The Chancellor gets it REIT

After years of delay, the UK Government has finally confirmed that from January 2007 the UK will have its own form of real estate investment trusts (“REITs”). The introduction of REITs has been universally welcomed. It is in fact hard to find anyone who has argued against introducing REITs. The Chancellor has received yet more praise as a result of the major concessions he has made to the structure of these tax-exempt vehicles.

What are real estate investment trusts?

In simple terms REITs provide the chance to invest indirectly in property. An investor does not own the bricks and mortar outright. There is therefore no need for investors to find a tenant, collect a rent, organise repairs, deal with insurance or even employ a letting agent. A REIT will pool its investments to buy a portfolio of properties which will be let to companies or individuals. Shares in REITs will be bought and sold like any other shares.

A REIT has tax-free status, or more accurately at least 75% of a REIT’s income will be tax free. That is the crucial point here. The UK Government receives its pound of flesh from the investors and not the REIT itself. At least 75% of a REIT’s income must come from property rents. That is the part of the business that is tax-free. The remainder of the business will be taxed as normal.

How are shareholders taxed?

Income and capital profits from a REIT’s tax-exempt business distributed to UK-resident individual investors will be treated as taxable property income in their hands. Income tax at the basic rate will be deducted at source by the REIT. Higher-rate taxpayers will have to pay a further 18%, but investors will be able to reclaim the tax if they invest in an individual savings account (ISA) or a pension. Income and capital profits from a REIT’s non-exempt business distributed to individual investors will be treated as dividend income. 

Income from a REIT’s tax-exempt business distributed to UK-resident corporate investors will be treated as rental income from land and buildings and therefore subject to corporation tax. Income from its non-exempt business will be treated in the same way as ordinary dividends.

Is there a maximum holding?

A proposed condition of a maximum 10% shareholding condition was widely attacked when first announced. Again the Chancellor has shown some flexibility and in the Budget announced that the existence of shareholders with more than 10% of equity no longer disqualifies the company from being a REIT. Instead where a company pays a dividend to someone who has beneficial entitlement to more than 10% of the share capital, dividends or voting power, there will be a tax charge levied unless the company has taken reasonable steps to avoid making such a payment. An example would be including rules in the memorandum and articles of association requiring a forced sale in situations where a shareholder holds more than 10% of the shares and does not make arrangements to reduce his shareholding to the 10% limit.

Conversion: worth the charge

To prevent another hole appearing in the UK Government’s finances the Government will impose a “conversion charge” on any company converting to REIT status. The Budget confirmed this to be 2% of the gross market value of the investment properties. The 2% figure has been welcomed and it is likely that this will result in the majority of listed property companies seeking REIT status. The conversion charge can be paid in full at the time or conversion, or spread over the first four years in annual instalments of 0.5%, 0.53%, 0.56% and 0.6%. This includes an interest payment of approximately 6%.

So how important is tax-free status? At present property companies pay tax twice – once within the company and once again on dividend payments. It is therefore easy to see why property companies will wish to obtain REIT status. On achieving tax-free REIT status, millions of pounds of capital gains/corporation tax liability disappears. That was in fact the major reason given by Hammerson, a listed property company, when it recently announced that it intended to seek REIT status.

What will it cost the Treasury?

In short, almost certainly nothing. Also, as the conversion charge is paid up front, the introduction of REITs will help government cash flow in the next few years.

The Treasury’s line on REITs has been as consistent as it has been straightforward. REITs were only to be introduced into the UK if there was no cost to the taxpayer. The Treasury has clearly concluded that the millions of pounds it will receive from companies converting to REIT status will sufficiently compensate it for the loss of revenue from tax-exempt REITs. The fact that it has been predicted that Britain’s listed property market will treble to £100 billion over the next five to 10 years will also ensure a steady flow of revenue, much of it new revenue, to the Treasury. In addition REITs will pay stamp duty land tax in the same way as any other company. This is likely to mean a further increase in the government’s SDLT revenue.

Compliance costs

One area that will be looked at closely by companies seeking REIT status is the cost of compliance. For example a REIT will require separate financial statements for the exempt and taxable parts of its business. A REIT will also have to regularly value each of its properties if it is to retain REIT status. No single property can represent more than 40% of the total value of properties held. Further, a REIT will have to ensure that a minimum of 75% of its income comes from property rents. For some there will also be the cost of listing. 

Owner-occupiers

No owner-occupied property can be put into a REIT. This will prevent any non-property company circumventing the rule that 75% of profits must come from rental income by transferring property into a separate vehicle but still holding most of the shares. A company such Tesco would have to sell and lease back its properties before they could be put in a REIT.

Looking for advantage

The concessions announced in the Budget have removed most of the concerns voiced in regard to the structure originally proposed for REITs. Evidence for this can be found in the fact that a number of property companies and a group of housing associations have already announced their intention to seek REIT status. The fact that the listing requirement remains may mean that a number of property companies wait and see if this requirement is removed in the near future, as happened in France when REITs were introduced a few years ago. Notwithstanding the listing requirement, a number of commentators have predicted that the introduction of REITs will transform the commercial property sector because it will be advantageous for companies and pension funds to invest indirectly in property through a REIT. Whether that does in fact happen cannot take away from the simple fact that the Chancellor has put in place a structure for indirect property investment that has been welcomed by almost all interested parties. That is an achievement in itself. 

James Aitken is a tax associate with Bell & Scott LLP, Edinburgh

How does a company qualify for REIT status?

• The REIT must be a property letting business.
• The REIT must be UK resident.
• The REIT must be listed on a recognised stock exchange (this includes the London Stock Exchange and the Channel Islands Stock Exchange but not AIM or OFEX).
• 75% or more of the REIT’s income must come from property rents.
• 75% or more of the REIT’s assets must be investment property.
• The remaining percentage is likely to come from “development or other services”.
• 90% of a REIT’s net taxable profit must be paid out to investors by the usual tax return filing date (currently 12 months after the end of the accounting period). These are concessions by the UK Government as figures of 95% and six months were originally mooted.
• The REIT must operate at least three properties during each accounting period. A property is a single property if it is designed to be rented out as a single commercial or residential unit. This definition allows an asset such as a large shopping centre to be treated as multiple properties for the purposes of this condition. 
• No single property can represent more than 40% of the total value of the properties held in the property letting business.
• The REIT is not allowed to sell any building that it has developed for at least three years after completion.
• The Chancellor also confirmed in the Budget a reduction of the interest cover test or gearing. REITs will now have to have rental profits of at least 1.25 times their loan interest payable. The original figure given was 2.5 times and again is a major concession by the UK Government.

What if the conditions are breached?

Most breaches of the REIT regime will not result in automatic withdrawal of REIT status but instead result in a tax charge. REITs will be able to remain within the regime provided that the breach is rectified by the end of the next accounting period.