WedlakeBell | Hotels and Leisure

hospitality news Winter 2008

UK REITs: A disappointing debut

The UK’s Real Estate Investment Trust (REIT) regime came into force in January 2007. It was anticipated that the launch of the new regime would transform property investment in the UK. This is because a REIT should, in effect, be exempt from UK taxes on profits and gains realised from its property portfolio. Hotel chains (particularly those with valuable properties valued at historic costs) would be an obvious beneficiary of the new regime, should their owners choose to convert into a REIT. This is because that upon a conversion to a REIT, a company will obtain an uplift (at market value) in the book costs of its property portfolio, subject to the payment of a tax entry charge of 2% (see below). This means that there should be less tax payable on a subsequent disposal of the properties involved. Yet the picture to date has not been so rosy.

The introduction of the REIT regime has coincided with the worst downturn in commercial property values since the early 1990s. For example, it is estimated that some REITS are trading at a discount to net asset value of more than 45%. Some experts also say this position has been exacerbated by the strict rules governing UK REITs – notably, the conversion charge (2% of the value of the properties) but also the stringent anti-avoidance regulations.

To date, it is estimated that 16 listed property companies have converted to REIT status but only one newly created REIT has been launched since January 2007.

What is a REIT?

REITs are property investment vehicles aimed at facilitating tax-efficient investment in a professionally managed portfolio of real property. In the world of international property investments, REITs are not unique to the UK but have been well established in the USA and Australia for decades. REITs can also be found in many continental jurisdictions.

Under the UK’s REIT regime, a UK company that satisfies certain legislative rules may elect to become a REIT. Its profits would not be taxable but only become taxable in the hands of the distribution from a REIT. An entry charge (at 2%) is imposed on companies that elect to convert to REIT status.

Becoming a REIT

The requirements for a company to attain REIT status are extremely complicated. These can be broadly described as ‘company conditions’ (that is, rules governing the corporate structure of a REIT) and ‘business conditions’ (that is, rules governing the business that should be run by a REIT). For example:

The REIT must be UK tax resident.
It must not be an open-ended investment company.
Its ordinary shares must be listed on a recognised stock exchange. It generally must only have one class of ordinary share capital in issue.
Subject to strict exceptions, it must not be a close company.
There are strict rules that govern the type of loans applicable to a REIT.
The company must operate a property rental business (its 'qualifying business'), the meaning of which is very prescribed.
There are strict threshold rules that govern the proportion of a REIT's income and assets which must be held in its qualifying business.

There are also detailed anti-avoidance rules that govern the running of a REIT.

UK tax treatment of REITs

As noted above, REITs are designed to be tax-efficient vehicles for the purposes of property investments but (as would be expected) the UK rules are detailed and feature anti-avoidance tests. In summary, the following tax rules apply to REITs:

REITs pay no UK tax on income and gains derived from its qualifying business.
A REIT is still liable to pay corporation tax in the usual way on profits and gains on any activities that do not form part of its qualifying business.
Although a REIT corporate group will be taxed on a direct sale of property, they will be taxed on gains made on the sale of shares in property-owning subsidiaries.
There are complicated rules that govern distributions made by a REIT. Once these rules are satisfied, a distribution by a REIT out of the profits and gains of its qualifying business are treated as UK rental income in the hands of its shareholders. Generally, income tax of 22% must be withheld by the REIT on all distributions to individual shareholders and to non-UK companies.
There are no special exemptions from stamp duty land tax applying to REITs.

Conclusion

The introduction of the REIT regime represented a dramatic change to the UK property investment landscape. It is, however, unfortunate that its debut has broadly coincided with the abrupt downturn in the UK commercial property market. It can also be said that their limited success has not been helped by the fact that the UK legislative rules on REITs can be onerous (particularly when compared with other major jurisdictions). Nonetheless, there is a strong case for a listed UK property investment company to convert into a REIT where it has a property portfolio with significant latent capital gains that substantially exceed the conversion charge. The case for other property companies (particularly non-UK resident companies) is less compelling, not least because of the high start-up costs.