22 March 2006

e-Newsletter

UK Real Estate Investment Trusts

Budget 2006 Provisions

Background

In December last year, the UK Government published draft legislation on the introduction of a new investment vehicle, Real Estate Investment Trusts (“REITs”).

Broadly, REITs will benefit from a tax exemption in relation to profits from a qualifying property letting business and an exemption for qualifying chargeable gains. The exemptions apply providing certain conditions are met. The conditions can be found in KPMG's Newsletter 1 on our web site.

Budget 2006 Developments

Following the 2006 Budget, the UK Government has published commentary on the draft Finance Bill 2006 clauses which set out how the regime will work (no updated legislation has yet been published). The Government has to a large extent amended the legislation in line with the property industry’s recommendations and most of the changes are to be welcomed. In addition, details of the proposed charge to convert (“Entry charge”) have been published.

The Entry charge

The Entry charge has been set at 2 percent of the market value of assets transferred into the REIT. The charge will be suffered in the first accounting period in which the REIT is a qualifying REIT or alternatively the REIT can elect for it to be spread over the first four years. If the charge is spread the instalments will be set at 0.50 percent, 0.53 percent, 0.56 percent and 0.60 percent of the assets’ market value.

The Entry charge will be levied on both conversion to a REIT and an existing REIT acquiring a company with a property. The Entry charge may be refunded to the REIT if assets move outside of the REIT in certain circumstances.

We regard the proposed method of calculating the Entry charge as a welcome move compared with alternatives such as a measure based upon the inherent capital gains on assets as it is likely to be simpler to calculate and fairer.

Significant changes to the draft legislation

Shareholder ownership restrictions

Shareholders will now be permitted to own greater than 10 percent of the REIT (“substantial shareholders”) without REIT status being automatically withdrawn. However, if a distribution is made to a substantial shareholder, a tax charge will be levied on the REIT equivalent to the proportionate interest of the substantial shareholder. This may disadvantage the shareholders in the REIT.

This tax charge may not be levied on the REIT if it takes “reasonable steps” to avoid making a distribution to a substantial shareholder. These are not exhaustively defined in the commentary but guidelines are anticipated in due course. The commentary gives as an example a provision in the REIT’s memorandum and articles of association removing the substantial shareholder’s beneficial ownership of the dividend. This mechanism is designed to prevent overseas shareholders from reducing the withholding tax on distributions under double tax treaties or, for EU resident shareholders, under the EU Parent/Subsidiary directive.

We think that this concession makes conversion to a REIT more achievable for property groups if they wish to retain a substantial shareholding. However it is disappointing that there are no specific relieving provisions for founder shareholders in newly listed companies or grandfathering of substantial shareholdings in existing groups.

Interest cover test

The interest cover test has been eased so that the required threshold for the REIT rental business is now set at 1.25 times taxable income before capital allowances and financing costs. This is broadly equivalent to a loan to value of 70 percent to 80 percent which is more in line with industry norms.

Where this threshold is exceeded any excess interest will be subject to an additional tax charge in the REIT.

This is a significant concession on behalf of HM Revenue & Customs (HMRC) and is a consequence of hard industry lobbying.

Profits distributed

The level of profits that must be distributed by the REIT has been relaxed, to 90 percent of the taxable profits of the REIT (from 95 percent). These profits should also now be distributed by dividend within 12 months of the accounting period end (previously six months).

This provision should make it marginally easier to stay within the REIT regime for those companies choosing to enter it.

Other changes to the draft legislation

• Classes of share
• -  The class of shares that can be issued by the REIT has been widened to include non-participating fixed rate preference share capital (as well as ordinary share capital).
• -  The REIT will now also be permitted to issue debt instruments which are convertible to ordinary share capital.

• Income and Assets tests
• -  The REIT must derive at least 75 percent of its total profits from its tax exempt property letting business. In the commentary, this income test has been simplified; it is now to be calculated based upon 75 percent of the accounts profits (previously taxable profits).
• -  At least 75 percent of the total value of assets held by the REIT must be held by the tax exempt business. This value is now to be calculated using the fair value of such assets (rather than their historic cost).

• Anti-avoidance
• -  HMRC has the discretion to cancel tax benefits afforded by the regime where it “thinks” that the REIT has been involved in tax avoidance.

Conclusion

In the Budget 2006 commentary the Government has in large part embraced industry recommendations. The changes are helpful to property companies seeking to convert to REITs. In particular, the entry charge is at the lower end of expectations and the relaxation of gearing restrictions goes beyond that which were expected. We think that the measures remove a number of the barriers to conversion and the Government has done enough to encourage a significant number of the quoted property companies to convert to the regime. It will now be important for property companies to quantify the benefits and cost of conversion.

There are still a number of areas which require further clarification in particular with regard to the group rules and how investments in offshore unit trusts are to be treated. We await revised legislation before commenting further.

If you would like more information on any of the issues raised above, we are holding a breakfast seminar on 29 March 2006 at Stationers’ Hall, Ave Maria Lane, London EC4M 7DD. If you are interested in attending the seminar please contact Charles Beer or Jonathan Thompson.

Please also refer to our web site for more information on these matters.

Charles Beer
020 7311 4193
KPMG LLP (UK),
One Canada Square,
Canary Wharf,
London, E14 5AG.

Jonathan Thompson
020 7311 4183
KPMG LLP (UK),
One Canada Square,
Canary Wharf,
London, E14 5AG.

© 2006 KPMG LLP, the UK member firm of KPMG International, a Swiss cooperative. All rights reserved.

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