The tax transparent nature of a REIT can often be seen as an appealing reason for a property investment business to convert, with clear tax advantages provided for under the governing REIT legislation. In this article, we set out the tax consequences of converting to a REIT and consider what that will mean for its investor profile.
REIT conversion status can carry substantial tax benefits, the REIT is a vehicle that holds and manages a portfolio of real estate from which its shareholders earn a profit. The tax neutral status of the REIT itself means that it pays no UK corporation tax on its profits from its property rental business and nor does it pay any capital gain tax on any disposals, providing the property held meets certain qualifying criteria (for details see article titled “The REIT Option for You?”).
Instead, for each accounting period, the REIT is required to distribute 90% of its profits to its investors by way of a dividend. Those distributions are then generally subject to basic rate withholding tax at 20%, except for example, where paid to a pension scheme, UK resident company or some sovereign wealth funds. These entities are able to apply for a tax exemption status and would then receive their dividends gross. Likewise, REIT shares can be held under an ISA wrapper and the fund manager will also receive gross distributions, making the investment highly tax efficient.
When the REIT legislation was first introduced back in 2001, there was some confusion as to the extent to which the REIT would be required to satisfy the UK corporate tax regime, given its exempt tax status. After a number of consultations and HMRC guidance, it was clear that the REIT was still required to operate under effectively a shadow tax regime, in order to replicate the tax treatment of a direct investment in property.
This, for example, includes the mandatory requirement to claim Capital Allowances where it has the entitlement to do so, an area which we explore further in our next article, Veritas Advisory’s Capital Allowances REIT Service.
The REIT status effectively removes the double layer of taxation where tax is actually paid out on profits at both the property company and shareholder levels. Instead, tax is typically only paid at the investor level, which gives rise to improved returns.
The current default for a property investor is to hold property offshore, often within a special purpose vehicle (SPV) and there were clear advantages for doing so, particularly with the capital gains exemption, however, this is to be removed from April 2019. Furthermore, from 1 April 2020, HMRC have now confirmed that corporate investors will be subject to UK corporation tax rules on rental income and not taxed under non-resident landlord rules for income tax.
Offshore investors will therefore have to abide by the corporate tax rules which will include the restrictions on deductions for interest payments and greater restrictions on the ability to use carried forward losses; the reasons for opting for the default offshore structure are narrowing and the REIT regime for some will be a considered alternative.
It however must be said that the REIT status will not suit all, with a lengthy list of conditions which must be considered and met. These include, that where a property is to be redeveloped and the development costs represent more than 30% of the market value of the property and any disposal is made within three years of practical completion of the development, then it is deemed to fall outside of the tax-exempt business.
Whilst the tax advantages are significant, a far wider consideration of the REIT conversion needs to be made before embarking on the journey.