REITs of Passage

The UK is following many other countries in looking to introduce Real Estate Investment Trusts (REITs), a tax-efficient vehicle for indirect property investment.

The Government's recent enthusiasm for REITs as a means to improve UK residential stock and to provide a new listed property vehicle for savers, has been further fuelled by the dramatic expansion of REITs worldwide. If the UK does not introduce a similar vehicle soon, fleet-footed global capital will find a more tax-efficient home.

PROPERTY INVESTMENT VEHICLE

After a period of consultation, the government published a discussion paper on Budget Day outlining proposals for a commercial framework for REITs.

The main features were that a REIT could be a company resident anywhere, investing in property anywhere and of any type (no residential requirement), with no minimum holding period, and it could be internally or externally managed.

There were of course a number of conditions, including the provision that a REIT must distribute 95% of its investment income (but there is no requirement to distribute capital gains), and although development and service provision is allowed, a 75% gross income and assets test needs to be met, as REITs are primarily property investment vehicles.

There are still a number of outstanding issues, such as whether the government will allow unlisted REITs, whether there need to be borrowing restrictions (especially in the context of unlisted REITs) and how the conversion charge should be structured.

However, the most difficult hurdle at this stage is designing a model for a REIT that enables the government to preserve its tax take from overseas investors, but which is also commercially attractive.

It is worth noting that Germany is facing a similar problem in relation to the design of its G-REIT, while the French were quite happy to exempt this issue when they introduced SIICs a couple of years ago.

REPLICATION OF DIRECT PROPERTY INVESTMENT

A key principle is that investment in a REIT replicates as closely as possible direct investment in property. Accordingly, investors should pay tax on distributions they receive from a REIT equivalent to the tax they would have paid on rental income, which currently stands at 22% or more.

If the REIT itself is tax exempt (exempt company model), this tax has to be paid by investors on distributions from the REIT. However, most of the UK's Double Tax Agreements (DTAs) restrict tax on such distributions (treated as dividends, not rental) to 15% or less.

Moreover, if the REIT is a non-resident company, a non-resident investor will in most cases pay no UK tax on dividends. The government therefore fears it could lose some of its ongoing (albeit small) tax take from non-residents investing in UK property.

TAXING NON-RESIDENTS

To protect against this, the UK would need to amend all its DTAs so that dividends received from REITs by non-residents are treated as if they were rent, which the UK can tax at 22%. However, as the UK has DTAs with over 100 countries, this is not a viable short-term solution.

There is an argument that the government would maintain its tax take from non-residents if initially it insists that REITs must be listed while seeking to amend its DTAs for a better long-term solution.

This is because the bulk of the REIT market will consist of existing UK plcs that have converted to REITs and tax can still be levied on overseas investors in such cases.

Furthermore, current overseas investors who invest directly in UK property, or via unlisted vehicles, will continue to do so for commercial reasons, so the tax-take from them will be preserved.

OTHER MODELS

There are a number of alternatives to the exempt company model. One is for the REIT to be taxable at 22% on its income (taxable company model), which would enable the government to preserve its tax take more easily, as the UK's DTAs will not impact on its ability to levy 22% tax on rental income.

However, a tax refund mechanism would need to be put in place to encourage investment by exempt bodies such as pension funds, which could also mean refunding tax to exempt bodies outside of the UK.

Another alternative is to adopt a hybrid structure (internal trust model), where the REIT company holds rental income in trust for its current shareholders, so that they are treated as receiving rental income (not dividends) for DTA purposes, which the UK has the right to tax at 22%.

However, this raises a number of complex tax and other implications that need to be resolved, which would lead to the unfortunate consequence that REITs would not be introduced until at least 2007 for the exempt company model.

The solution favoured by the real estate industry is the exempt company model widely adopted throughout the world. Only time will tell whether the government will accept that the macroeconomic benefits of having the same well-recognised model for a REIT will outweigh a marginal loss of tax take.