United Kingdom

Proposals for Real Estate Investment Trusts

The UK Government’s stated intention is to introduce a new investment vehicle—Real Estate Investment Trusts (REITs)—following their successful implementation in other countries. The expectation is that REITs would introduce greater flexibility and liquidity in the UK commercial property sector as well as boosting the property investment market.

Summary of Legislative Proposals

Broadly, REITs would benefit from a tax exemption in relation to profits from a qualifying property letting business and an exemption for qualifying chargeable gains. The exemptions would apply, provided certain conditions are met, such as:

• A REIT must be a UK tax resident company listed on a recognised stock exchange (this would not include the Alternative Investment Market). The REIT would have to distribute at least 95% of its net taxable profits (not gains), of the tax exempt (ring-fenced) property letting business during the relevant accounting period or within six months of its end
• The REIT would have to withhold tax (at the current basic rate of 22%) from distributions to shareholders. Qualifying chargeable gains, whilst exempt from tax if retained within the REIT, would also suffer the withholding on distribution.
• The REIT must derive at least 75% of its total profits from its tax-exempt property letting business and at least 75% of the total value of assets held by the REIT must be held for the tax-exempt business.
• The REIT’s property letting business must comprise at least three properties throughout the accounting period. If a commercial or residential unit can be let separately it is treated as a separate property. This definition would allow assets like shopping centres to be treated as multiple properties.

The final legislation is expected to be included in the Finance Act 2006, and companies would be able to join the regime at any date on or after 1 January 2007 by giving advance notice to HM Revenue & Customs (HMRC).

Restrictions

The draft legislation contains two key areas of potential difficulty that may restrict the ability of the listed property sector to convert to REIT status:

• No shareholder can own 10% or more of the shares in the REIT: Many property companies may not pass this test and therefore will be unable to convert to a REIT. The provision has been included to prevent tax leakage from overseas investors. Overseas shareholders owning 10% or more of a company may be able to benefit from substantially reduced or nil (0%) rates of withholding tax on distributions under the terms of double tax treaties or, in the case of EU resident shareholders, under the EU Parent/Subsidiary directive.

This restriction may also cause problems for the capital markets. One of the conditions of the draft proposals is that a REIT is required to be listed on a recognised stock exchange when it is necessary, to ease raising equity, that shares can be bought and sold freely without restriction. The 10% share ownership restriction could cause difficulties for REITs to raise equity in the capital markets.

• Interest cover test equivalent to 40% loan to value: The draft legislation states that net taxable income from the rental business must be at least two and a half (2½) times interest payable in relation to that business. This is broadly equivalent to a loan to value of no more than 40%, and in many cases, much less as taxable profits are often significantly lower than accounting profits as a result of capital allowances and other adjustments.

When the condition is not met, excess interest would be subject “an additional tax charge” which has yet to be determined.

Other Considerations

• Share classes in issue: To qualify, a REIT must only have in issue one class of shares being ordinary shares. This may restrict the attractiveness of REITs to some property groups where there may be other share classes in issue. Convertible debt is also not allowed.
• Owner occupiers: Owner-occupied property or property owned by a company whose shares are stapled to the REIT would not qualify for inclusion within the REIT. This would restrict the opportunities for owner occupiers such as retailers or hotel chains to take advantage of the regime.
• Development: Development for investment purposes could be undertaken within the ring-fence with no limit applied. Development for sale would normally be trading and, therefore, would be outside the ring-fenced business. Accordingly, it would be included in the measure of non-qualifying income and assets when the 75% test is applied.

Areas Still to Be Determined

• Groups: Details of how the REIT regime will apply to groups of companies have yet to be released. This would include application of the qualification tests to groups and the tax treatment of movement of assets, payment of interest and dividends within the group. The treatment of non-resident subsidiaries is also still unclear.
• Conversion charge: Details of the entry charge on a company’s conversion to a REIT are not to be disclosed until Budget 2006. As yet, it is not clear as to whether the charge will be based on inherent capital gains on assets to be contributed or instead applied to gross asset values—although the indications are that a charge on inherent gains is the more likely approach. This is the most significant omission from the information provided so far, being the immediate cost of entry into the regime which may determine how attractive REIT status is for existing UK property companies.

For more information, contact a KPMG tax professional in London:

Charles Beer, 020 7311 4193, charles.beer@kpmg.co.uk

Jonathan Thompson, 020 7311 4183, jonathan.thompson@kpmg.co.uk

Or with KPMG’s UK Centre of Excellence in New York:

Elliott Gingell, (212) 872.5799, elliottgingell@kpmg.com