The Reit stuff

Real Estate Investment Trusts (Reits) are being introduced in this year’s Finance Bill, and the first conversions to Reits may be early in 2007. On Budget day, 22 March 2006, the Chancellor announced long-awaited details of the conversion charge, as well as changes to the key requirements for Reits.

What is a Reit?

A UK Reit will be a listed property investment company with a favourable tax status. It will pay no tax on income or capital gains from its property letting business.

A Reit will be required to distribute most of its income to its shareholders, which will be taxable in the hands of investors in accordance with their individual circumstances. In return for this favourable tax status, any company that wishes to convert to a Reit will have to pay a conversion charge equal to 2 per cent of the gross value of its qualifying properties.

Budget day news

On 22 March the Chancellor announced the level of the conversion charge and also took the opportunity to amend some of the key points in the draft legislation published three months earlier.

Conversion charge

The conversion charge will be based on 2 per cent of the market value of the assets owned by a company at the time it becomes a Reit and which are treated as forming part of its property letting business – that is, the -business that will be tax-exempt following its conversion into a Reit. The company can choose to pay the conversion charge in four annual installments of 0.5 per cent, 0.53 per cent, 0.56 per cent and 0.6 per cent respectively (thus 2.19 per cent in total) instead of paying the full 2 per cent in the first year.

Where a Reit acquires a company, the conversion charge will be payable on the investment property owned by the target company.

Change to the 10 per cent limit on shareholdings

The earlier Reit proposals, published last December, included a requirement that a Reit must not at any time have any one person (directly or indirectly) control 10 per cent or more of its share capital. Breaching this would result in removal from the Reit regime.

To the relief of the property industry, this provision has now been removed. Instead, the Finance Bill will allow regulations to be made imposing a tax charge on a Reit if it makes a distribution to any person who (a) is beneficially entitled (directly or indirectly) to 10 per cent or more of the dividends or shares of the Reit, or (b) controls (directly or indirectly) 10 per cent or more of the voting power of the Reit.

This will not prevent a Reit from having shareholders who hold 10 per cent or more of its shares or remove it from the Reit regime if it does, but if it has such shareholders and makes distributions to them a tax charge will be levied on the Reit itself.

Significantly, a Reit will not suffer adverse tax consequences if it can show that it took reasonable steps to avoid making distributions to such shareholders. According to guidance issued on Budget day, steps that the Inland Revenue “intend to accept as being reasonable include a provision in the company’s Memorandum and Articles of Association requiring any shareholder that exceeds the limit to enter into a transaction that removes beneficial ownership of the dividend”.

Reduction in distribution level

A Reit will now only be required to distribute 90 per cent (rather than 95 per cent) of income profit from its property letting business to its shareholders in order to qualify for Reit status. This should give Reits more flexibility in managing their cashflow. Breach would result in a tax charge on the Reit, but would not lead to exclusion from the Reit regime.

Gearing limits

The controversial ‘interest cover test’ has been made less restrictive. Under the revised proposals, a Reit’s gross profit (ie before financing costs and capital allowances) must now be at least 1.25 times the interest payable by it, in order to avoid suffering an additional tax charge. Again, breach will result in a tax charge but not exclusion from the Reit regime.

Interest cover of 120-130 per cent is a common requirement in UK property finance loan facilities, so the new multiplier should be much easier for Reits to cope with than the previously proposed ratio of 2.5. Furthermore, the 1.25 ratio will now be applied before taking into account capital allowances, which will make the test easier to satisfy.

Groups and joint ventures

Earlier this year, draft legislation was published indicating how the regime will work for groups of Reits. These proposals broadly apply the same principles as for individual Reits. Notably, if a Reit owns 40 per cent or more of a joint venture company, the latter’s income and assets will count towards the income and asset tests to the extent of the Reit’s interest in the joint venture company.

All in all, the property industry considers that the Government has listened to its concerns and has established the framework for a successful Reit regime. Several UK property companies may now be far keener to convert. The rise in their share prices on the afternoon of Budget day suggests that the gap between share price and net asset value could now finally be closing.

won’t he?’ Reits saga has finished with a regime that satisfies the UK property industry
report Bridget Barker and Andrew Wylie