UK: The REIT Is Here – Update August 2007

Last Updated: 27 November 2007
Article by Cathryn Vanderspar

  • More relaxed rules on start-ups
  • New rules for joint venture groups
  • Facilitation of demergers

The REIT Regime

This note sets out the position on the REIT as at August 2007, following the coming into force of the REIT legislation in January 2007 and subsequent amendments in Finance Act 2007.

Initially, nine of the major listed players in the industry converted to REIT status and the list is getting longer as the details of the rules become clearer. Finance Act 2007 has already confirmed further (previously announced) changes, including some facilitation measures for start-up REITs, enlargement of the rules for REITs in corporate joint ventures to include those in group joint ventures and relief from a double entry charge on REIT demergers.

The rules still do not yet deal with all aspects which the property industry would like to see covered, such as seeding reliefs for start-ups and acceptance of AIM listed and unlisted REITs. However, interested industry groups are continuing to lobby in these areas.

Why A UK REIT?

The primary attraction of a UK REIT is an onshore regulated vehicle suitable for investment by a broad range of investors (including exempt institutions and individuals) with exemption from UK tax at entity level on qualifying profits - provided it makes an appropriate level of distributions. Effectively, this avoids a potential double layer of tax and increases potential returns for many investors.

The Criteria For A REIT

Broadly, there are three different tests which need to be met to have and maintain REIT status:

  • company test made up of 6 conditions, which set out the required legal structure of the principal entity;
  • an investment requirement, made up of 3 conditions; and
  • a business balance test, made up of 2 conditions. In addition, there is a financing cost ratio and a substantial shareholder rule (relevant to 10% (plus corporate shareholders only)), a breach of which may carry financial penalties, but will not debar the company from REIT status. Group REITs are also permitted and certain interests in corporate joint ventures may also benefit from REIT status and the rules are adapted to cater for this. As a listed vehicle, the appropriate listing rules and corporate law requirements will also be relevant.

Company Tests

  • Structure: closed ended company (body corporate) (not an OEIC);
  • Place of Residence: UK tax resident only and not dual resident (in determining dual residence, treaty "tie breaker" clauses are relevant);
  • Listed or Unlisted: must be listed on a "recognised stock exchange". (This will include a full listing on the London Stock Exchange and many foreign exchanges (for example, South Africa, Dublin, Luxembourg and Channel Islands), but will not include a listing on the UK Alternative Investment Market ("AIM")). (Satisfaction of this test at the time of giving notice of entry to the regime is no longer required, provided that it is satisfied for at least part of the first day of entry);
  • Share Type: must have only one class of ordinary shares, but may have non-voting fixed-rate preference shares;
  • Investor Mix: must not be a "close" company for the REIT rules (unless it is only close by reason of ownership of its shares by a limited partnership which is a collective investment scheme);
  • Profit Extraction Restriction: must not be party to any loan, interest on which is profit or asset linked or at a non-commercial rate (save where the interest rate increases where profits reduce or vice versa), or which, on repayment, gives an amount more than the consideration lent or the amount repayable in respect of general listed securities. However, debt convertible to ordinary share capital will be permitted.

Investment Tests

  • Properties Test: the REIT must have at least 3 single properties from which tax exempt income is derived. Notably, HMRC’s view is that jointly held property will not count as a single property, as it cannot be separately let;
  • Value Test: the value of no single property should exceed 40% of the fair value of property rental business;
  • Distribution Requirement: 90% of the income profits of the tax exempt business must be distributed by way of dividend on or before the corporation tax filing date, unless prohibited by law or by the withholding requirement under the 10% corporate shareholding rule (see below).

Business Tests

Broadly this requires the separation of tax exempt property rental business from other activities: • at least 75% of gross income (as reported in its accounts) must come from tax exempt activities; and • at least 75% of value of gross assets in property must be allocated to tax exempt activities.

What Types Of Property Will Be Treated As Falling Within The Tax Exempt Property Rental Business ("PRB")?

Subject to specified exclusions, in principle, PRB will be all property in the UK or outside the UK which is, or forms part of, a Schedule A or Schedule D Case V business. The exclusions fall within two parts - those that are expressly set out in the legislation and those implied by reason of the narrow definition of PRB.

Express Exclusions From PRB

These are:

  • incidental letting of property used for the purpose of a trade;
  • letting of property which is temporarily surplus to the requirements of the REIT for its own occupation;
  • the provision of services in connection with property outside the UK, if income from this type of service provision would not have been taxable under Schedule A in respect of a UK property;
  • owner-occupied property (i.e. letting of property to a group member or to a company whose shares are stapled to those of the REIT (or a group member) and which (in each case) is treated, in accordance with GAAP, as owner-occupied);
  • transactions that fall within the rent factoring provisions;
  • income in connection with the operation of a caravan site if material trading activities are carried on in connection with the site;
  • rent in respect of electric line wayleaves, oil or gas pipelines, the erection of mobile phone masts or similar structures and rent in respect of wind farms;
  • dividends from other UK-REITs which would fall to be taxed under Schedule A.

Implied Exclusions

What are, perhaps, more interesting are, however, the implied exclusions. These include:

  • shares;
  • units in a unit trust (see below);
  • car parking income, taxable under Schedule D Case I;
  • cash awaiting investment (other than following disposal of an asset (see below));
  • property derivatives (other than derivatives hedging PRB); and
  • interest income.

These aspects clearly need to be managed carefully in practice and may dictate how transactions are effected.

Are There Any Other Restrictions On Investor Or Business Profile?

As mentioned at the outset, subject to meeting the precise REIT regulatory requirements from time to time, there are effectively three other aspects that need to be considered:

  • 10% (corporate shareholder) rule;
  • financing costs ratio; and
  • listing and other regulatory requirements (see below).

10% Corporate Shareholder Test. What Is The Purpose Of This?

The purpose of this test, from HMRC’s perspective, is to ensure that there is no tax leakage to the UK Government in the structure, as a result of double tax treaty or EU claims. The main concern is that, as the REIT is a company, any distributions (however they are categorised for UK purposes (see below)), will be treated as a dividend in the hands of a foreign shareholder. As a result of this, any non-resident corporate investor, resident in a treaty jurisdiction (or after 2009 in the EU) who is beneficially entitled to 10% or more of the share capital, voting rights or dividends may be entitled to claim exemption from (or reduced rates of) UK withholding tax on the distribution received.

So What Is Proposed?

The 10% corporate shareholder rules have come a long way from those first proposed, so that, generally, they should not prove a barrier to conversion:

  • unlike the initial generic substantial shareholder test, the rules now only apply where a distribution is made to a company which holds 10% or more of the rights to voting, dividends or share capital. For this purpose, "company" means a UK company or non-incorporated association (other than a partnership or local authority) or a foreign entity which is treated for international tax purposes as a body corporate. Notably, the rules will not now apply to shareholders who are (say) individuals or trusts;
  • there is no issue at all if no distribution is paid;
  • where a dividend is paid to such a company, tax will be payable by the REIT (see below) on the whole of that dividend, unless the REIT has "taken reasonable steps to prevent the possibility of such a dividend being paid". HMRC have said that they will accept steps as reasonable if their articles of association include the following criteria, provided they are properly implemented:

    "- a mechanism that can identify ‘holders of excessive rights’;

    - a prohibition on the payment of dividends on shares that form part of an excessive shareholding unless certain conditions are met;

    - a mechanism to allow dividends to be paid on shares that form part of an excessive shareholding where the shareholder has disposed of their rights to dividends on their shares; and

    - a mechanism that will deal with dividends that are paid in connection with shares that form part of an excessive shareholding."

  • the company may also put in place a mechanism to require disposal of shares that form part of an excessive shareholding if the shareholder does not make arrangements to transfer entitlement to all their dividends;
  • companies will still wish to ensure that their articles of association give them sufficient powers to show they have taken reasonable steps to avoid the payment, to ensure that they can avoid the charge in unforeseen circumstances;
  • if, notwithstanding the above, the rule is triggered, the lower of the amount paid to that shareholder company and the amount retained by it, beneficially, is treated as income received by the REIT and potentially subject to tax in the REIT, at effectively 22% (20% from 2008);
  • where there is doubt as to the interpretation of the rules, HMRC have said that they will apply them by looking to the mischief that they are intended to prevent;
  • the potential ability effectively to side step the tax charge by (say) dividend stripping, repos, disaggregation of holdings in a group context (subject to a relevant double tax treaty) or use of an appropriate feeder vehicle should ensure that, if properly implemented (subject to costs) this 10% issue should not be a major deterrent to REIT status or investment; and
  • finally, breach of this rule will not, of itself, jeopardise REIT status.

So Does This Mean That The 10% Shareholder Test Has Effectively Gone?

Certainly, with regard to dealings with distributions, in most cases this test should be workable. However, as indicated earlier, one of the conditions for REIT status is that the REIT must not be a "close" company. This, potentially imposes a further 10% threshold, which should not be overlooked. Notably, a breach of this condition, save if inadvertent or in a takeover situation, would cause automatic expulsion from the REIT regime.

So What Is A "Close" Company?

The definition of a "close company" is a complex tax definition, as amended by the REIT rules. Broadly, however, a company will be close if it is controlled by five or fewer participators. This could, therefore, mean that in certain circumstances no shareholder must own 10% or more of the ordinary shares. There are, however, certain exceptions to this, the main one being that the REIT will not be treated as close if:

  • at least 35% of its ordinary shares are held by the public (as defined) (notably, shares held by a registered pension scheme will generally be treated as held by the public);
  • any such shares have been the subject of dealings within the last twelve months on a recognised stock exchange; and
  • no more than 85% of the ordinary shares are held by principal shareholders (these being (inter alia) anyone with more than 5%).

(In other contexts, there is an exception to the close company rule, where shares are held by a company which is not itself close (or a subsidiary of such a company), but importantly this rule does not apply to REITs.)

One of the changes implemented by Finance Act 2007, to facilitate start-ups, is to provide that satisfaction of the close company test need not be satisfied on the first day of a company entering the regime (due to the difficulty in satisfying the prior dealing requirement), provided that it is satisfied throughout subsequently.

The relevant stock exchange may have its own shareholder diversification requirements that also need to be satisfied in addition to this test.

What Is The Financing Cost Ratio?

There is no express restriction on borrowing in the REIT legislation. Therefore, subject to finalisation of proposed amendments to the UK Listing Rules, for REITs listed on the LSE (where there is currently a 65% gearing threshold for investment entities (see below)), the level of borrowing will effectively only be restricted by a tax charge if a financing cost ratio is breached.

Broadly, the ratio will be breached if the sum of the following is less than 1.25:

Profits                
Financing Costs

Profits for this purpose are income profits ignoring capital allowances, losses from a previous accounting period and disapplication of the annual amounts included in the disregard rules for (for example) loan relationships, debits and other amounts relevant in computing the amounts distributed. Financing costs are generally the costs of debt finance in that accounting period.

Breach of this ratio will not, however, result in exclusion from the regime. Instead, to the extent the result of the test is less than 1.25, a tax charge will be levied in the REIT under Schedule D Case VI on the excess at 30% (28% from 2008), without any losses etc being permitted to shelter it.

The purpose of this ratio is to ensure that the amount distributable is not reduced by excessive finance costs, thereby reducing the amount able to be distributed and HMRC’s tax-take from shareholders.

Is Development Permitted

Development to hold as an investment is permitted within the PRB and will fall within the exemption from tax on eventual sale (subject to what is said below), but development for sale is not. This would need to fall within the limit of permitted non-PRB and profits would be taxable in the usual way.

What Happens If A Development, Intended For Long Term Hold As An Investment, Is Sold Early?

If the REIT develops a property with the intention of holding it for the purposes of the PRB, but the development is sold within three years of practical completion, the disposal will be treated as if never part of the PRB and any gain or loss on disposal will be taxable in the usual way. However, any income arising in the interim will still be part of the PRB (provided of course, the requisite investment intention can be maintained).

What Is Development?

Building work will amount to development if the costs exceed 30% of the fair value of the asset at the later of the date the company enters the regime and the date that the asset was acquired by the REIT. Each refurbishment will need to be looked at carefully to see if it is "development" for this purpose to avoid substantial ongoing maintenance from qualifying.

What About Management?

Internal or external management will be permitted in a REIT. Where a REIT is listed under Chapter 15 of the UK Listing Rules (or their amended version, when finalised), issues such as conflicts which may arise will need to be considered. Generally management fees should be deductible, to the extent related to a Schedule A business, in computing profits required to be distributed. However, care will need to be given as to how this is dealt with in a group context to ensure this is the effect.

Groups

As mentioned above, group REITs will be possible. A group will comprise any 75% subsidiary (UK or non-UK) of the principal company (other than a life insurance company or open-ended company) and 75% subsidiaries of the subsidiaries, provided that the entity is an effective 51% subsidiary (i.e. is in 51% economic ownership) of the principal company.

How Are The Tests Dealt With On A Group Basis?

Only the principal company of the group (the REIT itself) needs to satisfy the company tests and the distribution requirement. Similarly, the 10% (substantial shareholder tests) and withholding requirements (see below) will only be applied at principal company level.

The investment and business tests and the financial cover ratio will, on the other hand, be dealt with on a consolidated basis, with the entire group being treated as a single business. In relation, for example, to the three properties test, it is not necessary for the principal company itself to hold any properties directly, provided that, as a group, at least three single properties are held 100%. (Notably, this consolidation would also apply to group OpCo/PropCo structures in the context of the prohibition of owner-occupied property for the PRB.)

What About Non UK Group Companies?

Non-UK companies can be part of the group for REIT purposes. While in each case, appropriate assets and income of the property rental business of the non-resident company will count as PRB assets and income for the 75% PRB thresholds, the REIT rules distinguish between the treatment of UK property and non-UK property for tax purposes:

  • income and gains relating to UK PRB and dividends received from a non-UK company in respect of UK PRB will be tax exempt for all purposes at REIT level. Correspondingly, assets of the UK PRB will be taken into account in computing the entry charge and income of the UK PRB in the 90% income distribution requirement;
  • on the other hand, the income and gains from the non UK property held by a non-resident company will not be treated as exempt PRB income. In addition to any tax in the local jurisdiction, in the hands of the REIT, dividends will be treated as a residual income and will be taxable as usual, subject to double tax treaty relief. Such property will not, however, be taken into account for the entry charge.

Other Interests In Companies

Interests deriving from shares, other than of a group company, will count as residual assets, unless the interest can be elected into the REIT regime by way of a joint venture look through notice (see below). Gains on disposals of shares, even in a REIT group company, will not be tax exempt.

Interests In Joint Ventures

The REIT rules now permit a REIT to elect for certain JV interests, which would otherwise be residual, to be treated as part of its PRB for all purposes. Broadly, these apply where:

  • the REIT has a 40% (or more) interest in a corporate JV;
  • the JV is itself carrying on a PRB and would itself satisfy the 75% asset and income tests; and
  • an election is made by the REIT and signed by the company secretary or a director of the JV.

The Finance Act 2007 changes have extended these (amended appropriately) rules to JV groups.

What Is The Effect Of A JV Election?

The effect of the JV election is that the business of the JV is effectively divided into two parts, with the same consequences following as for a REIT (for example, deemed market value disposal and reacquisition, entry charge and exemptions), pro rata to the REIT’s interest. (See Example 1.)

The entry charge and exemptions will be in the JV itself (not the REIT). This may have implications which may need to be considered (for example, for the REIT in meeting its 90% distribution requirement (see Example 2)).

Example 1

JV: Post Conversion (1)

PRB

Residual

  • Conversion charge at 2% on market value
  • Market value uplift in base cost
  • Income exempt
  • Gains exempt
  • Shadow capital allowances regime

  • No conversion charge
  • No uplift in base cost
  • Income taxable at 30%
  • Gain taxable at 30%
  • Capital allowances

Example 2

JV: Post Conversion (2)

Overall Tax Position

  • 1% conversion charge
  • 15% effective tax rate on income
  • 15% effect tax rate on gains

Interests In Partnerships

For UK direct tax purposes, partnerships are generally treated as tax transparent. This will remain the position for REIT holdings in partnerships also. Accordingly, the REIT’s interest in them will generally count for the purpose of determining the income and assets tests and in calculating the entry charge, which will be levied at REIT, not partnership, level. Where there are other non-group partners, properties will not, of course, count for the purpose of the three properties test (see Investment Tests above).

Interests In Offshore Property Unit Trusts ("OPUTs")

This has been a hot topic and the following reflects HMRC’s view at the date of writing:

  • an OPUT which is transparent for income, will be treated as counting towards the PRB of a REIT for the purpose of both the income and assets tests if the REIT holds more than 20%;
  • income arising in the REIT will be tax exempt;
  • on entry to the regime, if the REIT holds such interests, its pro-rata share of assets will be subject to the entry charge at 2%, payable in the REIT, not the OPUT;
  • if OPUT assets are subsequently acquired, they will not be subject to an entry charge (the OPUT not being a body corporate and, therefore, not capable of being in a REIT group or subject to JV look through election); and
  • disposals of units will be treated as disposals of shares and so will be taxable as residual interests (as with shares in a company), not exempt PRB.

Listing And Other Requirements

As well as the tax rules for a REIT, an entity will need also to consider the corporate, regulatory and other requirements prior to listing.

What Will It Cost To Become A REIT?

This will depend on the facts in any given case, and may affect the decision whether or not to become a REIT. Costs may include (for example): entry charge, listing costs (including broker and professional fees), seeding costs (for example, SDLT or CGT on disposals to the REIT), restructuring costs and ring fencing (e.g. possible non-utilisation) of losses (use of these may affect timing of entry).

Advice should always be taken on the facts.

How Does A Company Become A REIT?

Assuming the criteria are met, becoming a REIT will be effected by an election notified to HMRC in advance. HMRC appear to accept that the notification could be made one minute before midnight with status to commence immediately after midnight (assuming, of course, that the conditions are met).

The Entry Charge: The Basic Position

Though based on a formula, effectively the tax charge will generally be 2% of gross assets of the PRB at the time of entry to the regime. (Notably 2% is the tax charge - i.e. the tax is not 30% of 2%). The charge will be taxed under Schedule D Case VI and, on entry to the regime, can be spread over four years (at a slightly higher rate). Companies will not, however, be able to use historic or other capital losses to shelter the charge. In a single company REIT, the charge will be in the REIT itself and will include interests in PRB treated for REIT purposes as held by the REIT directly (for example, an interest held through a partnership or an offshore property unit trust).

In a group or JV context, the charge will be in the relevant JV company, pro rata to the interest of the REIT. This has various potential commercial, as well as tax implications, where the REIT may not have a 100% interest.

For those UK companies that have held assets for a long time where there are substantial latent gains, the entry charge is likely to represent good value. Similarly (potentially), for entities which have acquired UK companies with substantial latent gains - the charge would generally be less than the SDLT otherwise payable. It will not be such good value, however, for those who have only recently acquired assets. Notably, the charge will also apply to offshore companies (who may be outside the scope of UK capital gains) to the extent of their UK assets. Such offshore companies, who, through use of gearing and allowances have a low effective rate of tax may, therefore, wish to think very carefully before converting.

Entry Charge: Can There Be Any Further Hits?

Prima facie, subject to the new rules for certain start-ups (see below) the charge is only on the entry of a company (or certain JVs) into the regime, so in certain cases, subsequent direct property acquisitions in an entity will not be caught. However, as on conversion, the entry charge will also potentially apply in certain other circumstances.

For example:

  • acquisition of a company by a REIT, to the extent of the interest acquired by the REIT (notably in this case the entry charge cannot be spread);
  • interest in a JV interest increasing to become an interest in a group REIT;
  • demergers, subject to use of the new statutory exemption from a double entry charge on demerger of a REIT into one or more new REITs introduced by Finance Act 2007. (Notably this exemption is quite prescriptive and applies to the entry charge only. Consideration should be given to structuring generally to ensure there are no other unexpected tax charges.)

Care also needs to be taken as to whether relevant elections always need to be made and to the implication of them, as credit for charges paid will not always be available.

How Will The REIT Be Taxed?

Very broadly, the REIT will be exempt from PRB income and gains and taxed on residual profits and gains in the normal way. The legislation envisages a separation out of PRB from other business. To the extent of PRB:

  • property income will be tax exempt in the REIT;
  • gains on assets held for the tax exempt business will be exempt in the REIT;
  • dividends in respect of the PRB profits of the REIT (both of income and capital) will be paid out after a deduction of tax at source of 22% (to reduce to 20% from 2008) (see below) (for UK taxpayers not subject to tax (for example, non-tax paying individuals) this will be recoverable);
  • capital allowances attributable to the PRB will be automatically deductible in full and loan expenses and certain hedging and derivative expenses related to the PRB will be deductible in calculating PRB income profits for distribution purposes;
  • gains from the disposal of an asset from the tax exempt business, provided either reinvested or distributed within 24 months will generally be treated as remaining an asset of the tax exempt purposes. Interest arising on the cash, meanwhile, will be treated as a non-exempt asset and will be taxable; and
  • losses of the REIT arising other than in respect of the PRB will be ring-fenced from profits of the property rental business (the purpose here is to ensure that profits available for distribution are not reduced by other losses, thus ensuring tax can be levied at shareholder level).

The taxable business will be taxable at the standard rate of corporation tax (30% reducing to 28% in 2008). Notably, none of the reduced rates (for example, for small companies) will apply.

How Will Investors Be Taxed?

Investors will, broadly, receive two potential types of distribution:

  • a normal dividend in respect of the residual taxable REIT activities; and
  • a distribution relating to the PRB, whether of income or gains, generally taxable as Schedule A or UK property business income (subject to tax withheld at source) (property income dividend ("PID")).

The PID will be treated as a separate property business distinct from any other property business, so that losses of the latter cannot be used to offset income from the REIT business.

Transfers of interests in the REIT will be chargeable to stamp duty at 0.5% in the usual way (if the company is UK incorporated or, if incorporated overseas, if it maintains a UK register) and to chargeable gains again in the usual way. Shares in REITs should be eligible for the stocks and shares component of an ISA.

It is likely that investors will be taxed in aggregate as follows:

Type Of Investor

REIT

UK Company1

UK Company

30%

30%

UK Higher Rate Tax Paying Individual

40%

47.5%

UK Non-Tax Paying Individual

0%

30%

ISA

0%

30%

UK Pension Fund

0%

30%

Non UK Tax Resident Company (Non-Treaty)

22%

30%

Non-UK Tax Resident Company (Treaty)

15%

30%

Are There Going To Be Any Special Rules For Life Companies?

The rules in section 212 ICTA, deeming the company annually to have disposed of and immediately reacquired its shares at market value, will apply to life companies investing in REITs.

To Whom Do The Withholding Tax Rules Apply?

The REIT must withhold tax at 22% on all distributions of PRB (both of income and of capital) unless it has a "reasonable belief" that the shareholder falls within one conversion charge reassessed at the end of the period, with credit for the earlier amount. It also gives a further three accounting periods of leeway from breach of this test counting as a minor breach (with potential consequences of a termination notice from HMRC), provided that throughout the level of assets does not fall below 50%.

What Are The Anti-Avoidance Provisions?

First, the deemed market value rules on entry to the regime and cessation of REIT status will not apply where a company leaves the REIT regime within 10 years and where the asset is sold within 2 years (this could include a company in a REIT group). This would cause the full historic cost to be triggered on disposal without any rebate of any conversion charge. (This will be relevant also to corporate disposals, as well as when the principal company leaves the group).

Generally, where HMRC removes a company from the REIT regime within 10 years it has wide further antiavoidance powers.

What Will Be The Likely Shape Of The REIT?

This is where it all gets even more interesting. We have already seen REITS both with mixed assets and with more of a sector focus. However, following what is happening in the US and the funds market, we may see more sector focussed REITs (for example, shopping centres, offices, residential, retail, industrial), as managers with skills in these areas set up new REITs or existing REITs focus more exclusively. The new demergers rules are clearly intended to facilitate this.

Those entities with a high proportion of non-PRB will no doubt be looking carefully to see whether they wish (or indeed will be able) to manage this business within the REIT or whether they are going to have to sell or to spin it off to shareholders, say with stapled stock.

No express rollover reliefs are available under the REIT legislation (for example, for transfers of partnership interests). It may, however, be possible for some shareholders (for example in companies or in offshore property unit trusts) to make use of existing CGT roll-over or reconstruction reliefs (say) to defer tax on capital gains. This will, however, depend on the facts of any given case.

SDLT will be an issue where newly acquired assets are acquired. There is no seeding relief. Representations are continuing to be made for suitable reliefs.

Who May Find It Attractive To Convert?

  • many fully listed UK property investment companies who are able to satisfy the requirements with relatively little restructuring have already made the change. Of course, not all those that are currently fully listed will seek to convert - those, for example, who are primarily property developers or traders will not and those with substantial tax losses or reliefs may wish to utilise those first;
  • some UK property companies that are currently listed on AIM may now consider the further regulation of a full listing on the LSE or an alternative exchange. Alternatively, they may wait to see if AIM is included as a recognised stock exchange for this purpose (issues such as IHT and potential business asset taper relief may also be relevant);
  • UK companies that have gone private, may find the reliefs sufficiently attractive to reconsider a full listing;
  • OPUTs may wish to, provided the transaction can be structured to minimise the entry charge;
  • start-ups: notwithstanding the Finance Act 2007 changes, the position on start-ups is not yet generally as one would like. While there are effectively some seeding reliefs, which may be useful for some, they do not extend to all cases. Some further express roll-over facilitation would be very welcome. It is understood that HMRC are very aware of this and are considering the issue - so we hope for some changes in Phase II;
  • offshore property companies: there are already a number of these listed on AIM and on the LSE. Whether they will wish to convert remains to be of the following. In such case it must not withhold. The precise detail of those for whom the REIT must not withhold is set out in the regulations and is based on statutory definitions and further conditions, but very broadly includes:
  • UK companies;
  • non-UK companies within the charge to UK corporation tax on the distribution;
  • UK pension funds, ISAs, PEPs and child trust funds;
  • local authorities;
  • health trusts;
  • Crown offices;
  • certain scientific organisations;
  • charities;
  • European Investment Funds; and
  • partnerships where each partner is a company within the charge to UK tax.

To the extent the REIT’s "reasonable belief" proves to be wrong, the tax charge is on the REIT. The REIT will, therefore, need to put in place relevant compliance measures.

In any case of doubt, the default position is to withhold. It is possible that these provisions could be subject to challenge, as being discriminatory under EU law. The non-resident landlord scheme will not apply to avoid withholdings for non-UK residents (as for direct property).

Dividend Stripping

Notably, if the owner of shares has transferred the right to the dividend, withholding tax must be applied and accounted for by the REIT, regardless of identity of the counterparty or the recipient. Similar rules apply to the dividend manufacturer. This should not cause an insuperable issue in most cases, but participants will wish to consider the identity of the counterparty and UK anti-avoidance rules ensure that the rules are appropriately dealt with to avoid tax leakage.

What Happens If The REIT Conditions Are Breached?

Broadly, there are three different types of breach of the regime, which can ultimately cause a company to cease to be a REIT:

  • automatic termination on any breach of the conditions on residence, closed ended status, share capital, type of loans, listing or close company conditions (other than (in these latter two cases only) as a result of action of others or a takeover by another REIT); and
  • on service of notice by HMRC, if there is repeated and persistent breaches or serious tax avoidance; or
  • there have been more than a specified number of minor breaches in a given period.

The provisions are set out in the regulations (and see separate note on REIT regulations dated November 2006). Notably, breaches which merely give tax charges (for example the 90% rule, the financing cost ratio and the 10% rule) will not of themselves give rise to terminal breaches.

The effect of cessation of the regime will, generally, be a disposal and deemed acquisition of the assets by the non-REIT, at market value, with capital allowances passing automatically at tax written down value, subject to wide anti-avoidance provisions (see below).

Are There Any Specific Rules For Start-Ups?

As mentioned above, both the listing and close company requirements were amended to cater for start-up situations in Finance Act 2007.

In addition, special rules have been introduced where the 75% assets tests cannot be met on Day 1. This effectively gives one accounting period leeway, with the seen. This is very much likely to depend on the facts. Many of these are, however, already structured so that there is effectively little tax leakage at vehicle level and those on the full list already have access to the wider market, with the benefit of ISAability etc. While, some may find the practicalities of being able to bring their management into the UK attractive, of course, there may, in doing so, be a higher tax burden for the UK individual investor, as distributions would effectively be taxed at 40% rather than 32.5% (ignoring tax at vehicle level), as at present;

  • hotels, nursing homes and others (where the ownership of the property is separate from the operating business but ultimately in the same ownership through grouping etc) may find it difficult, because of the owner/occupied prohibition. It is unlikely that, without restructuring, the REIT will be viable for those with more than 25% of the business effectively "group" owned. There may need to wait for another day following further consultation;
  • corporates with substantial landbanks seeking to generate capital from their existing portfolio or fixed assets: again the owner/occupied property rule will be an issue to be resolved. Clearly, where operational assets are involved, they will also be concerned that they can retain sufficient control through a lease or otherwise;
  • funds: it should not, of course, be underestimated that the REIT was, in fact, originally intended to be a vehicle for collective investment into the UK generally. Due to the ability of the REIT to have external management, to give liquidity and ISAability, it should be popular as a new closed ended fund vehicle, for funds targeted at the retail market, but that can also cater for the UK fund or other investor. As the tax benefits do not extend to indirect investment outside the UK it is less likely to be used for this as to supplant existing structures;
  • residential: although one of the original aims was to help the residential sector, there are not as yet any residential REITs - the yield is too low and costs of conversion are too high. Some incentives are likely to be required to assist here.

What Type Of Investors Are Likely To Be Attracted To The REIT?

The intention is clearly that the vehicle will be open to all types of investors.

In particular the Government’s aim was to attract UK retail individual investors seeking long-term investments. This may, potentially, be an attractive investment for them in tax terms, due to the ISAability of REITS and the tax exempt status of the REIT itself.

Hopefully, the new withholding tax will not prove a deterrent.

High net worth individuals may find the ring-fencing of the REIT income from other forms of Schedule A income less attractive, as this will mean that there will not be the same possibility to set off losses of another investment against taxable REIT returns. Also those who wish for a more highly geared investment may look twice.

Pension funds and other exempt investors are likely to be key investors, attracted to the liquidity, subject to other commercial factors, such as potential pricing volatility.

Non-UK investors may be less attracted, due to the withholding obligation at 22% (on income and gains), unless they can get credit locally. Exits by disposals, are, of course, still tax free.

Footnotes

1. This is assuming 30% tax at company level, ignoring reliefs.

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.

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