Refurbishing property investment funds
This article sets out the changes proposed for Real Estate Investment Trusts (“REITs”) and Property Authorised Investment Funds (“PAIFs”) and how the obstacles experienced in the creation of such vehicles are being resolved.
REITs
REITs are close ended property investment funds, set up as UK companies.
The advantages of meeting the conditions for being a REIT compared to an ordinary company are the exemption from corporation tax on chargeable gains realised on property disposals and the fact that no tax is levied at the level of the REIT on income from that property, thereby shifting tax on income from the fund to the recipient of a distribution from that income, allowing a more tax-transparent treatment.
24 REITs have been created so far, focused on commercial property.
The point about a REIT is to promote widespread investment in property, not to allow small groups of individuals to realise property gains tax-free. Some of the conditions set out to ensure this have however been overly prescriptive.
Some changes are being proposed which have the potential of increasing the number of REITs in operation.
The following set of changes will apply only to REITs entering the regime after Royal Assent is given to the Finance Bill 2012.
Potential for Secondary Market REITs
Currently the ordinary share capital of a REIT must be officially listed on a recognised stock exchange. This means that REIT status can only be obtained with a full listing. This has included overseas stock exchanges, which has permitted the combination of a UK resident company with say a listing on the Channel Islands Stock Exchange.
The new rules will simply allow those shares to be “admitted to trading”, which apart from fully listed companies, will allow for Admitted to Trading Only shares to allow for alternative trading platforms such as AIM, Plus-Traded and their foreign equivalents.
An additional condition is however inserted to ensure that the shares are traded in every accounting period in which the company is intended to qualify as a REIT.
Relaxation of close company condition
A close company (in this context under the control of 5 or fewer participators) cannot qualify as a REIT.
Extension of potential pooled scheme investors.
This condition creates difficulties for fund managers routing investments in REIT via pooled vehicles, sometimes from third party fund managers, because although the investor are many, each vehicle is treated as a single investor, thus limiting the number of participants to the extent that the REIT is a close company.
There is one exception for collective investment schemes in LP form. Where there is a close company only by counting such an LP, this is ignored and therefore the company can qualify as a REIT.
This exception is however prescriptive in terms of available choices of vehicles.
It is therefore being extended by a list of permissible institutional investors comprising UK Authorised Investment Funds or their overseas equivalents, pension schemes, life insurance companies and persons not liable to corporation or income tax on the grounds of sovereign immunity. The list may further be reduced, extended or amended by secondary legislation.
This should make a REIT more readily accessible via global pooled investment vehicles.
Dispensation for first three years
At present, the rule applies from the outset, which means that a company can only become a REIT once it has reached a sufficient level of subscriptions. In the meantime, it is taxed as an ordinary company on income and gains, to the detriment of early subscribers. The combination of this and the entry charge discussed below tends to delay the formation of a REIT, with the ultimate decision being made in favour of an alternative vehicle.
To reflect the fact that such a level may be reached gradually, a three year dispensation from the condition will be introduced, which means that subject to the condition being met, the company can start bringing the benefits of a REIT structure to its early subscribers.
Cancellation of the entry charge
At present an existing company which converts into a REIT is required to pay an entry charge equivalent to 2% of the of the market value of its assets at the point of conversion..
The charge is to be abolished.
In particular, this means that existing REITs monitoring dealings in their shares to ensure that the close company rules are not breached will be unable to take advantage of the extended exclusions list or 3 year window or delist from the London Stock Exchange in favour of the AIM.
A prospective promoter of a REIT property investment company not envisaging the realisation of chargeable gains in the foreseeable future should therefore consider waiting for that date before converting into a REIT to avoid being locked into the restrictive close company rules.
The following set of changes will apply to all REITs, including existing REITs, for events falling on or after the date of Royal Assent:-
Time extensions to compensate for shortfalls in distribution of profits
A REIT must currently distribute 90% of its profits from property rental business by the filing date for its tax return (i.e. within 12 months of its accounting period).
There are new rules to allow time extensions in certain situations where there is an unexpected shortfall.
Stock dividend shortfall
Like an ordinary company, the REIT may give its shareholders the option of a stock dividend. This counts towards the 90% distribution, thus affording shareholders who have selected it the ability to invest for long term capital growth.
Normally, if the difference between the cash dividend on offer and the market value of the share capital exceeds 15% in either direction, the market value of the share capital is treated as the amount distributed. If that market value is lower than the cash dividend, it could be that in aggregate, less than 90% has been distributed even though the distribution represents 90% per share.
At present, the shortfall in distribution can be made up within 3 months of the filing date deadline. This will be extended to 6 months in the case of distributions made on or after Royal Assent, allowing REITs valuable time to raise or realise cash to make up the shortfall.
REITs with a filing date falling after Royal Assent and intending to offer a stock dividend option in relation to the period of account in question could therefore benefit from not paying the distribution in advance of the filing date deadline if there is a risk of the market value of the shares being lower than the cash dividend. This is because a distribution paid by the filing date deadline but after Royal Assent would permit a longer period to make up any shortfall. The possibility of a delay would however depend on what the company’s constitution and prospectus permits and what the value of a longer delay would be.
Shortfall arising from increase in profits after delivery of the REIT’s tax return
Current legislation is ambiguous regarding what happens in a case where it emerges that the profits from the property rental business are actually higher than the amount shown in the company’s financial statements, on which the calculation of the minimum 90% distribution was originally based.
It will now be clear that as long as the shortfall is made up for by a distribution within 3 months from the date when the REIT’s tax return can no longer be amended, the distribution condition will be met.
The balance of business condition -
At present, not only must 75% of the aggregate profit of a REIT consist of property rental income (the “profit condition”) but 75% of the total value of its assets at the beginning of each accounting period must consist of assets relating to property rental business (the “asset condition”).
This can put the management of the REIT under significant pressure when cash is held pending investment/reinvestment immediately after subscription or where disposal proceeds are held pending new opportunities. Normal commercial considerations would prescribe that as long as management ensures that the “profit condition” is met, they should be allowed more latitude regarding the timing of investments to allow careful selection and negotiation.
To some extent this is already provided for in the case where a property rental business asset is disposed of. For 24 months running from the disposal, the proceeds from that disposal can count as part of the 75% minimum for the purpose of the asset test as long as they are held on deposit (whatever the currency) or invested in gilts or bonds.
The limitation of this condition has now been removed so that any amounts held on deposit or invested in gilts or bonds can now count as part of the asset test regardless of its provenance or the amount of time for which it is held, therefore enhancing management flexibility.
Improved scope for leverage
At present, the permitted financing costs for a REIT are limited to 80% of the property profit, with exceptions for situations where unexpected circumstances arise while the company is in severe financial difficulties.
All the costs of debt finance are included in the 80% calculation, which means that in practice, the actual amount that may be borrowed could be pushed down to a punitive extent by the one off costs of raising capital.
The definition has been amended so that the costs for the purpose of the calculation are now limited to the interest payable on the loan. This produces a fairer, more transparent and more measurable in advance result.
Other amendments
As expected, there are anti-abuse provisions included in the new draft rules. Subject to those, however, there is a considerable improvement for the REIT industry in the UK.
PAIFs
To facilitate conversion to the PAIF regime, HMRC has announced that it will amend the tax regulations applicable to PAIFs to allow investors to exchange their units in a dedicated PAIF feeder fund for units in the PAIF and vice versa without incurring a charge to tax on capital gains at the time of the exchange.
This would prevent the crystallisation of a chargeable gain on an investor who in reality is still invested in the same underlying assets.
There are reorganisation provisions whereby no gains would be crystallised but the new units issued in exchange would simply take over the base cost of the old units but these only work in the framework of a general fund restructuring, and not on an investor by investor basis.
The amendment will take effect in 2012.