On 13 October 2011, HM Treasury published its feedback on the informal consultation exercise proposed at Budget 2011 and carried out over the summer on potential changes to the Real Estate Investment Trust (“REIT”) regime. The proposed changes remove a number of barriers to entry to new REITs as well as promoting good business practice for existing REITs.

Below are the headline points:

  • The conversion charge for companies joining the REIT regime is to be abolished. To date, on joining the REIT regime, companies have incurred a 2% entry charge on the gross value of their property assets involved in their tax-exempt business. The abolition of this charge should bring a significant cost saving to existing property companies wishing to convert into REITs, and therefore is hoped to encourage the establishment of smaller REITs.
  • The strict listing requirements are to be relaxed so as now to allow listing on non-regulated stock exchanges. Listing on AIM and PLUS markets and their foreign equivalents will now be permitted.  Although the establishment of private REITs will still not be possible, the facility to have AIM and PLUS-listed REITS should also encourage smaller REITs to be formed as a result of the lower IPO and ongoing compliance costs associated with the junior markets.
  • A three year fixed grace period for meeting the non-close company requirement is to be introduced.  To date, close companies for UK tax purposes (i.e. broadly, those controlled by five or fewer persons or by any number of persons who are also directors) have been ineligible to become REITs.  HM Treasury has now agreed that new REITs will be entitled to a three year grace period in order to meet that requirement.  However, there will be no discretionary extensions to the grace period.  If the non-close company rules are not met by the end of the grace period for legitimate reasons, the company will at that point lose REIT status but without any further penalty. If, however, a company fails to meet the non-close company requirement but is deemed to have joined the REIT regime to gain a tax advantage, then existing legislation will be invoked.  It is unclear what HM Treasury means by this, i.e. whether existing anti-avoidance legislation will be invoked to mean that any tax advantage during the entire three year grace period is clawed back in its entirety or whether the company will lose its REIT status only with effect from the start of the accounting period during which the grace period ends.  I would have thought the former.
  • Diverse ownership rule for institutional investors. The consultation sought views on the introduction of a diverse ownership rule to enable institutional investors to meet the non-close company rule and set up UK REITs.  HM Treasury has said that it will introduce this rule and thereby enlarge the pool of potential investment in real property.  There are no further details on this at present.
  • Cash to be a “good” asset for the purpose of meeting the balance of business asset test.  To date, 75% of a REIT’s assets by value must be within their tax-exempt business (i.e. their property rental business).  HM Treasury has indicated that cash will soon count towards that 75%.
  • Redefinition of “financing costs” for the interest cover test. Under current rules, REITs suffer a tax charge if their income profits do not cover their financing costs at least 1.25 times.  As a result of the consultation, HM Treasury will change these provisions so that it is only interest paid on excessive borrowing that will be measured in the test rather than the total finance costs incurred in borrowing.
  • The time limit for complying with the distribution requirement is to be extended from three months to six months.

Although scant detail has been provided in relation to many of these measures, HM Treasury will publish detailed provisions in draft on 6 December 2011 in readiness for inclusion in Finance Bill 2012. Technical comment on the new draft rules will be invited at that stage.

Comment:  These are the most significant changes to the REIT regime since it was first introduced in the UK almost five years ago. A large number of the previous barriers to entry for REITs are now being abolished or relaxed and this should make conversion to a REIT a much more attractive option for many players, especially smaller property companies and institutional funds currently established offshore.

While current volatility in the capital markets is unlikely to result in an onrush of new REIT conversions (as happened in January 2007 when the regime was first introduced), this is a very positive development and we expect a lot of interest from the property industry during 2012 and beyond in looking at REIT status as a viable alternative to existing offshore structures.Thumbnail image for Money House.jpg

One area which was not dealt with in the consultation or the feedback is the removal of some of the particular barriers to the creation of residential REITs.  Increasing investment in the private rented sector is a key focus of the government and we understand that HM Treasury is still looking into proposals to introduce mortgage REITs and social housing REITs. In the current economic climate, an extension of the REIT regime to include these forms of investment as well as to encourage residential REITs generally would be a positive move.  In particular, we would like to see the following two areas addressed:

  • REITs only enjoy a tax advantage in relation to returns from a “property rental business”.  However, the nature of residential property means that managers are likely to need to “trade” properties – i.e. buy low, refurbish, let out and sell high – in order to deliver sufficient and stable returns to investors. Returns from such activities are not eligible for REIT tax treatment and, indeed, where they represented over 25% of the income profits or assets of the REIT, would jeopardise REIT status completely.
  • The absence of capital allowances in residential property businesses means that the obligation on REITs to distribute 90% of their property rental income to shareholders would be, in effect, more burdensome for residential REITs than it is for commercial property REITs.  If the government is serious about encouraging residential REITs, it should consult on either relaxing the 90% distribution rule for residential REITs or allowing a equivalent benefit to capital allowances in the private rented sector (such as a 10% wear and tear allowance).

(With thanks to Maria Wall who co-authored this blog)