UK REIT Summary Structure and Investment Criteria

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1 UK REIT Summary Structure and Investment Criteria The following table is intended to provide a brief summary of how the Government s new thinking on a UK REIT compares with last year s recommendations by the Industry Working Party. In order to keep the table to a reasonable length the points set out are a very high level overview only. The Government has confirmed that it would aim to legislate in the Finance Bill 2006, so long as it finds workable solutions to the issues about which it is concerned. It continues to stress that there should be no overall cost to the Exchequer. Comments on the new paper are requested by 27 May Simon Clark (Linklaters) 16 Issue Industry Recommendations 2004 Government Proposal 1 Legal Entity A corporate rather than a trust or other collective investment scheme structure. As there will be no need to introduce a new regulatory framework for a corporate structure this will encourage speed of introduction. Investors will benefit from the existing corporate governance regime, protections afforded by directors responsibilities and the Takeover Code. Agreed, although the new Con Doc notes that tax should be consistent with that for property collective investment schemes generally. 2 Listed and Unlisted Vehicles should be both listed and unlisted leaving open opportunities for sophisticated and institutional investors to invest in unlisted vehicles. 3 Closed Ended UK REIT should be closed ended irrespective of whether a vehicle is listed or unlisted. International experience shows closed end vehicles are the predominant structure of choice. No conclusion reached yet evidence to be considered further. Agreed. A further consultation process should be implemented to consider aligning the tax and possibly regulatory treatment of APUTs and OEICs closely with that of UK REITs to ensure genuine open-ended alternative to UK REITS. 1

2 Issue Industry Recommendations 2004 Government Proposal 4 Investor Base Concentration limits for listed UK REITs should be as set by the UKLA under the UK listing rules, in particular: 25% of shares have to be in public hands; See the response to 2 above re listing. (iii) shares are not in public hands if held by a director ESOPS or pension funds of the company or any person holding an interest in 5% or more of the stock; and Controlling Shareholder provisions should apply. Concentration criteria should not apply to unlisted UK REITs where investor base is restricted to sophisticated and institutional investors. 5 Management No legislative restrictions, UK REITs (listed and unlisted) should adopt internal or external management business model of their choice. The market should decide can be internal or external. As long as vehicles offer investors absolute transparency in terms of cost and information etc and management is capable of being removed by the investors, decisions of management should not be determined by regulation. 6 Income Distribution Requirements Although distribution of the majority of the cashflow should be a key feature of the UK REIT, it is not appropriate to distribute a substantial element of the gross income predepreciation. A substantial proportion of UK REITs cashflow earnings (post expenses and depreciation) should be distributed at a payout ratio in line with international standards eg 80% plus. A UK REIT would be required to distribute at least 95% of its net ring-fenced income to investors, calculated by reference to its Schedule A profits (and its equivalent for overseas properties) after appropriate deductions and capital allowances. The Government acknowledges that further discussion with industry would be needed to establish how such a distribution 2

3 Issue Industry Recommendations 2004 Government Proposal As UK company law cannot be easily amended this should be subject to existing overriding provisions relating to distributable profits. requirement would fit with legal restrictions imposed on companies by UK Companies Acts. 7 Eligible Income Definition To define UK REIT income the following guidelines should be applied: 75% of UK REIT gross income must be from real estate related income; The Government contemplate a ring fenced property letting business relating to UK and overseas properties. (iii) 95% of net income must be from similar sources or other passive forms of income, eg dividends and interest from non-real estate sources; no more than 5% of a REIT income is to be from non-qualifying sources, eg non real estate business. Non-ring fenced business would include all other activities including income from ancillary services to be subject to corporation tax as normal. The second qualifying proportion should be calculated on a net basis as this better reflects the level of activity within property groups. At least 75% of the UK REIT s total gross income to derive from ring-fenced activities. UK REITs should be entitled to hold (above these limits) taxable REIT subsidiaries (TRS) subject to the following maximum exposure income and asset constraints: At least 75% of the UK REIT s gross value of assets to relate to property allocated to the ring-fenced business. value of gross assets of all UK REITs TRSs cannot comprise more than 20% of UK REIT gross assets; and at least 75% of UK REITS gross assets must consist of real estate or secured loans. In order to ensure that UK REITs are focused on property investment activity, it may additionally be necessary to permit only properties generating a significant proportion of Schedule A profits (and its equivalent for overseas properties) to be allowed within the ring-fence. 3

4 Issue Industry Recommendations 2004 Government Proposal Qualifying REIT subsidiaries (QRS) should be permissible to carry on eligible activities which can be consolidated with the parent UK REIT for purposes of incoming asset. The treatment of subsidiaries is seen as linked to other technical tax matters the Con Doc is open on the point. Trading activity gains should not fall within the eligible income rules and should attract tax at the basic rate of income tax. Development for long term purposes should be eligible as should the creation of major mixed use schemes/ communities where subsequent sales are integral to the business plan. Trading profits would be taxable. The Con Doc is in terms that all development would be taxable. Safe harbour rules should be introduced so that a development (or other asset) is regarded as being held for investment purposes if the asset was retained for at least 3 years by the REIT. Normal tests of trading should apply - no special rule. 8 Tax Regime General The tax regime for the vehicle (and investors) should replicate direct investment in real estate and to the extent this is the case, taxation should be levied at the investor level. The new Con Doc considers how such a regime might work in practice. It raises particular concerns as to how the regime might work for non-resident shareholders. The new regime should not cause a loss of tax revenue for the Exchequer. The importance of this is stressed again. There should be no tax on rental income or capital gains in the UK REIT. This is the general approach taken by the Con Doc. Distributions of rental income should be subject to withholding tax to minimise complexity for basic rate tax payers. Agreed. Profits from non-ring fenced activities would be treated as ordinary dividends. A mechanism for passing investment incentives eg capital allowances on to investors should be included. Not agreed capital allowances would not be passed through. Capital distribution to be taxed as capital gains (rather than Not agreed Con Doc sees distributed 4

5 Issue Industry Recommendations 2004 Government Proposal income) in the hands of investors. capital gains as taxable as income. 9 Distribution of Capital Gains Gains to be considered on a net portfolio basis rather than asset by asset. No obligation on UK REITs to distribute capital gains. Agreed. 10 Borrowing Levels No gearing restrictions should be introduced. This should be left to the operation of market efficiency. 11 Development Activity Market forces should be left to operate efficiently and no constraints on development should apply. 12 Definition of Property There should be no restriction on eligible property types. UK REITs should be free to invest in land and property in the broadest sense (including infrastructure and PFI projects). The Con Doc envisages further discussions due to fears about tax avoidance. No prohibition in principle from some development activity, although the Con Doc seems to see this as non ring fenced i.e. taxable. The intention is not to exclude specific property sectors (subject to general rules relating to income etc). All forms of real estate investment activity must be subject to clear arm s length contracts between the tenants and the UK REIT. Providing eligible income rules apply UK REITs should be able to hold other forms of real estate exposure (eg derivatives CMBS or shares in other UK REITs) without restrictions on the amount of this type of investment activity. No minimum residential qualification. No single asset REITs. No minimum holding period needed for each asset. UK REITs should be entitled to hold qualifying assets in any jurisdiction without restriction. Agreed subject to general income etc tests. No requirement for sector or geographic diversification within UK REIT portfolios ie single sector focus vehicles are permissible. No single property to exceed a specified proportion of total value. 13 Conversion Charge In principle, acceptance of a conversion charge, to ensure fairness of tax treatment and no loss of revenue to the There is no specific proposal in the Con Doc although the principle that there must 5

6 Issue Industry Recommendations 2004 Government Proposal Exchequer. However a conversion charge should be just one element of the broader tax debate and not a single solution. be no cost to the Exchequer is repeated. Points to be considered: (iii) the mechanism must reflect a diverse range of investment vehicles active across the UK real estate; the level of the charge must be set to encourage vehicles to convert; further dialogue with HMT and Inland Revenue is necessary to identify appropriate level for the conversion charge and its mechanism. 14 Stamp Duty Acquisitions and disposals of direct real estate by UK REITs to be subject to SDLT under normal rules. Agreed. Trading of shares or units in a UK REIT (listed or unlisted) should be subject to current SDRT of 0.5% of the value of the trade. The imposition of a 4% SDLT charge on REIT units or shares would hinder market development. Agreed. No transfer tax (SDLT or SDLT) to be imposed where existing vehicles convert to, merge with or acquire other REITs. This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other issues of law, please contact one of your regular contacts at Linklaters, or contact the editor. Linklaters. All Rights reserved 2005 Please refer to for important information on the regulatory position of the firm. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com 6