With the headlines regularly featuring items on share prices hitting five-year lows, the continued popularity of property as an investment is unsurprising. A direct investment in property has long been regarded as a good bet – hence the phrase 'as safe as houses'. While houses may indeed be safe, especially in comparison with struggling telecoms stocks and dotcoms, a direct investment in property has one major disadvantage – property is expensive.
If we are talking about institutional investors, the expense of direct property investment may mean they have to put all their eggs in one basket by investing in a single jurisdiction. With shares, the golden rule is safety through diversification of the portfolio. This is not easy when dealing in property, due to the costs involved.
There is an obvious solution – collective investment in property. There is a growing trend for UK institutional investors to diversify their investment portfolio outside the UK by means of pan-European property funds. These provide a cost-effective means of capitalising on the opportunities that exist in the European property market by making the most of the fund manager's expertise in the relevant jurisdictions, without risking the expense of direct investment in overseas property or having to invest the management training and resources necessary for a full onslaught on the eurozone.
The EU is an attractive target area, not only from a pure economic point of view – with property prices in each jurisdiction tending to move in cycles – but also from a tax point of view. The pressure towards freedom of investment within Europe, manifesting itself in legislation such as the EU Parent-Subsidiary Directive, gives the eurozone a more favourable investment regime than other potential target areas. However, while Europe becomes a more flexible place in terms of taxation of profits moving from one EU jurisdiction to another, complications arise when the investors in a fund are not exclusively part of the EU, although it should be possible to avoid these with appropriate structuring.
Structuring for tax-efficient investment in Europe
Investors are increasingly interested in European property funds, but what exactly are these funds and how do they work? The typical structure is, it is fair to say, tax driven. Working from the bottom up, there is a local taxable legal entity owning property or properties in its jurisdiction of incorporation. The form of legal entity used is likely to be governed largely by local tax law. For example, in some jurisdictions, partnerships are subject to more favourable tax regimes than companies. The property-owning entity is then owned by at least one holding company, usually in a different jurisdiction from the local property-owning entity. Countries with favourable double-taxation treaties are sought, and it is common for these intermediate holding companies to be in countries such as Luxembourg or the Netherlands. Finally, at the top of the structure is the fund entity itself – the collective investment scheme in which the investors will hold interests.
The entity that constitutes the fund is often not a separate corporate entity, so the investors are just that – investors. They hold units in a fund rather than shares in a company, and the top entity will often take a form that is regarded as transparent or disregarded for the investors' tax purposes. The investors are therefore interested in the after-tax return from the underlying investment structure, as they are unlikely to have the benefit of any double tax reliefs. The aim of the holding structure is to minimise taxation at each level. As the investors cannot expect any credit or deduction for tax suffered by entities within the holding structure, any taxation is essentially a cost to the fund, and a corresponding reduction in the investors' return, and for that reason is commonly referred to as 'leakage'.
Avoiding tax leakage – a two-pronged attack
The fund structure has to mount a two-pronged attack on tax leakage. The first prong, which could be described as the 'active' part of the tax structuring, involves maximising tax deductible expenses. By gearing up each entity to the maximum extent possible, with loans from within the structure and with third-party bank debt, it should be possible, at least in the early years, for the operating companies to have tax deductible expenditure that at least equals their profits from rental income. The major issue here is thin capitalisation – avoiding excessive debt-to-equity ratios – and the rules vary widely by jurisdiction. The after-tax return on an investment in a particular jurisdiction may have as much to do with local thin capitalisation rules as it does with the local property market.
The second prong is the 'passive' element of tax structuring, and simply involves minimising all the taxes to which each entity in the structure would normally be subject. For example, property realisations will normally be intended to be achieved by selling the local property-owning entity, rather than the real property itself, to eliminate local tax on any capital gain. Certain taxes may usually be thought to involve only a cashflow issue rather than a real cost, for example VAT and withholding tax. But whereas VAT can usually be recovered in the typical structure, withholding taxes on interest and dividends would be real costs, affecting the fund's after-tax results. This is because the structure is designed so that none of the entities in the structure actually pays any tax on profits, so any withholding at one level of the holding structure cannot be offset against the taxable profits of the parent company. Fortunately, the EU's Parent-Subsidiary Directive is likely to come to the rescue in the case of withholding taxes on dividends, although there are slightly different nuances and hoops to jump through, depending on the local laws. Withholding on interest varies more widely by jurisdiction, although there are usually methods of structuring around this.
The issue of thin capitalisation is linked with the other main issue of withholding taxes, as local laws may reclassify interest payments as dividends, thereby not only affecting the deductibility of the interest, but also the character of the payment and hence the withholding treatment.
Tax issues by jurisdiction
There are essentially four levels in the structure of a typical European property fund that each require rigorous tax analysis. The first is the local law of the jurisdiction where the property is, as modified by double-tax treaties and the EU Parent-Subsidiary Directive. The second is the holding-company tier, where there are treaty shopping and substance issues – the holding company must be 'real' and not merely established for the convenience of local tax reliefs/exemptions. Next, there are issues surrounding the nature of the investment vehicle itself, which will involve detailed analysis of the local law of the investment vehicle's jurisdiction. Finally, there are issues for the investors themselves in their own jurisdiction such as, in the UK, the application of the rules governing the treatment of income from offshore funds.
Do not forget the detail
The issues mentioned so far are the big picture tax structuring issues that are largely similar for each jurisdiction. While there are advantages for investors in diversifying across a number of countries, the need to conduct detailed investigation into local law, particularly tax law, in each jurisdiction should be borne in mind. Considering how to minimise each jurisdiction's own idiosyncratic tax charges can be as complex as dealing with big issues such as thin capitalisation and withholding – examples of this are the French 3 per cent tax on real property, the jurisprudentially uncertain trade tax exemption in Germany and a proliferation of indirect taxes in Italy and Spain.
Institutional investors in particular are becoming increasingly interested in European property funds. The challenge from a legal viewpoint is to devise structures that are capable of minimising tax leakage over a number of different jurisdictions, while remaining understandable from an investor perspective. Add to that the need for the running costs to be commercially competitive and the resulting legal matrix becomes very complicated. Sorting through it requires a blend of sophisticated country-by-country advice, commercial awareness and close cooperation between the various jurisdictions involved.
Peter Fisher is a partner and Philip Harle is an assistant in Lovells' tax department