UK: The REIT Stuff

With a new discussion document emerging from the smoke and noise of Budget Day, the Government still seems on track to bring the UK property sector in line with that of the US, Australia and other countries and introduce measures to create tax-efficient Real Estate Investment Trusts (REITs) in next year’s Finance Bill. However, while the discussion paper shows that the Government’s thinking has moved much further forward on what a UK-REIT will look like since its consultation paper last year, it still leaves a number of questions unanswered and gives a relatively short period of time for quoted property investment companies and others considering taking advantage of this new vehicle to plan how to do so.

The biggest unresolved issue is that the Treasury and Inland Revenue have still not given any indication as to how companies and other property investment vehicles will be taxed on converting to a REIT, beyond saying that there would be a charge. The discussion paper says no decision on this can be taken until other outstanding technical issues, which will be considered by a Working Party, have been finalised. However, as two of the key objectives for the regime are to promote new property investment and ensure no less income accrues to the Exchequer through a REIT investment than would through direct property investment, it may be assumed that whatever conversion charge mechanism is adopted will certainly provide no giveaways.

What is clear from the discussion paper is that a UK-REIT will be a closed-ended company, so that it will not have to hold back cash to meet redemptions by investors, with a minimum number of shareholders controlling it. It is proposed that a minimum 75 per cent of the REIT’s income should come from "ring-fenced" activities of renting out property and at least 75 per cent of its assets should relate to these activities. Income and gains arising from the ring-fenced assets would be exempt from corporation tax provided at least 95 per cent of the income is distributed to the REIT’s investors.

Individual shareholders would be taxed at their marginal rate on distributions of ring-fenced profits, basic rate tax having been deducted at source, while for corporate investors such income would be treated as property income and included as part of their ordinary taxable profits. Income and gains arising from non-ring-fenced activities, such as property development and services related to letting, would incur corporation tax and, on distribution to individual and corporate investors, would be treated as a normal dividend in their hands.

Unfortunately, the neat symmetry of tax exemption for the vehicle, taxation for the investor is spoiled somewhat by the fact that the UK-REIT will have to pay Stamp Duty Land Tax of up to 4 per cent on acquisitions of property. Investors’ share transactions will also be subject to 0.5 per cent Stamp Duty.

There is, meanwhile, still no confirmation whether the 95 per cent distribution requirement will be before or after the cost of depreciation on the ring-fenced properties, as well as capital allowances and interest costs. The discussion paper notes that a large number of respondents to the consultation documents warned that without taking depreciation into account, the 90 per cent distribution threshold mentioned in last year’s document would leave too little to cover the full cost of maintenance of the properties and vacancy periods. The fact that a higher 95 per cent rate "after appropriate deductions" is proposed suggests that Government may be considering making the 95 per cent requirement at an after-depreciation threshold.

Other questions from last year’s document remain unanswered, including how group structures will be dealt with and how much borrowing a UK-REIT would be allowed to take on. Although respondents to the consultation document have pointed out that REITs elsewhere in the world tend to be less geared than property investment companies without any restrictions being applied, the Government remains concerned that high levels of borrowing could reduce a UK-REIT’s income distribution to investors and therefore the tax yield to the Exchequer; worse, artificially increased borrowing could allow companies to channel interest and property income payments separately to different types of investor to achieve the most tax-efficient position, which it says would not be consistent with the principle of REITs as property income distribution vehicles. One option being considered is to limit borrowing to a prescribed ratio of interest payments to income, or debt to equity.

A final decision as to whether or not the UK-REIT should be listed is yet to be taken. The Consultation Document had suggested that all UK-REITs should be listed, mainly because of the transparency provided by stock exchange reporting and other requirements. It now seems less certain that listing would be compulsory as potentially high compliance costs might prevent small companies converting to, or establishing themselves as, UK-REITs and with so few listed residential property companies as it is, allowing UK-REITs to develop initially as unlisted it is considered could increase the size and scope of the market.

Indeed, with the Treasury and Inland Revenue also still to decide the technical issues of non-UK companies being REITs and the tax treatment for non-UK resident investors, perhaps too much about REITs still remains up in the air for property companies and investors to start putting their own plans for a REIT on the ground.

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© MacRoberts 2005

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