The lobbyists at the British Property Federation and investors in the listed UK property investment companies will certainly be buoyed by the relaxation by the government of the proposed REIT regime rules in the Budget. But, where does that leave the hotel and leisure sector?
The highlights of last week’s Budget announcements in relation to the REIT regime include the following:
- Conversion charge set at 2% of gross asset value with possibility of spreading over four years.
- Interest cover test to be a comparison between taxable profits (before interest and capital allowances) and finance costs with the target ratio reduced from 2.5:1 to 1.25:1. This means possible gearing in excess of 60%.
- Distribution requirements reduced from 95% to 90% of taxable profits after capital allowances.
- Extension to period during which that distribution must be made.
- Relaxation of the 10% shareholding rule such that REIT status is not lost but limited tax penalties applied in some situations where 10% shareholding exceeded.
- 75% qualifying investment and income test to be based on accounting profits rather than taxable profits.
- More flexibility in methods of capital raising of REITs.
- IAS need not be adopted.
It seems to the author, fellow commentators and indeed the stock market that all this now means that there will be a significant take up of REIT status by existing quoted property companies once the REIT regime comes into effect in 2007. This is of course to be applauded.
It is also likely that we will see a number of private real estate investment companies considering an exit via REIT flotations since the 2% conversion charge represents a significant discount as against the (double) capital gains tax bill that would have often arisen on private company exits.
On the other hand, offshore property structures are unlikely to come back onshore at a cost of 2% where tax would not otherwise apply.
What about the hotel and leisure sector?
As for the hotel and leisure sector, whilst we do still expect to see specialist hotel and leisure REITs there is one provision remaining in the REIT regime which adversely affects efficiency of hotel and leisure REITs and ultimately risks making them less competitive than we had hoped.
The provision in question requires that a qualifying REIT property is not owner occupied or let to a member of the REIT group. Readers may recall that CMS and others in the hospitality industry have for over a year pressed for the inclusion of hotels and certain facilities as an asset class qualifying for REIT status. Whilst it seems that our case was accepted, the above provision does mean that what is now a fairly typical Propco/Opco model for hotel and leisure investment will not be available for REITs. At least, it will not be available where Opco is part of the same group as Propco.
What does all this mean in practice?
It means that hotel and leisure REITs will be required to specialise in investment. Thus they will hold the real estate of the hotel and leisure facility but will have to lease that out (on fixed, variable or profit sharing terms) to an operating or an intermediary company (Opco) which will not be able to be a 75% subsidiary. This has two impacts. First, a stamp duty land tax liability will be implicit in the lease arrangements as group relief will not apparently be available. Secondly, there will need to be other shareholders in Opco and indeed it is possible therefore that Opco will be either a joint venture or some form of intermediary company operated by a specialist asset manager. Opco would itself manage the premises or grant a third party management contract. Additionally, if Opco is part owned by the REIT, care will need to be taken with the respective values of the real estate and the operating business to ensure REIT status. The need for financial guarantees of Opco performance will also be amongst the practical issues.
The question will be whether the SDLT and other (e.g. financial) costs in relation to the intermediate lease to Opco and the external or semi-external status of the Opco will mean that the costs related to hotel or leisure investment through REITs will be a disincentive or a handicap to their success.
Whilst we do anticipate that hotel and leisure REITs will be set up, we also remain sceptical whether existing owner-operator groups will use REITs as an exit route given that in most cases they are already entitled to substantial shareholding relief from UK tax as traders rather than investment groups.
That said, a number of the private equity and syndicate investors will undoubtedly look to REIT conversion or creation of new REITs as a possible exit strategy from their hotel and/or leisure portfolios. Given the likely (Propco/Opco) structure of their existing property holdings some restructuring will undoubtedly be necessary to achieve a REIT based exit.
The CMS hotel and leisure team will continue to lobby for alteration to the rules that prevent easy and cheap operation of a hotel and leisure REIT but in the meanwhile remain available to assist with preparation for and set up and administration of REIT structures.
For further information please contact Tax Partner Mark Nichols. Mark is a regular speaker at industry conferences on REITs and has been involved in lobbying for the inclusion of REITs.
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 28/03/2006.
