS are currently the two main types of listed property investment schemes in South Africa. The PUT is regulated by the Financial Services Board ("FSB"), having been the traditional stakeholder for property investment schemes but whose popularity has waned over the years due to regulatory constraints. The PLS, the newer entrant, is governed by the provisions of the Companies Act 71 of 2008 and if listed then also regulated by the JSE Limited Listings Requirements ("Listings Requirements"). There are currently over 20 listed entities operating as a PLS and less than 10 listed entities that operate as a PUT, which entities are subject to the Listings Requirements. There are many unlisted PLS companies.
The PUT and PLS structures typically provide a commitment to distribute the major portion of their net rental income to investors. In a PUT, investors acquire participatory units in a portfolio of investment properties which are held in the form of a trust and are managed by an external manager. The distribution of rental income from the PUT is tax-neutral in the hands of the PUT if the rental income flows through to investors during the same tax year in which such income was earned. PLS companies appear to achieve roughly the same result, but often without the official sanctioning and restrictions regarding their gearing and payout ratios. PLS investors acquire a linked unit comprising a debenture linked to a share, with a "distribution" by the PLS in the form of tax deductible interest which results in the PLS reducing its taxable income. A PLS may be managed internally or externally, although there is a clear trend towards internal management.
Generally, a REIT structure is a tax regime that provides "flow though" on a pre-tax basis of the net property income of a REIT (after expenses and interest to third party funders, such as banks) to investors. The PUT and PLS therefore operate in the same space as a REIT. The REIT structure exists in countries like the US, the UK, Australia, Japan and Singapore and is becoming an international standard as property investment globalises.
Rationale for the reform
As illustrated above, the net effect of the PUT, PLS and REIT is that rental income received or accrued by the vehicle is effectively only taxed in the hands of the investor. However, although the South African property sector has delivered favourable forward yields compared to global standards in recent years, neither the PLS or PUT offers international investors the uniformity and simplicity to facilitate international investment. For this reason the Property Loan Stock Association ("PLSA") has spearheaded the establishment of a "best-of-breed" REIT vehicle to encourage foreign investment into the South African property sector.
From a policy point of view the REIT regime seeks to balance the dissimilar regulation of the PUT and PLS. Although both the PUT and the PLS are currently subject to the same Listing Requirements (if listed), only the PUT is subject to regulation by the Financial Services Board ("FSB"). The National Treasury notes in its Explanatory Memorandum to the DTLAB ("Explanatory Memorandum") that the additional regulation of PUTs reduces the flexibility of a PUT whereas the PLS faces none of these direct restrictions and also lacks the certainty of regulatory formalisation. As the dominant form of immovable property investment vehicle in recent years proved to be the PLS, the introduction of the REIT regime will accordingly result in a higher level of regulatory oversight of these entities.
An issue which also came under the scrutiny of the National Treasury is the tax deductibility of the interest paid by the PLS to its debenture holders. In this regard, the Explanatory Memorandum notes that from a substance-over-form point of view an "excessive level of interest (along with the profit-like yield)" makes this form of interest questionable in tax terms and "to accept this practice is to essentially abdicate the question of debt versus equity." According to the Explanatory Memorandum the yield in respect of these debentures should rather be viewed as dividends.
Introduction of section 25BB
In terms of the DTLAB a new section 25BB will be introduced to the Income Tax Act 58 of 1962 ("the Act"). The section essentially aims to provide certainty to investors in REITs (a defined term) with respect to the tax position of the REIT and the investor.
The proposed definitions of a "REIT" and a "rental distribution" should be considered to better understand the workings of section 25BB:
- A "rental distribution" is defined in section 25BB as a distribution which stems from income and receipts earned by the REIT in the current or immediately prior year of assessment, provided the total gross rentals received or accrued by the REIT during that year exceeds 75% of its total gross receipts or accruals.
- In terms of the DTLAB a "REIT" refers to a
company which shares are listed as a REIT or a "property
subsidiary" of a REIT in accordance with the Listings
Requirements. The Listings Requirements have not yet been updated
in this regard and it remains unclear what the exact requirements
are for an entity to constitute a REIT or a property
subsidiary. In terms of the Explanatory Memorandum the
following four requirements will have to be incorporated in the
founding document of an entity before the entity may obtain a
- the entity must have a minimum amount of gross property assets i.e. direct interests in immovable property (such as land and buildings), interests in a lease relating to immovable property, interests in a property subsidiary or holdings in another REIT;
- the entity must solely invest in immovable property assets and collateral debt instruments and hedges used to reduce the risk associated with property related loans;
- the entity must distribute most of its profits on a yearly basis; and
- the entity must not have excessive borrowing (i.e. gearing) in relation to the total gross asset value of all immovable property held by that entity.
In terms of section 25BB any "rental distribution" by a "REIT" to its investor will be fully deductible by the REIT in terms of section 11(a) of the Act. The "rental distribution" will not constitute a "dividend" and/or a "return of capital" for purposes of the Act. The "rental distribution" will be deemed for purposes of determining the "gross income" of the investor to be an amount received by or accrued to that investor by way of rental from a source within South Africa. No withholding tax on interest will accordingly be applicable to foreign investors. However, the rental distributions will be subject to South African tax in the hands of the investors.
Section 25BB also provides that any amount received or accrued to a REIT during a year of assessment in respect of a financial instrument must, if that REIT is a resident, be deemed to be an amount that is not of a capital nature and be included in the income of that REIT for that year of assessment. Any capital gain or capital loss determined in respect of the disposal of an asset by a REIT must be disregarded in determining the aggregate capital gain or capital loss of that REIT for capital gains tax ("CGT") purposes. The REIT will accordingly be exempt from CGT. This is a significant concession from Treasury but probably does not give rise to any major loss to the fiscus.
Considerations going forward
The proposed REIT regime is the result of an ongoing negotiation
process between the National Treasury, the South African Revenue
Service, the PLSA, JSE and various lawyers and tax advisors. One
particular proposal by the PLSA was that both listed and unlisted
REITs should be accommodated. The draft section 25BB does not
accommodate unlisted entities at this stage. The REIT regime is
limited to JSE listed entities and "property
subsidiaries" of a listed entity. Should the structure be
adopted in its current form and unlisted PLS companies do not fall
within the parameters of section 25BB, we expect that numerous
unlisted companies will give serious consideration to listing in
the near future.
It is also not yet clear when an entity will constitute a "REIT" or a "property subsidiary" of a REIT. Based on the ordinary meaning of "property subsidiary", it would appear that an unlisted PLS would have to be a subsidiary of a REIT for the PLS to fall within the ambit of section 25BB. Unlisted PLS companies may not always be within a parent-subsidiary relationship with a REIT. For example, PLS companies often conduct joint venture agreements with other property investment vehicles. A leakage of tax will occur if these companies do not qualify as REITs.
In order to benefit from the preferential tax treatment of REITs, PLS companies may have to amend their Memoranda of Incorporation to convert to REITs. Careful consideration of the CGT implications for the holders of linked units should be had, to the extent that the amendment to their rights constitutes a conversion or variation. The current proposed provisions do not specifically deal with a conversion of a PLS into a REIT and presumably the legislature will grant a specific exemption to unit holders in this regard.
The DTLAB proposes that section 25BB comes into operation in respect of years of assessment commencing on a date to be determined by the Minister of Finance. It is expected that section 25BB will only become operative during 2013 after further refinements have been made to address, amongst other, the issues raised above.