Appendix 2 explores in detail some of the more technical aspects of the measures proposed as part of the consultation.

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1 Sent by only to 10 June 2011 Dear Sirs PIA 1 response to informal consultation on Budget 2011 REITs measures General comments We very warmly welcome the REITs measures announced by the Government at the 2011 Budget, which demonstrate that the Government has been listening to representations from industry both about REITs and about the residential sector. We also welcome the clear indications we have had that Government intends to implement all the REITs measures on which it is consulting in Finance Act If the time between now and then is used well and effective consultation with industry continues, we may hope to see one or more new REITs potentially with a residential focus launched when the changes take effect, as well as improved business practice among existing REITs as anomalies and confusion within the rules are removed. Our response to the informal consultation is broadly divided into three parts: First, we summarise the key strategic and commercial considerations arising from some of the new REITs measures and give our high level reactions to some of the specific measures proposed. Appendix 1 identifies important opportunities for reform which fall outside the scope of this consultation, but which we would like to see taken forward in the future to promote large scale investment in residential property through REITs and good business practice within the UK REIT sector more generally. Appendix 2 explores in detail some of the more technical aspects of the measures proposed as part of the consultation. 1 The Property Industry Alliance ( PIA ) brings together six leading property industry bodies which, while retaining their separate identities and roles, work together to tackle major industry issues in a more coordinated way. The PIA comprises the Association of Real Estate Funds, the British Council for Offices, the BCSC (British Council of Shopping Centres), the British Property Federation, the Investment Property Forum and the Royal Institution of Chartered Surveyors. PIA REITs submission 10 June

2 Key considerations Overarching issues/general reactions. Overall, feedback from the industry strongly supports the measures proposed. Some are optimistic that residential REITs might be brought to market in the light of these proposals. Others doubt whether they will be sufficient to trigger a step change in institutional appetite for investment in residential property but as should have been apparent from our response to the Treasury s consultation on the private rented sector in 2010, the emergence of a large scale, institutional residential market in UK residential property faces broader challenges than can be addressed through the REIT regime alone. For example, the change to how SDLT applies to purchases of multiple dwellings announced in the Budget is another very important piece of the jigsaw which has been warmly welcomed by the industry. Overall, we see real potential for large scale residential investment to begin to happen in the next few years, thanks to changes such as these as well as to likely market developments and the wider housing landscape. This is a good time to be bringing forward this significant reform of the UK s REIT regime. REITs are a very compelling, globally recognised model for real estate investment, providing good and low cost access to capital for real estate, and diversified, liquid and efficient exposure to real estate for investors. The potential pool of capital that might be invested in UK real estate, including residential in particular, is enormous and diverse. While the REIT regime will not be the natural home for all of it, we do think the regime should be made as welcoming as possible to as broad a range of investors as possible it would be wrong to focus solely on the UK pension funds and insurers, for example. The raft of measures now proposed send a very positive signal and, if implemented correctly, will represent important steps in the right direction. Government s focus on helping make residential REITs work has already encouraged many in the wider industry to look more closely at residential investment and build to let, as well as at the REIT regime. In discussion with industry participants, it seemed clear to us that there is a very broad overlap between the priorities of the commercial property industry and those focused on residential property generally, the measures proposed should therefore bring benefits across the board. It is important to note that the residential market (like the commercial market) is very diverse, with a range of different business models based wholly or (in the case of approaches involving shared ownership) partly on rental. We encourage the Government to continue to engage with a range of market participants and experts with a view to understanding how different models might be accommodated within the REIT regime. We support the introduction of a diversity of ownership test for institutional investors. The REIT close company rule is complex and unwieldy, treats as close arrangements that ultimately involve diverse ownership, and operates as a barrier to the formation of new REITs. Relaxing the rule in appropriate circumstances would make sense, as would making it clearer, simpler to understand and apply and more certain in its application. Government should remember in this context that it has other tools available to prevent (widely held) trading groups from creating captive REITs. Generally, however, this is a very complex area, so we have set out more detailed thoughts in Appendix 2. The term institutional investor should be widely defined. We welcome this measure which should make investment in property through REITs easier for investors generally and thereby enlarge the pool of potential investment in property. It is important that the definition of institutional investor be flexible enough to accommodate a wide range of potential investors; not just UK pension funds and insurance companies, but also potential investors from the sovereign wealth fund, hedge fund, private equity, charity, registered provider (housing associations, etc.) and listed company sectors, both UK and overseas, and PAIFs (for which REITs are an eligible investment). To provide both the certainty and the flexibility required, we would recommend an approach based around a non exhaustive list of approved types of institutional investor (set out in secondary legislation), with a PIA REITs submission 10 June

3 clearance mechanism allowing existing and potential REITs to clarify whether or not an actual or prospective investor would qualify as an institutional investor. We discuss this in greater detail in Appendix 2. New REITs should benefit from a grace period of between three and five years from having to meet both the non close company test and the listing requirement. Any grace period would have to be long enough to allow new REITs to feel very confident of having adequate time to find investors in even the toughest of investment climates. We see no sense in providing a grace period from meeting the non close company test while nevertheless requiring listing from the outset the law should recognise the close commercial relationship between the two conditions. We would suggest a period of between three and five years. Whatever the grace period, however, HMRC should have the power to extend it in exceptional circumstances, where market conditions have frustrated a new REIT s efforts to meet the requirements in good time. In order to facilitate the setting up of new REITs we would suggest that there be no minimum number of shareholders required during the grace period. We discuss grace periods in greater detail in Appendix 2. Relaxing the listing requirement should broaden the appeal of REITs. Smaller property businesses may be encouraged to adopt REIT status if they are able to list on AIM, and this should help deliver, over time, a bigger and more varied REIT sector. The lower listing and ongoing costs compared to a full London listing (see below) make AIM a good alternative for newer, smaller businesses in the sector. Listing on AIM is considerably cheaper than a main market (i.e. LSE) listing. Although the precise costs will very much depend on the type of business and their particular circumstances, a business could expect to incur between 150,000 and 300,000 upon first listing on AIM, and between 35,000 and 70,000 each year thereafter. The equivalent figures for an LSE listing are approximately 500,000 upon first listing and between 150,000 and 225,000 per year thereafter. These costs exclude any underwriting that may be required upon initial listing and the increased costs of disclosure and corporate governance required as a result of listing on AIM or LSE. We have considered whether there is a downside to allowing UK REITs to be listed on markets other than the London Stock Exchange and other recognised stock exchanges. REITs have a very strong global brand and a reputation for corporate governance, transparency and investor protection that might be watered down through exposure to markets such as AIM which attract retail investors but provide less protection to them. We do not think that risk outweighs the important advantages of making it easier for new and smaller REITs to access capital and liquidity at lower cost on what is, after all, a regulated and popular market. The Government has made it clear that it is not currently contemplating allowing private, unlisted REITs, and officials have indicated that no such proposal was put to ministers because limited interest was expressed in informal consultations prior to the Budget. We have heard a range of different views from industry, including many expressing strong interest in unlisted REITs. We would like to continue that discussion with you, but will not pursue it further here. We welcome the abolition of the REIT conversion charge. Since the introduction of the REIT rules the conversion charge has been seen by many as a major barrier to entry because it represents a substantial upfront cash cost which is difficult to justify commercially, particularly where a business considering conversion is not carrying latent gains, and particularly in the residential context where yields are generally lower. Removing the charge may encourage offshore funds (including residential ones) to become UK REITs, as their management would become significantly easier (e.g. no costs for PIA REITs submission 10 June

4 overseas directors, no more overseas Board meetings etc). It should also make it more likely that new funds would be set up as REITs rather than using offshore structures, for the same reasons. We understand that no change is being proposed to the existing rules regarding the rebasing for capital gains purposes of properties held by new entrants to the REIT regime. We would also expect transitional rules to ensure that the ability for REITs to recover conversion charge previously paid is retained post abolition. If Government were minded to explore broader changes to the REIT regime in connection with the abolition of the conversion charge or to approach transition differently, we would ask for engagement and discussion with the industry as early as possible, as contentious and complex questions could arise. The issue of churn in residential portfolios should not present an intractable problem for residential REITs. We understand that the Government decided against any measure to reduce the uncertainty that confronts residential investors because of the complex and sometimes contradictory way in which case law distinguishes, for tax purposes, between trading and investment (discussed in section 11 of the industry response to the Treasury s 2010 PRS consultation). While the trading/investment issue is certainly not one that will affect all residential portfolios, we would like to make the industry s position clear, because we suspect it may have been misunderstood. Residential businesses commonly talk about trading properties when they simply mean disposing of them, without any reference to whether the disposal is in the context of a trading or investment activity for tax purposes. We have not asked that businesses carrying on, for tax purposes, a trade of building or acquiring dwellings for sale should be allowed to do so within the tax exempt ring fence. The issue is simply that, because crystallising capital growth through periodic disposals often forms part of the residential investment business model, it can often be very unclear whether a residential investment business carried on with a view to delivering rental income (as well, of course, as capital growth) amounts to trading or investment for tax purposes. It would be helpful if REIT law or guidance offered greater clarity and certainty (perhaps via specific safe harbours) in such cases. We are at your disposal to discuss any of the matters discussed in this letter, including its appendices, over the coming weeks and months. Please contact Peter Cosmetatos at the British Property Federation on or at pcosmetatos@bpf.org.uk in the first instance. Yours faithfully Rosalind Rowe Chair, PIA REITs Strategy Group Phil Nicklin Chair, PIA REITs Technical Committee PIA REITs submission 10 June

5 Appendix 1 Additional changes that could be made in future to improve the REIT regime generally and promote residential investment through REITs We set out in the list below a series of measures outside the scope of the present informal consultation which the Government should consider implementing in future to improve the REIT regime and further promote large scale investment in residential property through REITs. REIT specific points Allow the formation of private, unlisted REITs Introduce greater certainty in REIT law or guidance regarding the trading/investment distinction in relation to residential property Where REIT A owns shares in REIT B, allow any PID payments made by B to A to be treated as income of A s property rental business Address the inconsistent treatment of investments by REITs in joint ventures of different types Address anomalies in the way the three year development rule operates in certain contexts (e.g. where original cost was incurred long before the disposal, or where the disposal is forced by the exercise of CPO powers) Clarify the rules governing how distributions by a REIT must be attributed, as these do not accurately reflect the intended policy objective or existing HMRC practice Consider reducing the 90% distribution requirement to 85% to reflect the significant reduction in capital allowances writing down rates since the original 90% level was set Permit the carry forward of section 550(2)(a) distributions made in excess of that required i.e. where more than the minimum required PID is found to have been paid by the time the tax returns for an accounting period are agreed with HMRC General points Many UK institutional investors remain concerned about the relatively low income yield on residential investment, but need third party management to help address concerns about reputational risk from direct management of residential tenancies. VAT at 20% on letting and management fees (as well as repairs and maintenance) has a significant effect on the net income available for dividends and we would therefore recommend introducing more favourable VAT treatment of costs incurred in connection with development and management of residential property Consider allowing some form of tax depreciation for owners of residential investment property. PIA REITs submission 10 June

6 Appendix 2 Technical considerations This appendix explores both some of the more technical issues arising from the REITs measures subject to informal consultation and areas of the existing legislation which would benefit from greater clarity. Measures included in the informal REITs consultation Introduction of a diverse ownership rule for institutional investors Introduction of a fixed grace period for new REITs to meet the non close company requirement Allow cash to be a good asset for the purpose of the REIT balance of business test Extension of the time limit for complying with the distribution requirement in particular circumstances involving stock dividends Redefinition of financing costs for the REIT interest cover test Areas of the existing legislation which HMRC has identified as needing technical amendments Repayment interest Losses in the context of the balance of business profits test Losses in the context of the profit : financing costs ratio test REIT takeover by another REIT Date of payment of a PID Controlled Foreign Companies treatment of REIT companies Other areas of the existing legislation that would benefit from greater clarity REIT demergers Requirement for reserves reconciliation 14 days after end of accounting period Three year development rule where original cost incurred a long time ago Three year development rule and intra group transfers Three year development rule and compulsory purchase orders REITs and loan relationships (Condition F of section 528 CTA 2010) Improved signposting in section 570 CTA 2010 All statutory references are to CTA 2010 unless otherwise specified. PIA REITs submission 10 June

7 Introduction of a diverse ownership rule for institutional investors We understand that the primary purpose of the existing close company condition in the REIT rules is to prevent a small group of investors from benefiting from the REIT regime in respect of closely held arrangements. This test can give rise to difficulties in circumstances where a small group of institutional investors who are themselves diversely owned want to establish or invest in a REIT. We think that a rule which allowed a REIT to be controlled by one or more institutional investors (that are themselves diversely owned or are charities/registered providers) would be of significant benefit in assisting with the establishment of new REITs. We are aware of a number of potential new REITs who would wish to take advantage of such a rule and might otherwise have difficulty meeting the existing close company condition. We have identified two alternative ways of addressing this issue, each discussed in more detail below. However, we think that there are a number of complex issues to consider here and believe it would be helpful to meet with you after you have digested the responses to the Consultation to discuss how best these issues could be addressed. Amending the "close company" condition The first approach we have identified would be to: repeal section 528(5) to allow REITs to be considered non close companies if they satisfy the requirements of sections 444 or 447(1)(a); and extend section 444 for REIT purposes, so that it also applies where a company is controlled by one or more institutional investors. The legislation should include a list of the entities which would be treated as meeting the definition of an institutional investor. We would strongly recommend that such a list was non exhaustive so that there was scope for an entity not included on the list, but which fell within the concept of such an investor to be accepted by HMRC as meeting the definition. We would expect that it would be helpful to include a power for HMRC to list further entities by way of regulation. We suggest that the non exhaustive list of institutional investors should include the following: registered pension funds life insurance companies financial institutions authorised under the Financial Services and Markets Act 2000 (or their wholly owned subsidiaries) registered providers collective investment schemes with more than (say) five participants investment trusts sovereign wealth funds registered charities (perhaps as recognised by Finance Act 2010) companies listed on a recognised stock exchange (or their wholly owned subsidiaries). PIA REITs submission 10 June

8 We suggest that it would also be necessary to include provision for any foreign entity which has similar characteristics to any of the above. We would also request that a clearance service be introduced to allow existing and proposed REITs to confirm in advance with HMRC that existing and potential investors to whom the REITs are marketing would meet the definition of an institutional investor. We note in this regard that a clearance regime exists for both PAIFs and offshore funds to determine whether they meet the genuine diversity of ownership condition. We would emphasise that the Exchequer is already protected from abuse of this condition by existing measures in the REIT rules. For example, the owner occupied rules in section 604(2) and the REIT (Prescribed Arrangements) Regulations 2009 would prevent a REIT being controlled by a listed company which occupies the properties for the purposes of its trade. The attraction of this approach is that the existing condition that a REIT is not a close company would remain in place and it would be relatively simple to amend it to include the new diversely owned institutional investor concept into the existing REIT rules. We think the above approach would continue to address HMRC's concern about a REIT being closely held, whilst allowing a REIT to be controlled by one or more institutional investors. A particular advantage of this approach is that diverse ownership per se does not have to form a qualifying condition for the special rule for institutional investors: registered providers and charities, for example, may not be widely owned as such, but the fact that they are run for the benefit of the public should nevertheless qualify them as institutional investors for the purposes of this measure. Replace the close company condition The second approach would involve replacing the existing close company condition with a new diverse ownership condition. An alternative approach might for example use the US REIT diverse ownership test (the 5/50 test ) as a starting point. This test essentially looks to see whether more than 50% of a REIT is held directly or indirectly by or for five or fewer individuals. It would look through direct shareholders to the ultimate beneficial owners. We think that this would also achieve the Government's objective of ensuring that a REIT is not closely held whilst permitting ownership of a majority of a REIT by institutional investors which are themselves diversely owned. A brief outline of the US REIT 5/50 test as we understand it is as follows. Essentially, an entity will not qualify as a US REIT if more than 50% of the value of its shares is owned directly or indirectly by or for five or fewer individuals at any time during the last half of the REIT's taxable year. For the purposes of the 5/50 test, there is a look through rule so that stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as owned proportionately by its shareholders, partners, or beneficiaries. There is also an anti avoidance rule to aggregate family shareholdings. Certain entities are deemed to be individuals for the purposes of the 5/50 test. The 5/50 test does not apply in the first taxable year for which the election to be treated as a REIT is made, so there is a one year grace period in the US rules. The 5/50 test is applied by looking through a US domestic pension trust and treating the pension trust's beneficiaries as holding the pension trust's stock in the REIT in proportion to their actuarial interests in the pension trust. This approach has some attraction as it is arguably simpler that creating definitions for various types of UK (and overseas) institutional investors. The operation of this rule need not cause any significant administrative burden for existing REITs or HMRC as it should be straightforward to identify whether a REIT is ultimately owned by or for five or fewer individuals and an institutional investor should PIA REITs submission 10 June

9 easily be able to demonstrate its diverse ownership. It could also work for appropriate charities etc., on the basis that they should not be owned for five or fewer individuals. However, we recognise that this approach would involve drafting a new concept into UK tax legislation. Interaction with holders of excessive rights rules It is also important to consider the impact of a relaxed diversity of ownership requirement on the existing penalty regime on making distributions to holders of excessive rights. If it is proposed as a matter of policy that in future a small number of institutions can between them own substantial shareholdings in a REIT, it will be necessary to mitigate the impact of that penalty regime. We would expect that a relaxation of the diversity of ownership requirement would encourage ownership of stakes of 10% or more by institutions which are of a sufficiently complex/regulated nature (an insurance company, for example) that there would not be available the ordinary market solutions such as fragmenting the total shareholding between sister subsidiaries none of which owned more than 9.9%. It therefore appears to us to be necessary to consider the various types of institution which might be treated as qualifying for these purposes and to consider how the dividend rules should apply to a holding 10% or more directly by such an institution. Introduction of a fixed grace period for new REITs to meet the non close company requirement Overview We welcome the proposal for a fixed grace period in which a company or group can look to meet the close company condition. We consider that this will be particularly helpful to institutions/property managers who wish to establish REITs, and need a period in which to be able to attract investors. In terms of the length of a grace period, it will be key that this is set realistically given that the ability to attract new investors will be dependent not only on factors relating to the specific company/group, but also on general market conditions. For example, if a start up REIT had been created in 2007, it is unlikely that new investors would have been willing to invest until the current year at the earliest (and certainly we understand that in Germany, which adopted a form of pre REIT as part of their REIT rules, a four year period initially applied (in which the pre REIT would need to achieve listing) which has recently been extended to take account of recent economic conditions). For this reason, we would recommend that the grace period is at least three years, and ideally up to five years, so that the REIT has sufficient comfort that it can achieve the required diversity of ownership notwithstanding a period of adverse market conditions effectively allowing the REIT to ride out the economic cycle. In connection with this, it would also be helpful of HMRC could retain a discretion to extend the grace period should (for example) market conditions mean that the relevant period proved in practice unrealistic this could be provided for as a REIT specific discretion, rather than applying to extend the period generally, so HMRC could for example have regard to the steps taken to attract new investors in exercising its discretion. PIA REITs submission 10 June

10 Scope of grace period Government should consider whether a grace period should be limited solely to the close company condition. For a start up REIT, it would be appropriate if the requirement to list is also relaxed during that grace period allowing in effect a private unlisted REIT during the grace period, with comfort being taken that the sponsors of the REIT will be looking to an IPO within that period to be able to continue REIT status. Here, we note that the listing and close company conditions are connected as a commercial matter, particularly when account is taken of the need for a certain minimum number of shares to be available to the public in connection with listing. Thus, in the absence of a relaxation of the listing requirement during the grace period, it is likely that as a matter of practice, few entities could benefit from the proposed grace period. Other considerations In relation to the number of shareholders the REIT should have at the commencement of the grace period, industry feedback suggests that this should be one. That links to the fact that we would anticipate that in many cases a single investor would look to seed the REIT on its own with new investors subscribing or purchasing shares over time thereby ensuring diversity of ownership. If a grace period is introduced, there needs to be a clear understanding of the consequences of a REIT failing to satisfy the diversity of ownership condition within the grace period. Any entity (and its investors) looking to take advantage of the grace period will need clarity and certainty as to the financial implications if, for whatever reason, REIT status cannot be maintained after expiry of the grace period. Obviously, the existing provisions of CTA 2010 relating to termination of REIT status will need to be amended to take account of the grace period. It is vital that the cessation of REIT status clearly runs from the expiry of the grace period (with a deemed accounting period ending on the relevant date), with no retrospective effects. We also consider that failure to meet the close company condition within the grace period should be a stand alone termination event, distinct from the Chapter 8 provisions on breaches of conditions, and one to which section 582 does not apply. Allow cash to be a good asset for the purpose of the REIT balance of business test We welcome the announcement that cash will be a good asset for the REIT balance of business asset test. This is a positive step which will allow REITs to hold cash until the right investment opportunity arises, without having to worry about the consequences for their status as REITs. We would wish to see this change made in a way which makes monitoring of compliance for a REIT as straightforward as possible. We think this could best be achieved by treating cash as an asset relating to property rental business for the purposes of the balance of business asset test, without any limitation on time or amount. We suggest that the definition of cash should follow that used for the purposes of the rule regarding funds awaiting reinvestment. For new REITs in particular, it will be important that capital raised from the initial public offering can count as an asset relating to property rental business so that the REIT is not required to invest that capital in any particular time period. For existing REITs, a similar point applies in relation to cash received on a rights issue or other capital raising. We think that it would be potentially unworkable for such cash to count as a good asset for only a certain time period. As a fungible asset, it would be almost impossible for a REIT to track the different sources of cash held on a pooled basis. We also think that it would be unnecessarily burdensome for only a certain proportion of cash to count as a good asset. It would make no sense from a commercial perspective for a REIT to sit on cash indefinitely when investors would want to see property returns. There should be no risk to the Exchequer of a REIT abusing this rule by having a main business of holding cash on deposit because a PIA REITs submission 10 June

11 REIT would still need to carry on a property rental business that involves at least three properties and to satisfy the balance of business profits test. We would expect that income derived from cash on deposit would continue to be treated as profits of a residual business. We think that the approach outlined above would benefit REITs and particularly the creation of new REITs, by allowing them to invest any cash in accordance with their business plan, whilst being a simple rule to understand and apply, so reducing the compliance burden for a REIT Extension of the time limit for complying with the distribution requirement in particular circumstances involving stock dividends We welcome the announcement that the time limit for complying with the distribution requirement is being extended in certain cases involving stock dividends as the current three month time limit has proved problematic for some businesses. The proportion of shareholders electing to take a stock dividend is difficult for a company to anticipate particularly at times of stock market volatility (for example one company which has an average of 40% of shareholders electing for a stock dividend has seen this fall to 10% on occasion). If, for example, the cash element of the dividend was to be a PID and the stock element a non PID the company will not know the amount of PID it is paying until after the election date. If the PID element is lower than anticipated it will be commercially difficult for the company to make a further PID payment within a short period of time. Listed companies will generally make dividend payments at regular intervals, generally quarterly or biannually, on predetermined dates which are indicated in advance. In addition the quantum of a dividend, whether it will be PID or non PID and whether there will be a stock option must be announced some time in advance of the payment date. The London Stock Exchange rules require that a dividend is declared at least 16 business days before the date to make an election in respect of taking the dividend as cash or stock and the dividend paid within 20 business days of the election date. If there is no stock element the dividend must be declared at least four business days before it is made ex dividend and paid within 32 business days of the ex dividend date. Paying a dividend outside the usual timeframe is problematic and it would be preferable to extend the timeline to comply to at least six months. Redefinition of the financing costs for the REIT interest cover test The definition of property financing costs in section 544(3) needs to be refined to accommodate the large debits or credits that might arise in a particular period when debt is repaid or restructured or derivative contracts are closed out, and in certain other cases where financing costs arise which are outside the control of the REIT and in no way represent extraction of profits undermining the distribution and withholding tax rules that this rule is intended to prevent. Such financing costs typically represent actual (but exceptional) cash payments, but sometimes they may merely reflect accounting entries (such as to recognise fair value movements in derivatives). The debits and credits arising can be particularly large in the period in which such transactions take place, resulting in a penalty under section 543, despite the REIT meeting the requirements of the profit : financing cost ratio under normal circumstances. Repayment of debt A company might hedge cash flows and/or market value movements in its debt with a derivative, the idea being that a profit/loss repayment of that debt would be matched by a loss/profit on the derivative. Currently the definition of property financing costs in section 544(3) to (5) (in particular PIA REITs submission 10 June

12 section 544(5)(a)) does not include credits in respect of a debtor relationship (although it does include debits in respect of such relationships). However, it does include the matching debit on the derivative in section 544(5)(c), so the net position for the purposes of profit financing costs will be a debit, despite commercially there being a matched position overall. We suggest that credits in respect of debtor relationships are included under section 544(5)(a). Derivative close out costs Debits and credits resulting from market value movements in derivatives that are used to hedge debt are generally disregarded until (and if ever) the derivative is closed out. This is normally as a result of the Disregard Regulations (SI 2004/3256). In the event such a derivative is closed out, the cumulative market value movements over the term of the derivative are all taxed in the accounting period in which the derivative is closed out (unless they can be spread because particular conditions are satisfied). This can lead to a distortion of the profit : financing cost ratio in that particular period. In recent years, the size of the debits or credits arising in such circumstances has been exacerbated by the large movement in interest rates. We suggest that debits and credits are excluded from property financing costs where they are exceptional due to their size or incidence. Unrealised fair value movements HMRC have for some time been clear that they do not expect debits and credits in respect of unrealised fair value movements to impact the profit : financing cost ratio. The legislation currently makes it clear that certain derivative movements (s544(5)(c)) are included in the test. In many cases unrealised fair value movements can be ignored on the premise that they are not 'costs' relating to financing, however, there have been a number of occasions whereby REITs have encountered unrealised fair value movements that cannot be ignored under the current legislation. In order to rectify this there would appear to be two options: Introduction of the words 'costs giving rise to' at the beginning of s544(5)(c), or Inclusion of an additional clause that states that debits and credits arising from unrealised valuation movements are not to be treated as financing costs for the purpose of this ratio. Repayment interest If a REIT disposes of a property by way of trade, in particular where the property has been developed since acquisition, the REIT can make a claim for repayment of the proportion of the entry charge paid in relation to that property. The legislation does not indicate from what date repayment interest should be calculated. A disposal of a property giving rise to a repayment of the entry charge could take place many years later during which period profits arising from the rental of the property will have been exempt from corporation tax. We agree with the solution proposed by Tony Linehan of HMRC in a letter dated 13 May The legislation should make it clear that the repayment results from the disposal of the property and it is that event that causes the repayment. The date from which repayment interest should be calculated for this repayment should be the due date for the accounting period (or if a REIT pays tax by quarterly instalments, the due date for the quarter) in which the disposal was made. PIA REITs submission 10 June

13 Losses in the context of the balance of business profits test In Tony Linehan s letter of 13 May 2011 he notes that The condition cannot be applied where the property rental business has a loss and the residual business has a loss. We would first like to add that we think the condition cannot necessarily be applied properly where the property rental business has a loss and the REIT is in a loss position overall (regardless of whether it has a loss or profit in the residual business). This is because section 531(1) compares the profits of the property rental business with the aggregate profits of the group or company (rather than just the residual profits). We would also like to point out that there are many other defects in the balance of business profits and assets tests that are far more important than the issue highlighted in relation to losses, e.g.: the exclusion of unelected joint venture companies; the exclusion of non corporate JV entities that are 20% owned; and indeed whether the profits test should really be an income test. We would therefore suggest that instead of making a minor amendment in relation to the issue raised in relation to losses, the balance of business tests should be reviewed holistically with a view to making amendments in Finance Bill Losses in the context of the profit : financing cost ratio test The policy intention of the profit : financing test is to ensure that REITs are not able artificially to reduce their exempt profits, and therefore their distribution requirement, through excessive gearing. We believe that in addition to the amendment to the definition of financing costs addressed above there are two technical matters which should be addressed in the way in which the financing cost ratio works: a. As identified in the HMRC letter on technical changes to be made to the legislation, the profit : financing cost ratio does not work where the REIT has no profit before the deduction of financing costs. b. In addition, the test produces anomalous results in circumstances where the excess financing cost is more than 20% of the profits before deduction of financing costs (referred to below as ungeared profits ). This is because the mathematical way in which the penalty tax charge is calculated has no maximum. In extreme circumstances, it is possible that the penalty can bring into charge more profits than the REIT would have if it had no debt at all, which cannot be the intention. The working of this test is best illustrated by way of examples using the terminology in the existing legislation (section 543). Profits are the aggregate profits (as calculated for tax purposes) of the members of the group before deduction of capital allowances or financing costs ( PP per the legislation). Financing costs are PFC in the legislation. PIA REITs submission 10 June

14 The ratio PP/PFC must be at least 1.25, otherwise an amount of profit is brought into charge to tax equal to the amount by which the financing costs exceed the maximum that would allow the test to be met: i.e., taxable profit = PFC PP/1.25. The illustrative examples using current legislation are as follows: Example 1 Example 2 Example 3 Example 4 Example 5 PP 5,000 5,000 (1,000) 5,000 5,000 PFC (10,000) (6,000) (2,000) (3,500) (4,500) Net profit (5,000) (1,000) (3,000) 1, Example 1 PP/PFC is 5,000/10,000 = 0.5. The test is failed. Excess interest is 6,000. This is more than the total ungeared profits (PP). Example 2 PP/PFC is 5,000/6,000 is The ratio test is failed. Excess interest is 2,000. This is more than 20% of the ungeared profits. Example 3 PP/PFC is (1,000)/2,000 is negative 0.5. This is not a meaningful ratio. It is not possible to calculate the excess interest where PP is negative or zero. Example 4 PP/PFC is 5,000/3,500 is The ratio test is met. Example 5 PP/PFC is 5,000/4,500 is The ratio test is failed. Excess interest is 500. In examples 4 and 5, the ratio test is operating in the manner envisaged by the policy. Example 3 shows the situation envisaged in the HMRC letter. Examples 1 and 3 show the situation outlined at b. above. Example 1 shows the extreme example where the result of the current test is to bring into the charge to tax an amount that is greater than the profits of a REIT with no gearing. The intended policy is that breaching the required ratio will generally result in a tax charge where financing costs exceed 80% of profits before deduction of financing costs. In Example 2 it can be seen that the amount brought into charge exceeds 20% of the ungeared profits and is, therefore (while not as extreme as Example 1) overreaching the policy objective. PIA REITs submission 10 June

15 In practice, these two issues can be resolved by the addition of some additional clarifications to the existing test: a. Where PP is less than or equal to zero, the notional income should be taken to be zero. b. The notional income (which is calculated as PFC PP/1.25) should have a maximum of 20% of the profits before deduction of financing costs, i.e. 20% of PP. These rules can be added to the calculation of the notional income or excess in section 543(3). REIT takeover by another REIT The two main issues in relation to the application of the REIT rules where one REIT takes over another REIT are: Ensuring that the REIT which is taken over ( T REIT ) meets the legislative conditions up to the point it is taken over; and Ensuring that obligations of T REIT to make distributions from its property rental business are taken on by the acquiring REIT ( A REIT ). Ensuring that the REIT which is taken over ( T REIT ) meets the legislative conditions up to the point it is taken over Section 527 sets out the requirements that must be met if a group or company is to be a UK REIT in relation to an accounting period. Furthermore, section 543 tests whether a REIT has met the required profit: financing cost ratio. We recommend that, in the case of T REIT being taken over by A REIT, these requirements should be tested for both A REIT and T REIT by reference to an accounting period that is treated as ending immediately before the takeover, but purely for the purposes of sections 527 and 543. In other words, no actual accounting period should end for any other purpose. Ensuring that obligations of T REIT to make distributions from its property rental business are taken on by the acquiring REIT ( A REIT ) In his letter of 13 May, Tony Linehan refers to ensuring that distributions from the property rental business made by the taken over REIT are treated as income from property in the hands of the new shareholder i.e. taxable in A REIT s hands. We believe that this gives rise to an inequitable result as all of T REIT s former shareholders (and in particular exempt pension funds) would suffer a higher overall incidence of tax on the profits of the property rental business of T REIT, than they would have if T REIT had distributed them by way of dividend directly to those shareholders. It would be more equitable if, as we suggest, the legislation were amended so that the obligations of T REIT to make distributions from its property rental business are taken on by the principal company of A REIT ( A plc ). This way, former exempt shareholders of T REIT that become shareholders of A REIT will still receive distributions gross and other former shareholders will be taxable on distributions of those profits in the normal way. What we have in mind is for A plc to fulfil the role of principal company in section 530(1) in respect of distribution of profits of the property rental business of T REIT, after the takeover: PIA REITs submission 10 June

16 A plc would then be required to distribute by way of dividend the remaining profits of the property rental business of T REIT not previously distributed by its principal company T plc (to the extent required by s530(1)); and Any dividends it pays in this respect to the former T plc and A plc shareholders would be taxable under s548 as a PID in the normal way. This could be achieved if, for example, it were possible deem a similar concept to section 170(10) TCGA, into section 530(1). Section 170(10) TCGA states: if at any time the principal company of a group becomes a member of another group, the first group and the other group shall be regarded as the same. In the case of a takeover, the T REIT group and the A REIT group would be regarded as the same and A plc would be the principal company of that same group after the takeover (as a group can only have one principal company). Applying section 530(1) to a takeover and deeming a similar concept to section 170(10) TCGA into it, section 530(1) would read:...the condition is met...if at least 90% of the group s UK profits [of the property rental business] arising in the accounting period are distributed a) by the principal company [of the T group i.e. T plc before and A plc after the takeover], b) by way of dividend, and c) on or before the filing date for the principal company's tax return for the accounting period In practice, A plc would add T plc s closing allocation of profits between the distribution pools of section 550(2) to its own allocation of profits for these purposes, and show this in the next reconciliation statement following the demerger. This ensures that in practice there is no difference in the amount or timing of PID and non PID dividends as a result of the demerger, and so no tax disadvantage for the Exchequer, investors or the REIT. As a result: A plc would then be required to distribute (and would be capable of distributing) by way of dividend the remaining profits of the property rental business of T REIT not previously distributed by T plc (to the extent required by section 530(1)); and Dividends paid by A plc to the former T plc and A plc shareholders would be taxable under section 548 as a PID in the normal way. We also believe that the application of this concept gives rise to an appropriate result where a non REIT takes over a REIT group (T REIT group whose principal company is T plc). Date of payment of a PID Section 530 provides that a REIT must distribute 90% of its tax exempt rental profits on or before the filing date for the principal company s tax return. Under section 564 a REIT which does not meet the distribution condition must pay an amount of corporation tax (calculated by reference to the shortfall of profits not distributed). However, no tax charge will be imposed provided the REIT pays a dividend within the three month period beginning with the date on which the REIT group s UK PIA REITs submission 10 June

17 profits can no longer be altered. Section 564 also provides that where the section 530 distribution condition is not met, the breach is to be ignored. HMRC s guidance indicates that the purpose of the three month rule is to allow REITs to meet the distribution condition where the finally agreed measure of tax exempt profits is higher than the amount returned (e.g. due to negotiations on a capital allowances claim). However, there is nothing in section 564 which restricts the circumstances in which a group can rely on the three month rule. That is, a REIT group could delay payment of its entire PID to three months after the date on which the REIT group s UK profits can no longer be altered. The inference taken from comments in Tony Linehan s letter of 13 May is that HMRC believe that they need to deal with the possibility of non payment of PID through a change to the legislation. However, in our view HMRC already has some protection against this circumstance and could bolster this through guidance rather than legislation. Under section 574, HMRC may issue a termination notice to a REIT where there is a serious breach of any of the conditions set out in sections 529, 530 or 531. As the intention of the legislation is clearly for groups to make a best estimate of their PID requirement and pay this by the filing date as set out in section 530, HMRC would be on strong grounds for arguing that non payment of a PID, or of a nominal PID, by the filing date is a serious breach. The converse argument to this is that where the section 530 distribution condition is not met, section 564 states the breach is to be ignored and corporation tax is charged instead. This could be taken to mean that there can be no breach of the distribution condition in any circumstances. But if that is the case, the reference to section 530 in section 574 would appear to be redundant. If HMRC have a concern on this aspect, we would suggest that this can be resolved by adding some additional guidance to GREIT That could indicate that a serious breach would include relying on the three month rule in circumstances other than where there has been a shortfall as a result of an increase in the finally agreed tax exempt profits of the UK business as compared with the amounts shown on the CTSA return. Alternatively, if HMRC wish to include some legislative amendment we believe that the simplest adjustment would be to amend section 564(5) to read: No charge to corporation tax arises under subsection (2) if (a) there is a post filing day adjustment to the computation of tax exempt profits; (b) as a result of the post filing day adjustment the condition in section 530 is not met in relation to an accounting period (c) an additional distribution by way of dividend is made by the principal company or (as the case may be) by the company; (d) the distribution is made within the relevant period; (e) as a result of the distribution the condition in section 530 is met in relation to the accounting period. PIA REITs submission 10 June