With housing portfolios all but excluded from German Reits legislation, the market could lose out on outside investment. Florian Schultz and Herbert Harrer report.
Germany’s grand coalition has finally approved the long-awaited draft of the German Real Estate Investment Trusts (G-Reits) law. The new law is scheduled to come into force on 1 January 2007. Several aspects of the law suggest that not every G-Reit will be attractive; investors and rating agencies will need to take a close look at each company on a case-by-case basis. But the law will have one major defect: housing portfolios are practically excluded.
A Reit is a vehicle that invests in property and enjoys a measure of protection from corporate and trade tax. In return, the Reit has an obligation to distribute a significant amount of its cashflow to shareholders.
Reits have been an important part of the real estate markets in the US since 1960 and in Australia since 1971. They exist in many countries such as Holland, Belgium and France and were launched in the Far East in early 2000. The UK will introduce Reits in 2007.
In Germany, which boasts the largest real estate market in Europe, the introduction of Reits has generated significant controversy. On 2 November 2006 the German government approved the draft law. Further delays in the legislative process are not expected, so the law can become effective on 1 January 2007.
According to the draft, German Reit stock corporations (Reit AG) will generally be unregulated stock corporations. Their business purpose is limited to the purchase, holding and sale of title of ownership and rights of use in rem to real estate in Germany and foreign countries, as well as the management relating to renting and leasing of such real estate and necessary ancillary services. All shares in the Reit AG must constitute a single class of ordinary shares with voting rights, issued against full payment of the issue price. The minimum nominal amount of stated capital is E15m (£10.18m).
At least 75 per cent of the total assets (valued at market value in the compulsory IFRS group accounts) of the Reit AG must be real property. Accordingly, the Reit AG may not hold more than 25 per cent of its assets in the form of participating interests. If these requirements are not fulfilled, or if the Reit AG will purchase a participating interest that will bring its total participating interests above the 25 per cent threshold, consideration must be given to sales or mergers within the group in order to achieve Reit status. However, such sales and mergers will generally trigger income and real estate transfer taxes. A further specified requirement is admission of the Reit shares to trading in an organised market on a stock exchange within the EU or the European Economic Area. There will be no private Reits in Germany, a fact that greatly pleases the open-end and closed-end real estate investment funds.
Restricted shareholder structure
Direct shareholding of 10 per cent or more of the shares of a Reit AG is not permitted. This rule is designed to avoid the application of reduced tax rates for foreign investors under many double-taxation treaties. The Reit AG’s free float must be 25 per cent initially, and at least 15 per cent thereafter. For the first time, ‘free float’ has been legally defined as the shares of shareholders who each hold less than 3 per cent of the shares. Contrary to preliminary deliberations, the current draft law does not provide for corporate law sanctions and only tax sanctions are imposed. The shareholder structure limitation is therefore regulated on a pragmatic basis. One interesting aspect of the law is the future economic significance of G-Reit free float shareholders: they are the prerequisite for maintaining Reit status and will therefore not be disappointed to have been granted such a relevant position.
New exit tax regulation
As a related measure, an exit tax provision will be incorporated into income tax law. This provision will be applicable only during a three-year period ending 1 January 2010. Under this provision, a tax privilege will result if hidden reserves are realised for real estate assets held over a period of more than 10 years as fixed assets of German property upon conversion into a G-Reit or upon sale to Reits, to preliminary Reits and (for reasons of equal treatment), or to open-end real estate investment funds with private unit-holders. In essence, only 50 per cent of the hidden reserves will be subject to taxation.
Fortunately, this privileged taxation also applies to sale-and-leaseback structures. This makes the G-Reit interesting for hotels, department stores,hospitals, and infrastructure projects. Sellers are likely to favour G-Reits and open-end real estate funds for future real estate transactions over foreign Reits, foreign investment funds and German companies without Reit or preliminary Reit status – for example, closed-end real estate investment funds. It may be argued that the 10-year time limit is too long or the three-year time limit too short and that the group of privileged purchasers is too narrow. However, the new law’s exit tax provision is very likely to give significant impulse to the German real estate market.
The Reit AG itself will be completely exempt from corporate tax and trade tax. No privileges at all are envisaged with respect to property tax and real estate transfer tax .
Fortunately, there will be no entry charge on the fair market value of the Reit real estate assets, as is the case for the planned UK Reit.
Taxation at shareholder level
As opposed to taxable stock corporations, the Reit shareholders must pay the full amount of tax on the high distributions (distribution of 90 per cent of the profit of the Reit AG is compulsory). Profits will be calculated on the basis of the individual accounts to be drawn up according to the German Commercial Code. Optionally, straight-line depreciation may be excluded.
An important aspect for foreign shareholders is a withholding tax of 25 per cent on the distributions, which can be reduced to 15 per cent in accordance with many double-taxation treaties. The current version of the latest amendment to the double-taxation treaty that Germany has with Ireland even grants a reduction to 10 per cent; Ireland will probably become a very interesting holding jurisdiction for G-Reit investors. This shows that amendments to important double-taxation treaties are part of a functioning G-Reit system. Unfortunately, this has been neglected in past years. This is not changed by the equal standing with non-German Reits surprisingly envisaged by the draft statute for reasons of equality of opportunity. In any event, German investors in non-German Reits must expect considerable tax increases on their investment returns.
Exclusion of residential portfolios
Unfortunately, the Social Democratic Party was successful in requesting an exclusion of flats and residential portfolios, fearing for the future of the tenants. As a compromise, portfolios will now qualify for Reit status only if they consist of more than 50 per cent commercial property; this rule practically excludes residential portfolios. Residential portfolios account for a significant part of the German real estate market.
In particular, private equity funds that are heavily invested in housing portfolios had hoped for a successful exit using the G-Reit vehicle. However, public authorities (cities and federal states) that have large portfolios had also hoped to be able to enhance their cash position by sale through a G-Reit. Germany will be the only jurisdiction with such an exclusion, and thus partially lose the international competition for capital.
Florian Schultz and Herbert Harrer are partners at Linklaters.