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01 August 2008
The UK real estate investment trust (REIT) regime is set out in Part 4 of the Finance Act 2006 (as updated by the Finance Act 2007) and is supplemented by a number of regulations. It is also supported by guidance published by Her Majesty's Revenue and Customs (HMRC). The regime has been operational since January 1 2007 and 18 listed UK property companies, including many of the largest companies in the industry, have converted to or listed with UK REIT status. Entry to the regime is by notice to HMRC and does not require the creation of a new form of corporate vehicle.
A potential UK REIT must carry on a property rental business (ie, a UK property investment business or an overseas property business, for UK tax purposes). It must also fulfil the qualifying conditions, although it need not fulfil all of the conditions at the time of entry. The qualifying conditions fall into three categories.
A UK REIT must be a company and must:
However, it may not be (i) a close company or an open-ended investment company, or (ii) a party to excluded loans (broadly, profit-linked, asset-linked or non-commercial loans).
Tax-exempt business conditions
A UK REIT must have a property rental business that forms its tax-exempt business. It can also have other taxable businesses. The property rental business carried on by the UK REIT:
The property income dividend must be made 12 months from the end of each accounting period. The tax-exempt business may not involve (i) owner-occupied properties owned by the UK REIT or another group UK REIT company, or (ii) occupation by any company whose shares are stapled to those of the UK REIT.
Balance of business conditions
A UK REIT must pass two balance of business conditions - known as the profit test and the asset test - in each accounting period.
First, at least 75% of the total profits (before tax and excluding realized and unrealized gains and losses on the disposal of properties and items that are outside the ordinary course of the UK REIT’s business) from the business of a UK REIT, calculated in accordance with international accounting standards, must arise from its tax-exempt business.
Second, the value of the UK REIT’s assets in the tax-exempt business must be at least 75% of the total value of all of its assets, as valued in accordance with international accounting standards.
Provided that they do not exceed 25% of its activities, a UK REIT can undertake activities other than running a property rental business and still pass the balance of business conditions. These activities could be ancillary services associated with the property rental business or other activities, such as property trading or services. Certain classes of income and profit are expressly excluded from the tax-exempt business. These include various forms of income which are not treated as property income at present, such as receipts from transactions falling within the rent-factoring tax provisions and dividends from other UK REITs.
Given the exclusion of items that are outside the ordinary course of the UK REIT’s business for the purposes of the profit test, a one-off event that enhances the total profits of a UK REIT should not prejudice its status. The Real Estate Investment Trusts (Breach of Conditions) Regulations 2006 provide that in certain circumstances the value of the property rental assets may temporarily drop to 50% without the asset test being breached.
The 2007 regulations further relaxed the test: broadly, a breach of the test by a UK REIT during its first accounting period as a UK REIT will be disregarded, provided that the test is met at the end of the first accounting period.
Private companies and companies quoted on AIM cannot opt for UK REIT status by virtue of the recognized stock exchange listing requirement. Thus, a UK REIT is a public rather than a private vehicle and must comply with relevant listing requirements, as well as the UK REIT regime.
In addition, a UK REIT must be a company and cannot be a trust or other non-corporate structure. However, these types of structure may be accommodated within a group UK REIT. The exclusion of owner-occupied properties from the regime has clear implications for retailers, among others.
The UK REIT regime is aimed at property rental companies. It is not aimed at property trading or at property development companies which carry on a trading business, rather than an investment business. A UK REIT that holds a property and disposes of it in the course of trading activity will suffer a tax charge; the property will be deemed never to have been within the tax-exempt business.
The operation of the tax-exempt business conditions allows companies to carry out development activities within the tax-exempt business, provided that the development is undertaken with a view to generating future rental income.
However, the provisions specifically provide that where a UK REIT develops a property held within its tax-exempt business and then disposes of it within three years of completion of the development, the disposal will be treated as falling outside the tax-exempt business. This will be the case if the cost of development exceeds 30% of the fair value of the land and buildings on entry into the UK-REIT regime or on acquisition, whichever is later.
In such cases the proceeds will be chargeable to tax as either a capital or a trading receipt. This may be the case even if the original intention was to develop and hold the property. However, the entry charge paid in respect of the redeveloped asset will be refunded.
Groups of companies can qualify as a group UK REIT. A group UK REIT is comprised of a principal company and all of its 75% subsidiaries, except open-ended investment companies and insurance companies. In broad terms, a company is a 75% subsidiary of another if the parent company is the beneficial owner (directly or indirectly) of at least 75% of the ordinary share capital. Each subsidiary must also be an effective 51% subsidiary under the statutory test used to determine a corporate group for chargeable gains purposes.
When applying the balance of business conditions in a UK REIT, the UK and non-UK property rental activities of a UK-resident company are included within the group UK REIT’s tax-exempt business, together with the UK property rental business of a non-UK company. Non-UK activities of non-UK resident companies are treated as being within the group UK REIT’s tax-exempt business for this purpose.
Additional requirements apply to group UK REITs, including the rules regarding the submission of prescribed financial statements for the group to HMRC for each accounting period.
A company (or group) that meets the conditions will not automatically become a UK REIT. The company (or principal company, if part of a group) must serve written notice on HMRC before the beginning of the accounting period for which it wants to be treated as a UK REIT. There is no minimum time limit for giving notice. In order to enter the regime, the UK REIT need not initially fulfil all of the qualifying conditions: at the point of giving notice it must be resident in the United Kingdom and it may not be an open-ended investment company. The Finance Act 2007 removed the requirement that a company had to have listed shares at the point of giving notice. Therefore, an unlisted vehicle may give notice of entry into the UK REIT regime and join the regime on the day it is listed.
The entry charge provisions of the UK REIT regime levy a 2% charge on the gross market value of the properties used within its property rental business. The market value is calculated at the date immediately before entry to the UK REIT regime. The entry charge will be collected at the same time as corporation tax is payable on the profits of the first accounting period following entry to the UK REIT regime. If the UK REIT pays corporation tax in quarterly instalments, the entry charge will be collected in instalments, which must be included in each quarterly computation.
Alternatively, companies can elect to spread the entry charge over four years in instalments of 0.5%, 0.53%, 0.56% and 0.6% (2.19% in aggregate, an effective rate of interest of about 6%). If a UK REIT leaves the regime within three years and this instalment option has been chosen, any remaining instalments are brought into charge immediately. A company wishing to spread the entry charge over four years must notify HMRC of this decision at the same time as electing to join the regime. This election to spread the cost of the entry charge is generally irrevocable, although the charge itself is refundable in certain limited circumstances. For instance, where a property previously used in the tax-exempt business is sold in the course of the UK REIT’s trade, that property may be treated as if it was never within the tax-exempt business and the entry charge paid in respect of that property will be refunded.
Group UK REITs and entry charge
There is no entry charge when a member of a group UK REIT purchases a property or acquires another UK REIT company. However, there is an entry charge when a member of a group UK REIT acquires a company that is not a UK REIT. This entry charge will arise in respect of the property rental business of the company being acquired.
If a UK REIT is acquired by a non UK REIT, the acquisition will effect a de-listing of the UK REIT. As a result, it will fail the recognized stock exchange listing requirement and will be excluded from the UK REIT regime from the end of the accounting period preceding the acquisition. The Finance Act 2007 introduced revisions to permit demergers without additional entry charges.
Effect of entry
On entering the UK REIT regime, the company will be deemed to dispose of and re-acquire at market value the properties to be used in its property rental business. Any chargeable gain or loss arising from the deemed disposal will not be brought into account for tax purposes.
Once within the UK REIT regime, the company will generally retain its UK REIT status until it issues a valid notice on HMRC to leave the regime (specifying a date of cessation after the date on which the notice is received by HMRC), or until HMRC withdraws the company from the regime (either on notice or through automatic termination for certain breaches of a qualifying condition). A UK REIT can give notice to leave the regime at any time. However, where companies elect to leave the UK REIT regime within 10 years of joining and dispose of any property that was involved in the tax-exempt business within two years of having left, any uplift in the base cost of the property that occurred under the regime will be disregarded. This may result in a higher capital gain or lower allowable loss than would otherwise be the case. There will be no rebate on the entry charge in such cases.
The 10% rule originates from HMRC’s desire to prevent a non-UK shareholder, resident in a country with a double taxation agreement with the United Kingdom, from receiving a dividend from a UK REIT and being able to avoid or substantially reduce the tax withholding under the UK REIT regime because of the size of the shareholding. The rule acts to restrict this possibility.
UK REIT status will not be lost if a person is beneficially entitled to 10% or more of the UK REIT’s dividends, shares or voting rights - a tax charge will be levied instead if a distribution is made to such a person. However, the rule now applies, by virtue of the regulations, to a person defined as ‘the holder of excessive rights’. A 'person' for these purposes is expressly limited to corporate shareholders; thus, individuals and non-corporate shareholders are outside the rule. The tax charge will apply to the whole of the distribution to that company, not merely to the excess, unless the UK REIT has taken reasonable steps to avoid the payment of such a distribution. A potential UK REIT should examine its memorandum and articles of association so that it can make any changes necessary to establish that it has taken reasonable steps to avoid the payment of a distribution to such a shareholder. The HMRC guidance defines the meaning of the term ‘reasonable steps’ to include a provision in the UK REIT’s memorandum and articles of association requiring a shareholder whose shareholding or voting power exceeds the 10% threshold (often referred to by the term 'substantial shareholder') to enter into a transaction designed to separate the entitlement to that dividend. This may be achieved by a dividend strip transaction, where the counterparty would not be beneficially entitled to 10% or more of the dividends, or by the establishment of a trust to hold the dividends for a person who is not a substantial shareholder (unless or until the shareholder ceases to be a substantial shareholder).
A company considering a change to its memorandum and articles of association should consider fully the practicalities of doing so, including any requirement to call an extraordinary general meeting and the need for shareholder approval. Shareholders must be fully informed of the effect of a conversion to UK REIT status on their tax affairs. The British Property Federation has developed a template circular for companies in the conversion process, as well as a draft article dealing with the 10% rule and the close company condition; both have been used by many companies in their conversion process.
Rather than a conventional gearing ration, the UK REIT regime uses a ratio test that compares the profits of a UK REIT’s tax-exempt business (before interest costs, capital allowances and losses brought forward from a previous accounting period) with its financing costs. This ratio does not limit how much a UK REIT can borrow, but creates a tax charge on the UK REIT to the extent that it is breached. The ratio must not be lower than 1:1.25. This ratio is applied to a group UK REIT on a consolidated basis. The purpose of the ratio is to prevent a UK-REIT being highly geared, or at least subject to finance costs which reduce the amount of profits available for distribution to shareholders. HMRC is seeking overall tax neutrality for the UK REIT regime. Reducing the amount of income in the hands of the shareholders would have an impact on that position. Breach of the requirement does not result in a loss of UK-REIT status; instead, the company will suffer a tax charge on its excess financing costs. Thus, a UK REIT can still adopt what it considers to be an appropriate level of gearing.
Where a property within the tax-exempt business is sold and the proceeds are to be reinvested in assets of the tax-exempt business, such proceeds are treated, for a period of two years, as assets held in connection with the tax-exempt business. However, any income derived from such proceeds is treated as being outside the tax-exempt business and is therefore taxable.
Broadly, a breach of certain of the qualifying company conditions will result in automatic expulsion from the regime. Inadvertent and minor breaches of other conditions will not usually lead to the loss of UK REIT status, unless such breaches are persistent. HMRC can also serve notice terminating UK REIT status where a company has been repeatedly involved in tax avoidance.
A group UK REIT can include a joint venture company carrying on a property rental business with a third party as part of the tax-exempt business to the extent of the UK REIT’s interest. The UK REIT must have an equity interest of at least 40%. On electing to include the assets and income of the joint venture company in the business of the UK REIT, the joint venture company is required to pay a proportionate entry charge equal to 2% of the value of its assets in the property rental business at the date the election becomes effective. This is the case even if the joint venture company was previously a member of a UK REIT group and an entry charge was previously paid in respect of the company. The Real Estate Investment Trusts (Joint Venture Groups) Regulations 2007, enacted in December 2007, extend the joint venture rules to more complex group structures. They are retrospective to January 2007.
If a group UK REIT holds property through a tax-transparent vehicle, such as a partnership or a transparent unit trust, its share of the property and income will qualify for the purposes of satisfying the balance of business conditions, provided that its interest in the partnership or unit trust exceeds 20% in HMRC's view. The stipulation of a 20% holding for this purpose is not statutory. Income from a tax-transparent vehicle which is part of the UK REIT’s property rental business is exempt.
For further information on this topic please contact Christopher Luck or Michael Cant at Nabarro by telephone (+44 20 7524 6000) or by fax (+44 20 7524 6524) or by email (email@example.com or firstname.lastname@example.org).
An earlier version of this update first appeared as an information download in the REITs section of the London Stock Exchange website.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
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