Targeted changes to UK REITs for asset holding companies
The latest consultation was published in December 2020 and provides a summary of the responses made under the initial consultation (published Spring 2020) as well as more detail on the likely way forward and further questions. The document suggested that there would be a further comprehensive review of the REIT rules as part of the wider funds review. In January 2021 the wider review of the UK funds regime was published, but rather than set out comprehensive changes the review reemphasised the issues raised in the AHC consultation. Despite this inconsistency in strategy, the proposals put forward under the AHC review still suggest that the government is committed to making lasting changes to simplify the REIT regime.
In order for the UK to be an attractive jurisdiction to locate real estate fund vehicles, UK funds need to be structured in a way that results in rental income and gains accruing directly to the investors without additional layers of tax. This means that fund vehicles must either be transparent or exempt for both income and gains. Offshore property unit trusts, often located in Jersey (JPUTs) and partnerships are typically used because they are transparent for income and gains, and this is one of the main reasons for their continued popularity.
The same tax-neutral result could be achieved by the use of a UK REIT as an AHC, as REITs are exempt on both UK property income and gains (subject to elections being made in the case of JPUTs). The relaxation of certain of the REIT requirements in 2012, including the listing requirement, have meant that REITs have been used more widely since then by joint ventures involving institutional investors that would otherwise have used a partnership/JPUT structure. A key benefit of using a REIT is that it is based in the UK. Not only are the costs in terms of time and expense of operating offshore SPVs avoided but a UK based REIT is internationally recognised.
Often the upfront cost of establishing a REIT makes them unattractive. Also, in a joint venture or closed ended fund where there is unlikely to be regular trading of investors’ interests, the listing requirement will generally need to be satisfied by listing the REIT on the International Stock Exchange (TISE), which does not have a trading requirement. The use of a foreign stock exchange, especially one in a low tax jurisdiction, can dilute the attractiveness of a REIT vehicle if one of the main attractions is that it is seen as a UK based vehicle.
What changes need to be made?
There are a number of changes that we think could be made to the UK REIT regime to make it a more viable alternative and we made these comments in response to the first consultation.
The condition in CTA 2010 section 528 that REITs must be listed is one of the primary issues that the government must address. Following the relaxation of this requirement in 2012, allowing funds to meet the requirement by listing on TISE, the condition does not represent a meaningful bar to entry to the regime for vehicles that are not widely held and traded. Instead, the government could consider borrowing the tests used for capital gains exemption for non-resident real estate funds in TCGA 1992 Schedule 5AAA. Here, eligibility for exemption under this regime depends on a fund meeting either a genuine diversity of ownership test or a non-closeness test (similar to the REIT regime’s own non-closeness test).
Holders of excessive rights
The provisions in the REIT regime designed to prevent the reduction of UK tax on rental profits through treaty relief can introduce complexity where a funds’ interest is 10% or more. As most treaties provide for reductions in withholding tax on dividends where the shareholder holds 10% or more, the tax charge on REITs making distributions to corporate shareholders with “excessive rights” (namely ones whose shareholding is 10% or more) effectively prevents treaty relief on withholding tax reducing the UK’s right to tax rental profits. This often means investors have to consider fragmenting their holding so that it is held by a number of separate subsidiaries, none of which holds 10% which in turn creates an unnecessarily complex holding structure for the investor. It should be possible to retain an effective safeguard for the government with the inclusion of an anti-avoidance rule, essentially permitting REITs to make distributions to investors holding 10% or more where the recipient is not entitled to treaty relief (or a greater amount of relief) as a result of meeting the 10% threshold or potentially providing for that right to treaty relief to be waived as a pre-condition to investment in a REIT.
In addition to the headline changes to the REIT regime, we also think there could be a series of other supplementary changes to make the use of UK REITs more attractive.
UK real estate investments and joint ventures will often be funded with shareholder loans as well as (or instead of) third party debt. Where this is the case, and the fund structure is a REIT (or other UK entity), interest on shareholder loans will be subject to UK withholding tax, with the possibility of a domestic exemption or treaty relief limiting this, depending on investors’ residence and status. Generally where withholding tax arises in a UK-based holding structure, the quoted Eurobond exemption can be used, however this is not an ideal solution. Removing the liability to pay withholding tax for qualifying UK holding companies (including REITs) would make the UK significantly more attractive as a holding company jurisdiction, at no or minimal cost to the Exchequer.
An extension to the SDLT group relief rules would help to make it easier for REITs to remain entirely based in the UK by collapsing any JPUT SPVs they hold and transferring their UK property assets to UK REIT subsidiaries without SDLT. REITs may often acquire properties in their JPUT wrapper, and a REIT’s preference will almost always be to hive the property up from the JPUT into a REIT subsidiary post completion, as this will simplify the running of their structure and avoid Jersey running costs. However, it is often not possible to extract a property from its JPUT wrapper without an SDLT charge arising, where the property has debt secured on it (due to the provisions treating secured debt as chargeable consideration for SDLT purposes).
What is the government considering under the AHC regime?
In the government’s response published in December 2020 it was acknowledged that there are a number of areas where the REIT regime could be reformed. These include the priorities we raised in 2020 around the listing requirement and holders of excessive rule, but also challenges with institutional investors, the close company requirement and the balance of business test.
- The government has taken on board the responses received in relation to the listing requirement. Whilst the government is not wholly convinced by the proposal to remove it entirely they entertain the notion, but they seem to more keenly welcome views on a targeted relaxation.
- The government is also considering the excessive rights rule so that it would only apply on distributions to entities where withholding tax would be required. This is line with our recommendation.
- Despite the rules being relaxed in 2012, representations have been made to review the interaction of the close company rule with institutional investors. The government appears prepared to review the list of institutional investors (including equivalent overseas REITs) and seeks views on which types of investors should be added to the list. The government is also considering introducing a requirement to be widely owned to apply to certain investor types in the list of institutional investors, as is the case for the NRCGT rules.
- Responses were also made in relation to the balance of business test. This test requires that 75% of a REIT’s assets and income derive from property investment assets but the results of the test can be aggravated in situations where certain property development is required by regulation or planning. The government seems willing to consider a number of reforms to reduce the burden of the test.
- On withholding tax the issue is acknowledged as a barrier by the government. The government appears to be looking at a withholding tax exemption in the AHC regime, however they also state that the issue will be taken forward in the wider funds review (however, as the list below highlights, this issue is not explicitly covered by that review).
- Finally, it appears that the points we made regarding SDLT have not been taken forward for now.
What is the government considering in the wider funds review?
A number of other issues raised in the AHC consultation have been pushed into the wider funds review. This includes work to:
- reduce the unnecessary burden where both the Corporate Interest Restriction and the interest cover test apply;
- update of the 3-year development rule to be more in line with commercial practice;
- remove the 3 property holding requirement; and
- reduce double tax arising where a REIT holds overseas property
We have submitted our detailed response to the AHC consultation. HMT and HMRC are also conducting a number of stakeholder meetings that we are taking part in. After the consultation ends, the government plans to issue draft legislation in the summer of 2021, and it is anticipated that changes would take effect during 2022.
The wider funds review is open until 20 April 2021. As it is a call for input there is no clear timetable for implementation, however the government is likely to undertake more detailed consultation on specific proposals. There is likely to be some prioritisation of issues, as the first question in the review asks respondents to list their top three priorities for implementation.