As we consider the landscape for investors in UK real estate, the list of factors influencing yields, sector performance and investor strategy is certainly not a short one. I imagine business analysts across the country updating PESTLE analysis v200, and it seems the Bank of England gave investors reason for a further update last week.
As well as borrowing rate increases and the energy crisis, we’re dealing with supply chain disruption and cost inflation, not to mention war and pandemia. With all that is going on, even Brexit, which commanded attention for a long time, is no longer a major feature in my conversations with clients. What is clear though is that, post-pandemic, our working, living and shopping patterns have changed and the many years of low interest rates and quantitative easing are over. Quantitative tightening - a term I heard for the first time only recently!
As well as those macro-environmental factors, over the past few years, we have seen some of the most significant changes in UK real estate tax for decades. After some time to adjust, many investors will have become used to the wider scope of UK tax on non-resident capital gains (NRCGT) introduced in 2019, and the migration of corporate non-resident landlords to the more stringent corporation tax regime a year later.
Looking ahead, the next significant event will be the corporation tax rate increase, as it is set to go up by 6% to 25% from April 2023. Undoubtedly, these significant changes to the way UK real estate is taxed will reduce the net returns for some investors.
Elsewhere, long standing and much used Luxembourg structures have not yet been impacted by the NRCGT rules as they have benefited from protection under the current UK/Luxembourg double tax treaty. Sovereign Wealth funds have similarly been immune to the changes due to the tax exemption offered in the UK. However, the Luxembourg protection will be lost, potentially as early as next April, once the proposed changes to the UK/Lux treaty are ratified. Currently, the potential removal of Sovereign tax exemptions is subject to UK government consultation.
What does this mean for my clients? Well, it is clear that some appetites have cooled. Borrowing rate increases have been enough to make a few pause for breath, but there are still those who are hungry for investment and with capital to deploy, and for them the appeal of the UK Real Estate Investment Trust (REIT) regime continues to grow.
Since its introduction in 2007 there have been a series of changes to the regime, including the latest relaxations made in Finance Act 2022, and those changes have been designed to make REITs more attractive and accessible.
The combined effect of the REIT relaxations, and the broader real estate tax changes, has been a tremendous increase in the number of PwC clients who want to find out more about the UK REIT regime, including overseas REITs, Sovereign Wealth Funds, fund managers, non-resident investors and Build To Rent investors.
Today there are more than 90 UK REITs, listed on various exchanges including the London Stock Exchange, TISE - The International Stock Exchange and, more recently, also on London's new IPSX. There are in addition a number of unlisted REITs following the relaxation to the listing requirement.
To recap, a UK REIT is a property investment company which, very broadly, simulates (from the investor’s tax perspective) direct investment in UK property, and so avoids the additional layer of taxes that can arise when investing through a corporate structure.
It is worth emphasising that despite being called a trust, the REIT is a UK company or group of companies with a UK tax resident parent, and so a REIT is a structure which, apart from its special tax treatment, behaves in a way landlords and investors are familiar with.
The rules of the regime mean that the REIT itself is exempt from corporation tax on qualifying income as well as gains on disposal of qualifying properties (and shares in property investment companies).
On entry into the REIT regime, and when REITs acquire or sell companies owning property investments, the assets are generally rebased to market value. This means that REITs do not need to seek a discount for any latent capital gain inherent in the target company, nor should those negotiations feature in their eventual sale.
Tax is effectively levied at investor level, according to their individual tax status, on their share of rental income which is distributed to them by the REIT as a property income distribution. Distributions of exempt gains, if made, are treated in the same way as property income distributions. There is an annual requirement to distribute at least 90% of the exempt income.
The REIT therefore enables exempt investors to benefit from their own tax status. For non-UK investors, where there is a double tax treaty with the UK, the effective tax on net rental income and relevant gains is limited to the applicable treaty dividend rate (a 20% withholding tax is levied but depending on the treaty some or all of this may be reclaimed). Although special rules apply where there is a holding by a non-UK tax resident company of 10% or more in the REIT (the holders of excessive rights rules), typically, a reduced rate of 15% is still available under most treaties.
There are a number of conditions to satisfy on conversion and on an ongoing basis to preserve REIT status:
- The property rental business must represent at least 75% of the REIT’s profits and assets, and include at least three properties (balance of business and property rental business requirements)
- The Parent must be a UK tax resident company
- 90% of the exempt property income must be distributed
- The Parent must be admitted to trading on a recognised stock exchange; and either listed on LSE (or equivalent main market eg TISE) or traded on a recognised stock exchange (the listing requirement), unless certain conditions are met.
- The REIT must be diversely owned (as defined) although certain institutional investors count towards this requirement and can therefore own up to 100% of the REIT (the non-close test)
- The REIT cannot have excessive gearing and debt finance must be broadly on ordinary commercial terms
- Corporate shareholders holding 10% or more (holders of excessive rights) can cause the REIT to suffer a tax charge
What do the latest changes to the REIT rules mean? :
- The listing requirement was originally put in place to protect retail investors, by ensuring that REITs are established and overseen by a competent authority. However, since April 2022, broadly, where a REIT is at least 70% owned by institutional investors the shares will no longer need to be listed. This is because those investors are seen as being more sophisticated, relative to the average retail investor investing in stocks and shares, and therefore requiring a lower level of protection than is afforded (indirectly) by the conditions companies must satisfy to be listed on a recognised exchange. This is possibly the most significant change to the rules as operating a listed company, even on some of the more user friendly exchanges, adds cost and effort whichever way you look at it.
- In order to evidence that the balance of business and financing tests are satisfied, detailed REIT Financial Statements are required to be submitted annually. However, since April 2022, if a REIT’s group accounts for a period show that property rental business profits and assets comprise at least 80% of group totals, it will not have to prepare the additional financial statements which would be required to meet the full test. This seems minor, but will save time and effort (and in many cases cost) for a large number of REITs.
- Non-rental profits arising because a REIT has to comply with certain planning obligations will be disregarded for the purposes of the test. Potentially super helpful for those in the residential Build to Rent space.
- Ownership by an overseas REIT, where that REIT qualifies as an institutional investor, will mean that the UK REIT satisfies the non-close test. A relaxation was made by FA 2022 so that the definition of an overseas equivalent of a UK REIT within the list of institutional investors is amended so that the specific overseas entity itself, rather than the overseas regime to which it is subject, needs to meet the equivalence test. This has been a very helpful change and has removed an obstacle that had prevented a number of such REITs to qualify despite demonstrating the expected characteristics.
- The last significant FA 2022 relaxation is that the ‘holders of excessive rights’ charge which has been removed where property income distributions are paid to investors entitled to gross payment. This means that UK companies and certain charities no longer have to fragment their holdings to less than 10% to avoid the penalty tax charge - a welcome simplification which also reduces administrative and compliance costs.
Key message
Effective rates of tax on property income and gains have increased and will increase further from April 2023 for non-REITs. There are fewer barriers to REIT conversion than before and, if listing can be avoided, REIT running costs should not be dissimilar to those of a “normal” corporate structure. As a result, we believe the number of UK REITs will continue to increase and many of them will not be listed.
If you would like to discuss this further, please get in touch with Jo Cox or your usual PwC real estate tax contact.
