The long-awaited Real Estate Investment Trust ("REIT") tax proposals have been introduced as part of the recent Draft Taxation Laws Amendment Bill. Whilst the effective date will only be an undetermined future date to be announced by the Minister of Finance the proposals seek to standardise the tax treatment of Property Unit Trusts (PUT) and Property Loan Stock (PLS) companies. Currently the tax treatment of both these type of entities broadly result in tax deductible interest paid and distributions made to unit or linked unit holders, leaving the entity largely tax neutral.

REIT legislation has been implemented in numerous countries across the world and the South African legislation broadly reflects international policy in this regard. SARS has for some time expressed discomfort with the current tax treatment of PLS companies in particular, on the basis that the excessive level of interest paid to linked unit holders arguably constitutes a profit distribution. National Treasury argues that the continued tax neutral treatment of these entities would clash with the overall tax policy of debt versus equity which follows a substance over form principle.

In order to unify the approach for all property investment schemes the concept of a REIT is proposed. The REIT provisions will encompass both PUT and PLS tax regimes. The objective of the REIT is to provide investors with a steady rental stream that acts as a substitute for interest income whilst also providing capital growth stemming from the underlying properties.

A REIT is defined as a South African resident company (which now includes a PUT), the shares of which are listed on the JSE as a REIT, or an unlisted property subsidiary company (South African or foreign resident) of a REIT. By definition a foreign property fund, for example incorporated in Mauritius, cannot be a REIT unless it is a property subsidiary of a South African REIT.

The new proposal provide that any rental distribution made by a REIT during a year of assessment to a shareholder in the REIT will be deemed not to be a dividend or capital distribution, will be deemed to be a tax deductible expense and will be regarded as gross income from a source in South Africa in the hands of the recipient. A rental distribution is defined as an amount distributed by a REIT if during the immediately preceding year of assessment more than 75% of the gross income of the REIT consisted of one or both of the following categories of income: rental or similar income from immovable property, or amounts received or accrued as distributions from another REIT. The effect of this is that the rental and similar income distribution will not attract tax in the hands of the REIT provided the qualifying criteria of a rental distribution are met.

Any amount received by or accrued to a South African tax resident REIT in respect of a financial instrument (e.g. loans or shares) must be deemed to be taxable income. This includes dividends, interest and gains on disposal of property. No exemptions apply for these amounts (e.g. participation exemption on dividends). Based on normal interpretation principles these types of income will also not qualify as being income similar to rental (i.e. income arising from the property) and will therefore not form part of the two categories of income required to achieve the 75% threshold for a rental distribution. Gains realised on disposal of assets by a REIT are expressly excluded from the capital gains tax regime.

All distributions by a REIT that do not qualify as a "rental distribution" as described above will be regarded as a dividend. No tax deduction will be available and dividends tax will be payable to the extent that it is not paid to exempt shareholders. Based on normal tax principles, a market related interest charge should still be deductible in respect of any debt component of the linked unit. That said, one of the requirements to list as a REIT is that the company should not be excessively geared. The remainder of the "excess" interest currently paid through a PSL tax neutrally, will now become a dividend, resulting in taxable income in the hands of the REIT. It will also impact on the returns of linked unit holders.

The impact of the new legislation is far reaching for property investors and many aspects of these proposals require careful consideration. An area of particular concern relates to foreign investment in property funds. It is in most circumstances unlikely that South African property companies will be able to regard a foreign property fund in which it invests as a property subsidiary (control more than 50% of voting right). As such the foreign entity cannot be a REIT and income received from these funds do not count towards the 75% threshold for qualifying rental distributions. Especially in the African context most property investments will be held through local companies in country. This is in most instances a regulatory requirement of the country. Investment into these properties will be by way of shares and loans. In these circumstances a South African resident REIT must receive less than 25% of its income from non-REIT foreign property investment entities (in the form of interest and dividends) in order to still qualify for a tax deductible rental distribution in a year of assessment. The impact of this is likely to apply in the case of investment in an offshore property fund or in individual property companies that will not be subsidiaries of the REIT. Included in the 25% category of income will also be all interest and dividend income from unlisted South African property companies that are not property subsidiaries of the REIT.

In its current format the proposals will severely restrict the ability of South African property groups to expand and invest internationally. There are of course ways in which to plan and mitigate this dilemma but the interplay with these proposals and CFC legislation will most likely result in PLS companies paying tax on amounts they are not currently paying.

It is interesting that these proposals also coincide with the property industry's BEE Charter that was recently issued. One of the requirements for compliance with the economic development aspect of the Charter is for property development companies to invest at least 10% of their annual property development investments in under-resourced areas in South Africa. The proposals may signal a broader intent of the South African government to encourage property groups to invest in local South African development and property investment.

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