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June 23, 2011

The UK real estate investment trust (REIT) regime was introduced on 1 January 2007 in response to lobbying by the UK real estate industry for a tax transparent vehicle for collective investment comparable to those found in other major jurisdictions. Despite the tax benefits afforded by the regime for groups that meet the qualifying criteria and opt in, uptake has been relatively low – with only 23 UK REITs currently in existence.

Since Budget 2011, the Government has been engaged in an informal consultation with the property industry to consider whether some of the conditions for REIT qualification can be relaxed to make the regime more accessible to new entrants and examine some technical aspects associated with the ongoing operation of REITs.

Here are the proposals aimed at attracting new entrants to this sector:

Abolition of Entry Charge
On entry to the REIT regime, the chargeable gains cost of property investment assets is effectively rebased to their market value at the date of entry. Provided that certain ongoing requirements are met, any future disposals of investment assets become exempt from corporation tax on chargeable gains – with rental income also becoming exempt. The quid pro quo for this beneficial tax treatment is that an entrance charge is payable equal to 2 per cent of the market value of those properties used in the exempt business. At the top of the property market, this one-off fee was a price worth paying in return for sheltering unrealised gains from future taxation. However, on the back of the recent global recession, this has quickly become a less attractive proposition. Furthermore, international investors have the viable alternative of investing through non-UK resident entities that are not subject to capital gains tax. It may not be surprising then that one of the Government’s key proposals is the possibility of a complete abolition of the entry charge.

Introduction of Diverse Ownership Rules for Institutional Investors
Currently, to qualify as a REIT, a company cannot be “close” – meaning it cannot be controlled by five or fewer participators. The proposal would allow institutional investors to hold significant investments in REITs without worrying about this condition. The logic for this is that such institutions already represent the economic interests of a large number of investors. As part of the discussion, the Government is examining what type of organisations would qualify as “institutional investors” and, while pension funds and insurance companies would appear to be the obvious target, it will be interesting to see whether private equity funds will be included in this definition.

Introduction of Fixed Grace Period for New REITs
This would permit a REIT to be founded by a small number of shareholders at the outset, with a view to increasing the diversity of its ownership over a period of time. The founders could establish a portfolio and build the company’s reputation before seeking additional investors. While the Government has not made a specific suggestion as to how long a grace period would be, we believe it would need to be no less than three years to allow founder investors sufficient time to establish a successful platform and then execute a plan to meet the “non-close” company requirement on the grace period’s expiration.

Relaxing the Listing Requirement
This proposal would relax the requirement that a UK-based REIT company must be listed on a recognised stock exchange, and include junior exchanges such as AIM and its overseas equivalents. This measure should be attractive to smaller investors because it is aimed at reducing the regulatory burden and costs encountered by groups with a main market listing. However, the proposal does not remove the listing requirement altogether to open the door up to private companies – the Government presumably wishing to retain regulatory protection for investors.

The outcome of the consultation will not be known until autumn 2011, when the draft Finance Bill 2012 is published – at which point there will be an opportunity for further lobbying before the final proposals become law next year. While these proposals are aimed at increasing the uptake of the regime, the Government will no doubt want to see that uptake reflected in increased capital flow into the market, rather than the new entrants being smaller property groups taking advantage of the removal of the entry charge. It will be interesting to see whether the measures will entice offshore property investors to come onshore, particularly as the burden of successfully maintaining overseas residence becomes increasingly difficult.

Jonathan Hornby
Senior Director
+44 207.715.5255

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