January 2015 Practice Groups: Real Estate Investment, Development, and Finance Tax Banking & Asset Finance

Overview of UK Real Estate Structures and Transactions By Stuart Borrie, Paul Beausang and James Spencer

Summary This Overview provides a general summary of the different corporate structures that may be used to hold, and transact in, UK real estate (such as special purpose vehicles, property unit trusts, partnerships and REITS), the key features of each structure and why they are used by investors and developers. It also discusses joint ventures, where two or more investors may wish to combine to acquire and/or develop property. This Overview also discusses finance issues, tax and assembling a professional team.

Key vehicles used to hold UK real estate Typical vehicles that are used are: • Limited liability companies, whether located in the UK or elsewhere. Where the vehicle is a "clean" special purpose vehicle ("SPV"), it will contain nothing except for the property and the rent, leases and other contracts, and any registrations and liabilities associated with that property. An SPV may be a convenient way of parcelling up the real estate in a discrete entity with its own legal personality, and which can enter into contracts, including to finance the property, manage the property and/or develop it. Recourse can be contained and limited to the assets of the SPV. The board of the SPV can exercise control and make professional appointments, such as of an asset manager. By buying the shares in the company rather than the property itself, a buyer may make significant savings by not having to pay Stamp Duty Land Tax ("SDLT"); • Jersey property unit trusts ("JPUTs"). These are constituted by trustees who are located in Jersey. Usually the trust instrument follows a well settled form as there are hundreds of JPUTs in existence holding real estate all across the UK. The income in the unit trusts belongs to the beneficiaries of the trust provided that the unit trust is appropriately drafted so as to constitute a 'Baker Trust', and normally this is recognised for the purposes of UK tax on income. For capital gains tax purposes, the JPUT is treated as a company located in Jersey provided that it is correctly controlled and managed in Jersey. The transfer of JPUT units is not usually subject to SDLT; • limited partnerships, registered under the Limited Partnership Act 1907. These protect the investing partners from liability provided they do not get involved in the control and management of the partnership. Accordingly, a general partner (usually a company with limited liability) takes full responsibility for the real estate and any investment strategy and makes all decisions (eg whether to lease the property, who to and on what terms). The general partner may be advised by an investment manager. Sometimes limited partnerships are used in conjunction with JPUTs. Partnerships can be more flexible than corporate vehicles because, for example, they do not have capital maintenance rules or strict rules on dividends. Partnership interests are usually considered to be real estate for the purposes of SDLT and accordingly the transfer of a partnership interest is subject to SDLT as if the partnership interests were

Overview of UK Real Estate Structures and Transactions land itself. Partnerships are tax transparent for most purposes, although not for VAT, though some tax filings are needed. • REITs – Real Estate Investment Trusts. Only a small number of very large UK property investment companies have reconstituted themselves as REITs because the qualifying conditions are stringent. REITs are not used for structuring particular transactions in the UK real estate market; and • PAIFs - property authorised investment funds. These are designed for use where there is widely held ownership. PAIFs are open ended vehicles which are tax transparent. They have stringent conditions. The UK Government has been consulting during 2014 on the introduction of SDLT relief for the seeding of PAIFs, and for the transfer of interests in PAIFs.

Finance Often the entities holding the real estate are financed using a combination of equity/shareholder loans and secured third party debt. The level of third party finance is primarily a commercial matter and depends on the appetite of the investors for gearing. Banks are much more restrained in their appetite for commercial real estate lending risk than before the financial crisis and loan to value ratios are accordingly lower, although loan pricing has become highly competitive (for the benefit of borrowers) and, outside of traditional bank lenders, there is a wide range of other lenders able to provide funding on higher LTVs. The loan agreements will contain terms that can be expected in any facility, such as interest terms, prepayment and hedging arrangements. They also typically contain detailed provisions specific to running, operating and managing of the property and the rent. Any debt is likely to be secured on the property and any rent receipt account and it may well also be secured on the shares, units or other equity. The debt arrangements may be structured so that there is limited recourse to the ultimate beneficial owner. This is achieved by the SPV being the borrower. The shares in the SPV may be secured but otherwise the ultimate beneficial owner is not liable to the lender should there be a default. Internal debt may be attractive for tax purposes, provided that it satisfies transfer pricing requirements (essentially arm’s length terms, including the amount of the loan). The bank will typically conduct commercial and legal due diligence on the property, and also on the holding structure and will ask for existing professional reports to be addressed to it.

Key tax issues Trading A key tax issue on a number of these corporate - wrapped property entities is whether or not they are involved in trading in real estate in the United Kingdom or whether there is investment activity. Where there is trading in the UK, all of the income from the activity (including any increase in property value) would be subject to UK taxes on income. If the entity is a UK tax resident or there is a permanent establishment in the UK (such as an office from 2

Overview of UK Real Estate Structures and Transactions where the trade is carried on, or even a building site), then any trading activity will be subject to UK tax. Accordingly, care needs to be taken that investment activity is not inadvertently brought into the category of being trading in the UK. If the property is development property which is being developed for the purposes of a short-term sale, then it may well be trading. By contrast, holding property for the purpose of receiving rent is likely to be an investment activity.

Central management and control Any vehicles in the structure which are registered offshore should be centrally managed and controlled offshore. If in practice they are centrally managed and controlled in the UK, then they will be treated as if they are based in the UK for tax purposes (ie they will be liable for UK income and capital gains charges). Accordingly, care needs to be taken that the structure is robust and that decisions which are meant to be taken offshore are indeed taken offshore. There is usually care taken that the board has appropriate expertise, that board meetings are properly quorate offshore and that decisions are made at those board meetings.

Non-resident landlords If the property owner is not UK resident, it will need to register with the UK tax authority in order to receive rent free of any withholding under the "non-resident landlords scheme".

Joint ventures Pooling capital and risk Where UK real estate is particularly valuable, it may be owned by more than one party. A joint venture or 'club deal' allows investors to contribute capital and share risk. It may be that one party has the investment proposition and relationships and only some of the required funding. The parties may therefore want a structure which sets out an agreed strategy and allows investors to have rights of control or influence depending on the relative sizes of their investments. One of the parties may also be a professional real estate entity, providing services.

Board and shareholder control Where there is a joint venture, typically there will be an agreement regulating governance. Where the relevant entity is a company, as background there will be rules relating to that company under the relevant corporate law. For example, certain matters will require an ordinary resolution and others, being more fundamental constitutional matters (such as an increase in capital or a change of the constitution), may require a special resolution under the relevant company legislation. In common law jurisdictions, those rules are often a milder variation on English company law. When the joint venture entity is a unit trust or partnership, there may not be a clear legislative underpinning for governance issues. In any case, the parties will specify that certain commercial matters need a certain level of approval between the investors. There are two main ways in which this is handled in the joint venture agreement, being 'positive' and 'negative' matters.

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Overview of UK Real Estate Structures and Transactions Positive matters – business plan Positive matters are actions that parties agree to take and they are usually set out in a business plan with an attached budget. These set out, positively, what the parties intend to do with the property. They form an agreed strategy, with tactics as to how to make profits and gains from the property. The initial business plan is a very important document and it is advisable that it is prepared before the relevant transaction is completed. Usually joint ventures involve an agreed business plan which is renewed every 12 months. The business plan may set out proposals for refurbishing or redeveloping some or all of the property and a strategy for letting and sale. The business plan will be accompanied by a budget for capital expenditure, VAT, refurbishment costs, insurance and rent etc.

Negative matters – veto rights 'Negative' matters are things that cannot be done without consent. Accordingly a significant deviation from the business plan should be something which any joint venture investor should be able to veto. Matters which are minor variances from the business plan (eg a 5% alteration in capital expenditure for any one year) are not usually open to veto by one investor out of several. The joint venture agreement will therefore be prescriptive and set out categories of decision that may be vetoed (with tolerances e.g. for expenditure and voting thresholds for different types of decision).

Exit rights Exit rights in a joint venture typically include concepts also seen in private equity transactions, such as: • a right of first refusal (ie if an investor wishes to sell its stake, before selling it on the open market, it needs to offer the stake to the other investors) • a right of any one investor to demand the sale of the property after a period of time • 'drag along' rights i.e. investors holding a significant majority of the investment may be able to force the minority to sell alongside them so as to achieve the highest price (which is usually payable on the sale of the whole) • 'tag along' rights. When drag along rights are involved, the minority may have a corresponding right to demand that its investment be sold whenever the dominant owners sell. For example, if investors holding two-thirds of the equity decide to sell to a third party, the one-third owner may have the right that its investment be sold at the same time. After all, the investor holding one-third may not be content to be left as a joint venture investor with a new, unknown third party.

Key features of sale agreements Sale and purchase agreements are used to buy and sell the equity in the vehicle or structure holding the UK real estate. The key features of the agreement are likely to be: • the valuation is asset-based (being itself closely linked to the future yield from the real estate, either from rent or from capital appreciation or development potential); • they do not incorporate the Standard Commercial Property Conditions; 4

Overview of UK Real Estate Structures and Transactions • if exchange is to be prior to completion (rather than simultaneous with completion): o

the seller will expect the payment of a deposit (often 5%) to be held by the seller’s solicitor as stakeholder;

o

the buyer may wish to include provisions restricting the seller’s management of the property up to completion (e.g. restrictions on granting consents, settling rent reviews and granting leases without consent of the purchaser);

• the agreement may include completion accounts (so there is a fair reconciliation between the parties, which may carry on after completion) providing for the apportionment of the benefit of rent and expenses such as VAT. Service charges may be subject to a separate reconciliation process; • warranties and indemnities.

Warranties and indemnities In any corporate purchase the seller is usually expected to provide warranties and indemnities about what it is selling (except where the seller is an administrator or liquidator). This contrasts with a property purchase, where the buyer’s protections are through appropriate searches, pre-contract enquiries and due diligence reports or certificates on title. There will also be a disclosure letter (in which the seller makes disclosures against the warranties it is giving in the sale and purchase agreement). However: • the property warranties are unlikely to be extensive: the seller will expect the buyer to carry out due diligence in respect of the title to the property in the usual way; • the seller is likely to provide replies to CPSE and other property enquiries. The buyer's ability to sue for misleading replies to the property enquiries must be preserved in the sale and purchase agreement. The buyer should seek a warranty that the replies to enquiries are accurate; • the buyer may seek a warranty that the seller has provided all necessary information and that such information is accurate; • tax protections about the running of the company are usually a feature of these transactions and often there is a tax indemnity; • where commercial problems are identified in due diligence (such as a defect in the building), the buyer may expect an indemnity for the relevant matter. There needs to be a blend of protections from a corporate perspective about the equity and the liabilities of the company and the protections that the buyer would have if it acquired the property directly.

Insurance It is fairly common for the buyer to purchase insurance against warranty exposures and it is a growing feature of the market. Premiums are generally around 0.5% to 1% of the maximum exposure on the warranties. Paying premiums can allow the seller to release capital for other purposes, as otherwise the capital would be tied up for a period of time against the potential for a warranty claim against the seller.

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Overview of UK Real Estate Structures and Transactions Assembling a legal team Generally Buyers, sellers and other parties involved in corporate real estate transactions need to obtain specific legal advice. Corporate real estate transactions (which may sometimes be called "indirect property transactions") typically involve a team of people with complementary skills and may involve law firms in several international jurisdictions acting for each side of the transaction. The skills relevant to making an asset acquisition are also relevant when buying a property wrapped up in a corporate vehicle. For example, it will still be necessary in many cases to investigate the title, conduct searches, produce a report on title or a certificate on title, consider environmental and planning issues, assign any benefit of existing construction warranties and deal with the requirements of lending banks wishing to take security. The purchase of the relevant legal entity may mean that a corporate lawyer is involved who will ensure, for example, that the right level of warranties is provided and disclosure against the warranties is appropriate. The purchase agreement needs to be negotiated, completion accounts dealt with and so on. Where the transaction involves the purchase of units in a JPUT or the establishment of a new partnership, tax lawyers will also be involved. Typically corporate real estate acquisitions involve a lot of documents. There may be quite a complicated structure to set up with investment advisors agreements and secretarial agreements. Board meetings and relevant resolutions will be required. There may be several vehicles. Filings may be required in the UK or abroad. It is partly for this reason, and the increased deal risk that results, that sellers may expect to share half of any SDLT saving. Where a JPUT is involved, increasingly the trustees will require that they have the benefit of their own legal advice (ie separate legal advice from the advice for the unitholders). The trustees may seek to ensure that they have recourse to the fund in the event of a claim coming out of the transaction.

Joint ventures Where the transaction is a joint venture, each investor will want to have the benefit of specific legal advice and a duty of care which has regard to the transaction and the circumstances. It is likely to be problematic under professional rules for one law firm to act for all of the joint venture investors. It is quite common for a key role to be taken by an investment manager appointed by the joint venture vehicle to manage the property: there will be points in the investment management agreement where the owner and the investment manager may have diverging interests.

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Overview of UK Real Estate Structures and Transactions This article does not constitute legal advice on any particular situation. If you have any questions, please contact us.

Authors: Stuart Borrie, Corporate

Paul Beausang, Tax

James Spencer, Finance

Partner [email protected] 020 7360 8155

Partner [email protected] 020 7360 8100

Special Counsel [email protected] 020 7360 8176

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