Will it be all-REIT on the night?

In recent years, sustained strength in the market has made property an
increasingly important asset class for investors. Many high net worth
individuals have participated by buying directly, while smaller investors have
acquired residential property through buy-to-let. The broad appeal of property
to investors of all sizes has prompted the industry to focus on developing a
pooled vehicle for indirect investment, however.

Existing solutions include investing through UK limited companies, limited
liability partnerships, limited partnerships, investment trusts, unit trusts and
offshore companies. Without going into the pros and cons of the current options,
to a greater or lesser extent, each presents its own specific challenges. An
individual investing in a property company will, for example, be hit with a
double tax charge, in the form of corporation tax on the company, followed by
income tax when the profits are distributed.

This proliferation of ill-fitting solutions arose, in part, from industry
attempts to work around the frustrating absence of an ideal vehicle for property
investment – a ‘holy grail’, which is tax transparent, liquid, listable and,
ideally, whose values move with property prices, not equity prices. From the
government’s perspective, the ungainly arrangements which evolved to fill this
gap have led to an inefficient market and a lack of supply.

Broad consensus between government and industry was only achieved with the
publication of the Barker Report, in December 2003, which proposed a new bespoke
vehicle, the tax treatment of which would be more closely aligned to the
arrangements in place for direct investment in property.

That vehicle has come to be known as a UK-REIT (real estate investment trust)
and will be introduced when the Finance bill (No. 2) is enacted, in respect of
companies with an accounting period beginning on or after 1 January 2007.

In essence, the UK-REIT will be a company. Provided the relevant conditions
are met (see box) a company which distributes at least 90% of the profits from
its property business to shareholders will be tax exempt. Its shareholders will
then be taxed on dividends paid out of the tax exempt property business, as if
they had received rental income. Tax of 22% will be deducted at source.

It’s important to note the government’s stated intention was ‘not to reduce
the tax contribution made by the property investment market, but to reform the
means by which it is made’. As such, companies electing to become a REIT will be
subject to a 2% conversion charge on the market value of their property
business. The charge may be spread over four years.

So, are UK-REITS up to the weighty task to which they have been assigned?
It’s probably fair to say that, after extensive consultation, the chancellor
appears to have taken into account most of the major concerns expressed by the
property industry. Judging by experience in other jurisdictions which have
introduced REITs – for example the US, Netherlands, Australia, Belgium, Canada,
Singapore, Japan, France and Hong Kong – there will be a steady take up over the
next three to five years, which is good news for many companies in the listed
property sector. It should certainly result in a more liquid market and provide
greater access to property as an asset class to UK investors.

But it is a major disappointment that the requirement for the company’s
ordinary shares to be listed on a ‘recognised stock exchange’ will preclude both
unlisted companies and those listed on the Alternative Investment Market from
qualifying as a REIT. In one fell swoop, the bulk of the mid-market property
deals will, for all practical purposes, be excluded.

In addition, the mechanism used for calculating the conversion charge – being
a percentage of market value, as opposed to a percentage of unrealised gains –
may well act as a disincentive to companies wishing to start a property business
today, then convert to REIT status after January 2007.

In short, those players seeking either to build up a property portfolio, or
to invest in a portfolio of medium size are unlikely to find a UK-REIT to be the
holy grail they hoped for. Already, demand for an unlisted ‘virtual-REIT’ is
becoming apparent and the question now is whether offshore jurisdictions will,
once again, be able to offer something the UK cannot.


Conditions for company:

• Must be resident in the UK
• Must not be an OEIC
• The ordinary share capital must be listed on a ‘recognised stock exchange’.

This excludes AIM
• Must not be a close company
• The shares must be ordinary shares, or non-voting, fixed-rate preference
Interest payable to any loan creditor must not be linked to the company’s
results or the value of its assets and must not exceed a reasonable commercial

Conditions for tax exempt business:

• Must involve at least three properties
• No one property may represent more than 40%of the total value of the
properties included in the company’s rental business
• No property may be owner occupied
• At least 90%of profits of the property rental business must be distributed by
way of dividends

Conditions for balance of business:

• The profits arising from the tax exempt business must be at least 75%of the
company’s total profits
• The value of assets involved in the tax exempt business must be at least 75%
of the company’s total value of assets

Additional charges:

In addition, regulations are expected to be introduced which may cause a sum
to be charged to tax if:
• A distribution is made to any person who is entitled to 10%or more of the
dividends, or who holds or controls more than 10%of the company’s shares or
voting rights; or if the sum of the tax exempt profits and the financing costs
attributable to the tax exempt business fail to cover such finance costs by a
ratio of at least 1.25:1

Alastair Maclean is a partner in the corporate department at Maclay
Murray & Spens

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