June 2006

e-Newsletter

Where we are now, recent changes and issues to consider

Background

In December last year, the UK Government published draft legislation on the introduction of a new investment vehicle, Real Estate Investment Trusts (“REITs”). In the 2006 Budget, the UK Government published commentary on the draft Finance Bill 2006 clauses which set out how the regime will work and updated legislation was published with the Finance Bill (No.2) 2006 in April 2006. More recently, HMRC have published draft regulations which will supplement the primary legislation and some changes to the Finance Bill have been made through the parliamentary process. 

Where are we now?

We now have an almost complete picture of how the REIT regime will initially work, with only a few of the finer details to be resolved. 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. Distributions from the REIT's tax exempt business will then be taxed in the shareholders' hands as if they had received property income (and there will be a withholding mechanism for distributions from the tax exempt business) eliminating one level of taxation and shifting the burden of taxation from the company to the investor  The conditions needed to be met for REIT status are as follows: 

The company conditions (only applicable to the principal company of a REIT group)

A REIT must:

• be a UK tax resident company (cannot have dual residency)
• be listed on a recognised stock exchange (this does not include the Alternative Investment Market)
• not be an open ended investment company
• only have one class of ordinary shares (non participating preferences shares and debt instruments convertible to ordinary shares are allowed)
• not be a close company for tax purposes
• not have any non commercial loans (as defined for tax purposes).

 The conditions for the tax exempt business

• there must be at least three single properties
• no one property must be more than forty percent of the total portfolio
• no owner occupation / letting to a stapled sister company
• ninety percent of the taxable profits of the UK property rental business (rental profits normally subject to either UK income or corporation tax) must be distributed before the filing date of the principal company's tax return (i.e. usually within 12 months of the end of the accounting period).

The conditions for the balance of business

• seventy five percent of the total profits must be from the tax exempt property letting business (broadly based on the accounting profits)
• seventy five percent of the assets of the REIT must be engaged in the tax exempt business (assets valued in accordance with International Accounting Standards ("IAS") but fair value must be used if IAS gives a choice between cost and fair value).

In addition to the conditions for entry into the REIT regime there are restrictions in relation to the maximum shareholding a person can have in a REIT and there are restrictions on the financing costs in the REIT.  Breach of the maximum shareholding restriction or financing ratio does not result in exclusion from the REIT regime. Broadly, there will be a tax charge on the company (or the principal company if the REIT is a group) if a shareholder holds more than 10 percent of the ordinary shares in the REIT or if the REIT breaches an interest cover test of 1.25:1.

The cost of conversion to REIT status or "Entry Charge" has been set at two percent of the market value of assets transferred into the tax exempt business. 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. The Entry Charge will be levied both on conversion to a REIT and when an existing REIT acquires a company with qualifying property.

Although the conditions and rules are numerous, the property industry has been largely successful in lobbying for changes and the Government has amended a number of the conditions in line with industry recommendations (e.g. the 10 percent shareholder restriction is no longer a condition for REIT status, the distribution requirement has been lowered from 95 percent to 90 percent and the interest cover test has been eased).  In addition, the entry charge has been set at the lower end of expectations. After the clarification of the rules (in particular the level of the entry charge) and given the potential benefits to property companies to convert, it has been no surprise that a number of the largest listed property companies have announced the intention to convert to REIT status.

Recent Changes/ Issues

Trading Property in the REIT regime
The draft regulations exclude from the definition of exempt income all rental income arising from any type of property trade.  This has the effect of excluding all assets held as trading stock from qualifying as assets used in a REITs exempt business. 

On entry to the REIT regime there is a deemed disposal and reacquisition of assets used in the exempt property business and any chargeable gain which accrues is exempt from tax. Previously, assets from which a company was receiving rental income but were held as trading assets could qualify as being used in the exempt property business (provided they were not held for a development trade) with the associated rental income then being exempted from tax.  The effect of this on entry to the REIT regime for a company with such property was a 2 percent charge on the market value of the assets and potentially a taxable trading profit in relation to the deemed disposal and reacquisition (as only chargeable gains were exempted).  This "double" charge on entry has now been rectified with the removal of trading properties from the exempt business. 

This potentially bars entry to the REIT regime for some residential property investment companies as because of the relatively low rental yields, such residential property held as part of a rental investment business is often classified as trading stock. HMRC have agreed to look again at this issue in the Autumn and it may be that changes to the regime may be made in the future.  

Offshore Property Unit Trusts ("PUTs")

In recent years a number of property companies have used PUTs as a Stamp Duty Land Tax ("SDLT") efficient vehicle for holding property.  The REIT legislation makes no specific provisions for PUTs, but it is understood that assets held via a PUT will in most cases be exempt assets and therefore there will be a 2 percent entry charge on conversion but the associated rental income will then be exempt from tax.  

However, an issue arises on the sale of an asset by a PUT.  On sale of an asset any gain will be exempt but the proceeds from the sale can only be distributed via a capital distribution or a buy back of units by the PUT which will create a disposal/ part disposal of the units for capital gains purposes. Any gain on the units will not be exempt, just as gains on the sale of shares by a REIT in a company with an exempt property letting business will not be exempt.  Companies thinking about converting may therefore consider moving property out of their current PUT structures but this in itself gives rise to complex capital gains and SDLT issues.

International Considerations - non resident subsidiaries of REITs with property letting businesses
In summary the rules in relation to non resident companies with property letting businesses work as follows:

• for the purposes of the balance of business test, the income and assets of non-UK resident property investment companies are to taken into account (regardless of whether the property held is situated in the UK)
• income of non-UK resident companies relating to UK properties is included within the tax-exempt ring fence
• there is a two percent entry charge in relation to UK property held by non residents 
• taxable income from UK property held via a non resident company must be included for the purposes of the 90 percent distribution requirement
• distributions from a non UK resident company with a UK property business are then treated as if they had been received from a UK company (and hence exempt from tax)
• distributions from a non UK residual company with overseas business have no exemption, and are taxed in the residual business, with credit for any overseas underlying or withholding taxes.

The legislation as currently drafted provides that distributions from non-UK resident companies with UK property business are not treated as if they were dividends from a UK resident company if there is an intermediate non-resident holding company.  However, the government has confirmed that this was unintended and they will make amendments to the Finance Bill such that dividends relating both directly and indirectly to a UK property business are treated as dividends of a UK company for UK tax purposes.

However as the rules are currently drafted REITs are not necessarily efficient vehicles for holding overseas property as dividends received from non-UK resident companies owning overseas properties are not treated as tax-exempt income.  Therefore REITs that have tax efficient overseas operations and receive low taxed income in respect of overseas properties will be subject to UK corporation tax at 30 percent.

Ownership restrictions
The initial legislation published with the pre budget report did not permit a company with shareholders who owned greater than 10 percent of the company to convert into a REIT (or if this limit was breached after obtaining REIT status the rules provided that REIT status was automatically withdrawn). The legislation has been amended such that a tax charge is now imposed on the REIT if the 10 percent limit is broken instead of the company being automatically withdrawn from the regime. 
Specifically the legislation provides that there will be a tax charge on the REIT if the REIT makes a distribution to a shareholder who

a) is beneficially entitled (directly or indirectly) to 10 percent or more of the dividends paid  

b) is beneficially entitled (directly or indirectly) to 10 percent or more of  the company's share capital 

c) controls (directly or indirectly) 10 percent or more of the voting rights in the company.

The draft regulations give a relatively complex formula as to how the tax charge will be calculated but broadly the charge is intended to represent tax at the basic rate on the dividend to which the 10 percent  shareholder is entitled.  

This tax charge may not be levied on the REIT if it takes “reasonable steps” to avoid making a distribution to a substantial shareholder.  Guidance is to be published on this 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.

It should also be noted there is no "connection" test in the legislation that requires associated or connected persons to aggregate their holdings for the purposes of the shareholdings test which means it may be possible for property companies which perhaps still have a large family ownership to convert because there is no need to aggregate their interests. The exact share ownership structure would need careful consideration.

Demerger provisions
The Finance Bill included a clause which disapplied the provisions of s139 TCGA 1992 which applies to company reconstructions if the reconstruction was in relation to a company either entering or leaving the REIT regime. s139 TCGA 1992 is useful in helping companies reorganise or demerge without creating a tax charge by deeming certain transfers to take place at no gain or no loss.  The Government have stated their intention to remove the clause disapplying s139 TCGA 1992 in relation to the REIT regime.  This is potentially helpful to companies looking to reorganise or spin off property portfolios into the REIT regime although there are still a number of other issues to consider. In particular as the rules are currently drafted in addition to the two percent entry charge it is possible that a degrouping charge may apply (under s179 TCGA 1992) which may lead to an element of double taxation on entry.

Financial Statements
The principal company of a REIT group is required to produce three financial statements for REIT purposes

A) A financial statement for the group's worldwide property rental business (G (property rental business))

B) A financial statement for the group's residual business, i.e. activities not included in the worldwide property rental business (G (residual))

C) A financial statement in respect of the group's UK property rental business i.e. rental activities in relation to UK property held by resident and non resident group members.

Statements A and B must specify for each member income, expenses, profit before tax (excluding gains or losses realised or not on property) calculated under IAS. Assets must be valued at the beginning of the accounting period under IAS using fair value where there is a choice and disregarding liabilities secured against or otherwise relating to the assets. The statements will then be used for the purposes of the 75 percent balance of business tests.  The financial statement must exclude financing costs payable between one member of the group and another.

On a literal reading of the regulations, the requirements here seem potentially very onerous, but it is hoped that guidance will follow giving some examples of how this works in practice, and indicating a pragmatic approach to the requirements here.

Statement C must specify the UK rental income profits as calculated for tax purposes of each of the group members and will be used to calculate the 90 percent distribution requirement.

Conclusion

After a number of changes to the REIT regime since the Pre-Budget report in December 2005 we are almost in a position to understand the final form the REIT legislation will take for companies electing to join the regime with effect from 1 January 2007.  There will be further amendments to the draft regulations (we do not expect final regulations to be published until some time in the Autumn).  There will also be Guidance Notes issued around the same time, which it is hoped will clarify some of the main complex areas of the new rules.  However, the changes which have been made have largely been helpful to property companies wishing to convert and a number of the large listed property companies have already announced their intention to join the regime. As noted above there are still a large number of practical issues companies should be considering in relation to joining the REIT regime, as well as a substantial compliance requirement. 

Although the rules have been modified and certain conditions have been relaxed, REITs will not necessarily be the answer for all property investment or property owning companies. Indeed, traditional routes companies have used to manage their property portfolios such as property outsourcing, sale and leasebacks or property securitisations may still be of more relevance to many large corporate occupiers.  Going forward, once the REIT regime has been established it is possible the Government will look at ways of amending the rules to encourage the growth of the regime which may lead to more IPOs and opportunities for property funds, private companies and institutionally backed REITs.       

How can KPMG Help?

KPMG can assist companies considering REIT status by:

• high level review of eligibility
• review of tax impact on company and its shareholders
• diagnostic review to identify risks of not meeting tests or tax inefficiency in REIT structure
• structuring advice to help increase tax efficiency for company and shareholders.
• modelling future effects of REIT status
• advice on acquisitions, disposals and restructuring
• systems and compliance assistance to help companies understand and comply with the various reporting obligations.

If you would like more information on any of the issues raised above 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

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