Background
In December 2005 the Government published draft legislation for the introduction of Real Estate Investment Trusts in the UK (“UK-REITs”). The introduction of a UK-REIT is intended to facilitate access to property as an asset class to a wider range of investors, by creating a more liquid and tax efficient vehicle. This will encourage growth in the commercial and private rented property sector.
HM Revenue and Customs (“HMRC”) has asked for feedback on the proposed legislation to be provided by 27 January 2006.
http://www.hmrc.gov.uk/drafts/estate-investment.htm
What are REITs
A REIT is a company that owns and operates income producing real estate, which can be commercial or residential. Most of this income is distributed to shareholders and in return the company is exempt from corporation tax.
REITs are designed to securitise the income from rented property assets in a tax efficient way and to ensure that the return from investing in a property company is more aligned with direct property investment. This is done by removing the requirement for companies to pay corporation tax, thereby taking away “double taxation” at both the corporate and the investor level.
The benefits
A property company converting to REIT status would benefit from the tax exemption and should be better able to raise funds through the stock market. This is because many property companies currently trade at a discount to net asset value, partly as a result of double taxation suppressing the value of the shares. A more tax efficient vehicle should help to correct this anomaly.
Investors will benefit from easy access to property as an asset class and relatively healthy dividend returns. UK-REITs are expected to qualify as investments for savings products, such as ISAs and CTFs, in addition to SIPPs. They will also provide good diversification for investors as REITs have shown low correlation with equities and bonds.
Qualification and key features
In order to qualify as a REIT a company will need to meet certain conditions. The key features are summarised here:
- the company must be a UK resident, closed-ended company listed on a recognised stock exchange (which means the Main Market and does not include AIM);
- the shares in the company must not be closely held, which means that no one person (individual or corporate) should hold more than 10% of the shares;
- the property letting business, which will be tax exempt, must be effectively ring-fenced from any other activities and should comprise at least 75% of the overall company, with regard to both its assets and its total income;
- a minimum of 95% of the UK-REIT's net taxable profits (after interest and capital allowances) from the ring-fenced letting business must be distributed to investors;
- the UK-REIT will be required to withhold basic rate tax on the distribution of profits paid to investors; and
- the company will be subject to an interest-cover test on the ring-fenced part of its business (which is a means of calculating how highly geared it is) and should attain a specified level.
Points for consideration
One of HMRC’s key objectives is to ensure that the introduction of a UK-REIT regime is revenue neutral for the Exchequer. Therefore, it intends to impose a conversion charge on companies wishing to take advantage. HMRC will complete the consultation on the legislation before deciding upon the rate and mechanism of this charge, which will be announced at Budget 2006.
The requirement for a limit on individual shareholdings of 10% is also being driven by the desire to minimise revenue leakage, as well as allowing greater access to retail investors. This is effectively aimed at capping overseas investment, such that any clawing back of withholding tax through double-tax treaties is minimised. This requirement and the level and method of any conversion charge are generating a lot discussion in the industry.
Another point worth considering is the interest cover test, which aims to restrict UK-REITs from being highly geared. Many in the industry would prefer any change in gearing level to be a disclosable event rather than having a prescriptive limit imposed. These key features could be fundamental in establishing traction for a UK-REIT sector, as existing companies consider the pros and cons of conversion.
Many readers will be aware that the UK Listing Rules currently impose requirements on property investment companies which could conflict with the proposed UK-REIT regime. However, the UK Listing Authority is already working closely with HMRC and the London Stock Exchange to review the rules for investment entities, the aim being to ensure a streamlined listing regime that dove-tails with the proposed legislation and does not impose regulation on top of legislation.
Next steps
The introduction of a UK-REIT is long awaited and will bring economic benefits to the UK property industry and the wider economy. The regime will help to improve the quality and quantity of finance for investment in property and allow greater access to property assets through a vehicle that will appeal to both retail and institutional investors alike.
The REIT markets in the US and Australia are often described as being saturated, with investors and companies looking for opportunities overseas. It is imperative that the industry works with HMRC to implement a regime that will ensure the UK becomes the natural home for the listing and trading of European REITs.
The consultation on the draft legislation is the crucial final stage and industry participants are encouraged to consider some of the key points discussed and respond in a constructive way to help shape the regime. The London Stock Exchange will be at the forefront in the preparation and implementation of a UK-REIT and is looking forward to working with our customers on this exciting new initiative.