ArticlesReal Estate: Structures for all seasons

Release Date:

18 November 2006 

REITs may seem to many like an attractive choice as a vehicle for collective property investment. Marion Cane and Belinda Bridgen examine whether they always fit the bill
For many months, if not years, the UK property press has focused on the impending introduction of real estate investment trusts (REITs). REITs are welcome news for many of the larger quoted property companies and for fund managers who will create the “second wave” of REITs entering the market. Furthermore, they are good news for investors that want to access property returns through a tax-efficient and liquid vehicle. Draw a  flowcharts and you will note that the UK REIT is nothing more than a tool in the tool box of potential structures available to allow investors access to property returns. Complex structures The array of possible structures for property investment can be complex and bewildering. This article aims to point the reader, by way of flowcharts, to suggested structures for investment into UK property that might be suitable in given circumstances, without getting too embroiled in complex legal and tax analyses.
The right choice of structure for a collective property investment fund can depend on a number of variables that often act in conflict, such as:

  • who are the target investors?

  • what is their risk profile?

  • do they expect income or capital return, and when?

  • what is their tax status?

  • do restrictions govern the type of vehicle in which an investor can invest?

  • do investors require investment liquidity? (namely, will they expect to redeem or sell down their investment as they choose or are they prepared to retain their investment for a defined or minimum period?)

  • how will the activities of the fund be taxed?

  • what is the location and nature of the underlying property asset?

  • what compliance regime governs the investment vehicle?

  • are there any operational restrictions?

Different categories of investor have different tax profiles. Some may pay no tax at all (for example, investors in pension funds and self-invested personal pensions (SIPPs)). Others may be entitled to specific tax breaks (individuals who invest through an ISA wrapper into quoted shares or authorised funds or who may be able to take advantage of business asset taper relief).
With any fund structure, a key objective will be to adopt a structure that does not dilute investors’ returns by imposing a layer of tax at the fund level (namely, the desire is for a tax-transparent structure). If the fund is aimed at different categories of investor, this can mean that the structure has to have different substructures within it to meet the needs of specific investor groups. The solution is often a compromise determined by the main investor groups.Are REITs the right tool? A UK REIT is exempt from tax on rents and capital gains from property investment. Even though a UK REIT is tax efficient, it may not give effective tax transparency for all investor groups. For example, an individual selling shares in a UK REIT will not be entitled to business asset taper relief, even if the REIT invests in the right kind of property assets. Furthermore, if a REIT distributes capital gains to investors as well as income, non-UK resident company investors will suffer a withholding tax cost (the 10% shareholding restriction ensures this), whereas capital gains from direct property investment would normally not be taxed. When specific tax breaks like these are important to the marketing of a fund, a REIT will not be the suitable structure.

With the ever-tightening yield gap in the UK market, overseas investment opportunities can seem more enticing, but it is important that tax does not dilute returns. REITs are not suited for investment in overseas property because a REIT will pay UK tax on its overseas property returns (subject to relief for overseas taxes paid). This is perhaps a missed opportunity given the globalisation of property investment, although changes could be seen in this area in the future as industry lobbying continues and with developments in EU law.
REITs may not be the right answer for reasons other than tax. For instance:

  • A REIT is aimed at the non-sophisticated property investor that requires the comfort that its investment is subject to the scrutiny and protection afforded by the UK listing authority rules. REITs are also for investors that want the flexibility to sell their investment when they want to. A REIT may not necessarily be the right investment choice for investors that are prepared to accept a higher risk-reward ratio. REITs are for income-generating investment property; they are not designed for speculative property development.

  • A REIT must comply with the operating restrictions imposed by the regime, which also protect investors. However, these may not fit with the investment strategy for a fund. If not, an offshore company listed on the alternative investment market of the London stock exchange (AIM) or even an overseas stock exchange (the Guernsey exchange has often been used),may offer a more flexible solution, provide similar benefits and still meet the liquidity requirements of the target investor group

  • A REIT will list on the UK stock exchange because that gives it access to the deepest pool of equity capital. However, for sophisticated investors seeking to reduce their exposure to equities by diversifying into property, it is arguable whether investment in a UK REIT is the perfect solution as a REIT’s share price will be affected by the general performance of the equity market, not just the performance of the underlying property investments. The choice could point towards the open-ended, authorised investment fund (AIF) (if current lobbying for much needed tax changes eventually succeeds), to direct investment, or investment through an offshore unit trust (such as a Jersey property unit trust (JPUT)).

Private investor funds At the other end of the spectrum, a private investment fund cannot be a REIT (although lobbying continues). Private funds cannot be promoted to the public. The choice of fund vehicle in these circumstances will usually be driven by the tax status of the investors that the fund is targeted at.

For high net-worth investors, a partnership structure (such as a partnership formed under the Limited Partners Act 1907 or possibly a limited liability partnership (LLP) formed under the Limited Liability Partnerships Act 2000) offers the potential to benefit from business asset taper relief (giving a 10% tax rate) on capital gains on the sale of properties let to unquoted trading businesses. A conflict of interest could occur if management rewards reflect fund performance built on a strategy that does not produce the highest return for the investor after tax (for example, securing a public sector or quoted tenant). However, an investment strategy driven by tax benefits may not produce the optimum return. There are also potential tax downsides. For example, if all income and gains are reinvested by the fund, investors will have to fund their tax liabilities from their own resources.
An LLP is not suitable for pension fund investors since it would compromise their tax-exempt status. A partnership structure might not also be suitable where new investors are to be admitted or investors change hands. This is because capital gains may arise to existing investors if new partners are admitted. There will also be a stamp duty land tax (SDLT) cost (usually at 4%) if partnership interests change hands and, potentially, when new investors are admitted. A partnership is generally unsuitable where investors want the flexibility to sell their investment through a secondary market. SDLT can also arise when the partnership sells the property.

Some investors may want to invest through their SIPPs and a direct partnership investment is usually then not possible. Feeder funds in the form of an unauthorised exempt property unit trust (EPUT) are commonly used for SIPPs and other exempt investors given that they are permitted investment vehicles and are tax transparent (so long as only certain categories of exempt investors are permitted to invest in them).
Non-UK resident investors usually prefer to invest through offshore companies or unit trusts because their share of capital growth in the fund may be received free of UK tax and tax on income is restricted to 22% on net income after capital allowances.
UK resident, non-domiciled individuals (broadly those who regard their permanent home to be outside the UK) usually want a structure allowing them to defer, potentially indefinitely, any charge to UK tax. An offshore structure could be suitable for them. However, use of offshore structures can, in some circumstances, result in tax charges being imposed on UK resident and domiciled investors as though they had received income and gains directly. Some pros and cons of unit trusts Offshore unit trusts (such as JPUTs) are still in widespread use despite a clamp down on SDLT saving schemes. They remain attractive vehicles because they are tax transparent for many classes of investors and when an investor sells his units, SDLT does not arise for the purchaser. One downside is that a unit trust needs overseas trustees who must manage the trusts’ business offshore, which means an extra layer in the decision-making process and extra cost. Offshore unit trusts can also be problematic for some investors if they do not distribute all their income each year.

A qualifying investor scheme (QIS) is a form of AIF aimed at sophisticated investors that is lightly regulated. It is an open-ended vehicle, but investor redemptions may be restricted according to the reasonable expectation of investors. They have the same tax treatment as the retail form of AIFs, which, at least for now, makes them unsuitable for pension funds and other exempt investors and suitable only as a vehicle for investment by individuals holding less than a 10% interest and redemptions can be restricted to ensure interests remain below that level.
Marion Cane is a tax director in the property and construction group at Grant Thornton UK LLP and Belinda Bridgen is a corporate tax principal at Mishcon de Reya 


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