REITs.

Quick Guide: UK REIT Following the enactment of the Finance Act 2006, the UK REIT was launched on 1 January 2007. From this date, existing listed companies can convert to REIT status and new REITs can be incorporated and listed provided that the various conditions set out below are satisfied. Regulations have been published which flesh out the details of the code set out in the primary legislation. HMRC has also prepared informal guidance to provide assistance in interpreting the legislation and a guide as to how HMRC views the REIT regime working in practice.

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Company Conditions for REIT Status −

UK tax resident and not dual resident.

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A body corporate which is not an “OEIC” (i.e. not openended).

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Single class of (ordinary) shares only together with nonparticipating fixed rate preference shares if desired.

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No non-commercial loans (convertibles to ordinary shares permitted).

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Listed on a recognised stock exchange (not AIM).

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Not “close” (i.e. not controlled by five or fewer participators).

Contents Quick Guide: UK REIT 1 Company Conditions for REIT Status 2 Tax-exempt Business Conditions 3 Balance of Business Conditions 4 Entry Charge 5 The 10 per cent Rule 6 Gearing Restriction (“Interest cover test”) 7 Development 8 Ring-Fenced Business 9 Taxation of REITs 10 Group REITs 11 Other Considerations

Failure to comply with the Company Conditions listed above results in immediate loss of REIT status unless, in respect of the latter two, a breach arises as a result of the REIT being taken over.

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Tax-exempt Business Conditions −

The REIT must have a property rental business (“PRB”):

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includes Schedule A business and overseas property business; and

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excludes e.g. incidental letting of development property, income from REIT shares, rent from electricity way leaves, pipelines, telecom masts and wind turbines.

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The PRB must involve at least three properties (a property is defined as one rental unit, so e.g. one shop within a shopping complex counts as one property).

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The value of a single property must not exceed 40 per cent of the total value of the properties involved in the PRB.

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The PRB must not involve property which is owner-occupied.

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The REIT must distribute at least 90 per cent of the (income) profits of the PRB within 12 months after the end of the accounting period, subject to a company law override. Note that this requirement only relates to income profits and not capital gains (there is no requirement to distribute capital gains). The measure of profits for these purposes is the tax computation, not the accounts.

Balance of Business Conditions −

75 per cent of the REIT’s total pre-tax profits (accounts test)

must be from PRB. −

75 per cent of the REIT’s total assets by book value must be in PRB.

This requirement is to ensure that the main activity of the company is property investment.

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2

Entry Charge −

There is an Entry Charge equivalent to 2 per cent of the market value of the property assets going into the PRB when a company converts to REIT status. There is an option to spread the entry charge over four years (although the charge increases to 2.19 per cent).

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After conversion the REIT will not pay further 2 per cent charges on new properties acquired unless the properties are held by a company which itself becomes part of the REIT group. The REIT will however pay the usual SDLT charge at 4 per cent on any acquisitions of property into the PRB.

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Acquisition by a REIT of a non-REIT will lead to a 2 per cent charge on the non-REIT’s PRB assets.

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The 10 per cent Rule −

Regulations provide for tax penalties if a dividend is paid to a company beneficially entitled, directly or indirectly, to 10 per cent or more of the REIT’s dividends or share capital or control 10 per cent or more of the voting rights.

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The REIT will not be penalised if it has taken reasonable steps to prevent dividends being paid to a corporate shareholder with a holding of 10 per cent or more. Corporate shareholders who would otherwise offend this rule may divest themselves of their dividend rights in order to avoid doing so. Guidance issued by HMRC provides details as to what constitutes ‘reasonable steps’. It includes procedures to identify 10 per cent shareholders, empowering the REIT to withhold dividends the payment of which would breach the 10 per cent rule or putting in place a mechanism whereby if dividends are paid to 10 per cent shareholders, then that dividend is held on trust for a third party. REITs will incorporate provisions in their Articles of Association in order to entrench these ‘reasonable steps’.

This rule is designed to prevent non-resident shareholders benefiting from reduced withholding tax rates.

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Gearing Restriction (“Interest cover test”) −

Gross income of the PRB (before capital allowances) must be 125 per cent of the PRB’s finance costs.

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Failure to abide by this will lead to a tax charge but not loss of REIT status.

Note that in respect of borrowing generally, the fact that financing costs will no longer be tax deductible might have a wider effect on the REIT’s borrowing levels.

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Development −

A development by the REIT can be within its PRB provided

the REIT intends to retain it as an investment property.

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If the REIT sells the development property within 3 years of completion, the property will be treated as never having been within the PRB.

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Building work amounts to development if the costs exceed 30 per cent of the fair value of the asset at the later of the date the company becomes a REIT and the date of the asset’s acquisition.

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Ring-Fenced Business −

Converting companies will be deemed to have sold PRB

assets and immediately reacquired them with any gain not giving rise to a chargeable gain for corporation tax purposes (the REIT will therefore benefit from an uplift in the base cost of its PRB assets).

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The tax exempt business (i.e. the PRB) is treated as a separate business from the pre-entry, residual (i.e. non-PRB) or post-cessation business.

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There will be no carry across of losses e.g. losses in the tax exempt business may not be set-off against profits of the residual, pre-entry or post-cessation business.

Taxation of REITs −

Exempt from corporation tax on property rental profits (based

on Schedule A) and capital gains.

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Automatic claiming of capital allowances taken into account in determining profits. Because the REIT does not pay tax on its PRB profits the effect of capital allowances is only to reduce the amount required to be distributed.

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Distributions taxable in the hands of the shareholder as rental income (including distribution of capital gains).

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REIT required to withhold tax at basic rate on distributions. Regulations permit recovery of this tax by certain tax exempt shareholders.

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No tax credits on dividends.

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Normal rules for residual business and dividends paid by residual business.

Group REITs A Group REIT will comprise a principal company and all of its 75 per cent subsidiaries provided the subsidiary is also an effective 51 per cent subsidiary of the principal company. −

The principal company must satisfy the Company Conditions

(see 1 above) and in addition, supply annual financial statements in a specified form to HM Revenue & Customs. −

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The 90 per cent distribution requirement (see 2 above) relates to the principal company and applies to the profits from the worldwide property business of the UK subsidiaries

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and from the UK property business of the foreign subsidiaries.

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The Balance of Business Conditions (see 3 above) apply to all subsidiaries carrying on PRB, including foreign subsidiaries holding foreign property.

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Ring-fencing of tax exempt Group: treated as a separate group distinct from the residual group, the group pre-entry and post-cessation with no carry across of losses.

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The corporation tax exemption applies to the profits of the UK subsidiaries and foreign subsidiaries holding UK property (with the gearing restrictions (see 6 above) being calculated in respect of these profits).

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Capital gains on disposals by UK resident members are exempt from corporation tax on capital gains.

Other Considerations −

Possibility of sanctions if the REIT becomes involved in tax avoidance.

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Regulations provide for grace periods for minor or inadvertent breaches (see Breach of Conditions Regulations).

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Regulations provide for joint ventures to be included in a group REIT provided REIT has a 40 per cent interest in a joint venture and joint venture carries on PRB and satisfies Balance of Business Conditions.

Simon Clark Linklaters 1 January 2007

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Issue 5 ⏐ 1 January 2007 A07050953