REITs in Europe - A U.K. Legal Perspective
by David J. Evans and Susan Crawford
Almost every day the European property press reports that one or another of the U.S. property fundsi is either rumored to be or actually acquiring positions in European real estate. While it is clear that many of the more risk-hungry and aggressive U.S. opportunity funds have been and continue to be fairly active in Europe, so far there has been no wholesale influx of REIT money. A combination of "focusing on our own backyard" and "can it be done?" inertia seem to be slowing down the U.S. REITs' European activities.
There are many reasons for interest in European real estate, including: attractive cap rates; interest rate convergence following the onset of the single European currency; the need to "service" the existing U.S. occupier base on a global level; or simply the desire to hedge against any downturn in the U.S. property cycle. So the need for REITs to address the more fundamental issues of investment in Europe becomes ever more pressing.
With particular reference to the U.K. legal and tax regimes, this article identifies and addresses some of the more fundamental legal issues facing REITs that want to invest in European real estate.
Can REITs Invest in Non-U.S. Real Estate?
There are no specific restrictions on the geographical location of "real estate assets"ii for the purposes of qualifying REIT investment. In fact, the IRS has ruled that "real property" includes land and improvements outside the United States.iii Whether any particular REIT would find its stockholder base or stock analysts receptive to its venturing over to Europe is a separate issue that will need to be addressed by each REIT at the outset.
European Investment Options
1. Direct Property Acquisitions
One attraction to REITs is the single-layer tax at the stockholder level only. In the U.K., for example, property companies quoted on the U.K. Stock Exchange (the closest vehicle to REITs in terms of liquidity) are taxed at a 31 percent corporate rate, subject to a further level of tax at the individual stockholder level. U.K. pension fund and corporate investors pay no further tax on such dividends.
It is important therefore to seek to minimize any "leakage" of tax benefit when structuring a European real estate acquisition. From the U.K. perspective, if the REIT acquired the real estate directly, while there would be no U.K. tax on the REIT's capital gain once the real estate was sold, any rental income derived in the U.K. would be subject to U.K. tax at 23 percent.
One way to minimize the leakage is to introduce methods of reducing the locally taxable income, by way of leverage with third party debt, for example. In the U.K. this would involve the real estate being acquired by, say, a Jersey (Channel Islands) tax exempt company ("JerseyCo"). JerseyCo would be a qualified REIT subsidiary (QRS) and therefore effectively tax transparent from a REIT's perspective.iv It would be a vehicle capable of being leveraged with a result that, as interest costs are deductible from gross rents,v net taxable income is reduced. Furthermore, there would be no withholding on dividend income paid by JerseyCo to the REIT. Also there would be no capital gains tax, either in the U.K. or Jersey, in the event of JerseyCo selling the asset.
The simple leverage route leads to further issues however:
( REITs have market-imposed leverage caps, traditionally in the 35 to 40 percent region,vi which in many cases may not be exceeded, even for a one off "international" acquisition transaction;vii and
( By leveraging to reduce local tax on income, on the premise that the higher the leverage ratio the less the tax "leakage," the REIT effectively gives away an income/earnings return in place of a growth return. This may run contrary to the general earnings philosophy of REITs and their investments.
The use of inter-company loans (such as the REIT itself lending to the QRS), potentially on a "participation" basis, is one way to consider getting around the problem of leverage caps while bringing the added benefit of an earnings-type return geared to the underlying assets. The use of participating mortgages as a way in to non-U.S. real estate is fairly well known. However, in the U.K. there is a careful line to be drawn between debt and equity and (correspondingly) deductibles and non-deductibles. In the context of inter-company debt, the newly introduced U.K. "transfer pricing" rules closely control the amount and terms of inter-company debt.
The European market is no different from the U.S. market, at least in one key respect. If a purchaser can give a seller deferral on paying capital gains tax when disposing of his real estate, yet still allow that seller to receive a return on his disposal, that seller may be more inclined to deal with that purchaser rather than another who cannot.
From the U.K. perspective, the use of operating partnership units (OP units) as hard currency for sellers would seem to be achievable from a legal perspective, although care needs to be taken to ensure that the U.K. seller is not deemed to be receiving non-dividend income in the U.S. If he were, he could be hit with a 39 percent U.S. tax liability.
To protect against this, one possibility is to set up a single purpose sub-limited partnership (that is, beneath the operating partnership) in the U.K., with the operating partnership as general partner of that sub-limited partnership and with the U.K. seller as a limited partner. The U.K. seller's return would then be generated from the sub-limited partnership and would be pegged to the OP unit return by way of a fluctuating participation in the U.K. limited partnership's return. This structure is not without its limitations and there are additional, more sophisticated refinements that can be introduced to replicate better the UPREIT structure.
3. Corporate Acquisitions
Entering into the European real estate market via a corporate acquisition is, on the whole, more attractive than direct single or portfolio asset acquisition because it brings with it benefits of indigenous management personnel familiar with and experienced in the relevant local market.viii In the U.K. there is a further advantage in that it gives rise to an acquisition tax (stamp duty) of merely 0.5 percent of the consideration for the share acquisition as opposed to 3 percent on the consideration paid for the real estate assets themselves.
Against that, one must set the disadvantages of having to structure around the fundamental restriction of REITs owning more than 10 percent of voting securities of any company, and the corporate acquisition bringing with it the additional tax layer. In the U.K., for example, corporation tax on income and gains currently is at a 31 percent rate. In both cases these disadvantages can be addressed, but not without complexity.
A REIT may own no more than 10 percent of the voting securities of any other non-REIT company.ix One recognized "exception" to this is where the REIT owns 100 percent of the stock of the relevant company and that company is, or becomes, a QRS.x
A private U.K. company is one whose stock is not quoted on a public market such as the London Stock Exchange. In relation to U.K. private companies, if the REIT acquires 100 percent of all the stock of the relevant U.K. company, the REIT could then elect for the private company to be a QRS. Moreover, it should be noted that in the case of electing for such a U.K. company to become a QRS, certain obligations arise, most notably, in relation to distribution of historic earnings and profits of that company, all of which will need careful consideration from a tax perspective.
When, however, less than 100 percent of the stock of the U.K. private company is to be acquired, the QRS route is not available. In these circumstances, use could be made of the U.S. "check-the-box" regulationsxi whereby the U.K. private company would be treated as a partnership for U.S. tax purposes. The REIT then would be deemed to own its share of the underlying assets of the U.K. private company in proportion to the REIT's shareholding in that company.
If a REIT chooses to treat a U.K. company as a partnership for tax purposes under the check-the-box regulations, the target U.K. company is deemed to have liquidated and distributed its assets to the REIT, with the REIT deemed to have contributed the assets to a new partnership. If the REIT (either directly or through its OP) owns more than 80 percent of the U.K. target, then the REIT receives the deemed liquidation proceeds on a tax-free basis, and therefore uses the tax basis of the target assets "carryover" to the REIT.xii
Conversely, if the REIT (directly or through the OP) owns less than 80 percent of the target U.K. company, the REIT receives a "stepped up" basis in the assets equal to their fair market value.xiii Since the U.K. target presumably has little connection with the United States, the U.K. target would not be taxed by the U.S. on this deemed distribution. In addition, the REIT should not be taxed because its tax basis in the stock of the target company should equal or exceed the fair market value of the U.K. company's assets. Thus, the check-the-box election can be used as a tax planning tool to "step up" the tax basis of assets for U.S. tax purposes, thereby generating more depreciation deductions for the REIT.
As with the UPREIT structure, there is a possibility for tax deferral. The seller of the stock in the private company to a REIT can achieve a capital gains tax deferral in the U.K. if the REIT acquires at least 25 percent of the ordinary share capital or the majority of the voting rights of the U.K. company. This is known as a "paper-for-paper" transaction, whereby, in effect, the U.K. stock seller would receive REIT stock in return for his or her stock in the U.K. private company.
In relation to U.K. companies listed on a public market, the position becomes somewhat more complicated, principally because, in the U.K., there is a set bid timetable laid down by the Takeover Code. This applies whether or not the proposed acquisition of the U.K. public limited company's stock has been agreed by the U.K. public limited company. Given that there may be 28 days from announcement of an offer to posting a bid document, followed by up to 60 days acceptance period and a further 21 days for all conditions to be satisfied, the total period may be as long as 109 days. The shortest period is 21 days, but there is no guarantee of success within this period.
When one then introduces the further restriction that check-the-box provisions require a U.K. public limited company to be treated as a corporation for U.S. tax purposes "per se," it becomes clear that once the REIT stockholding in relation to a U.K. public limited company exceeds 10 percent, the REIT will fall short of the 10 percent voting securities rule come the relevant REIT quarter.xiv
It is important to have a thorough understanding of the relevant regulatory framework governing public company acquisitions in the relevant European jurisdiction. Also, to achieve the desired results, the REIT may have to use preferred stock subsidiariesxv to own stock in excess of 10 percent voting control.
Additional Tax Layer
In terms of the ongoing tax position, as mentioned above, the U.K. company would be subject to 31 percent tax. In addition, any U.S. shareholder of the U.K. company pays no further tax. While the U.K. company would pay Advance Corporation Tax (ACT) with respect to the dividend, there is no withholding tax as such on dividends paid overseas by a U.K. company. In fact, the U.S. shareholder can obtain repayment of some of the ACT paid by the U.K. company. However, after April 6, 1999, ACT will no longer be in effect, so the U.S. shareholder will no longer be able to claim this repayment of the ACT.
As discussed earlier, leverage (or other means) can be used to mitigate local tax. However, it would seem sensible in the context of a U.K. corporate acquisition, (be it private or public), to give thought to restructuring the basis upon which vehicle within the underlying real estate assets are held to reduce any tax leakage as a consequence of, in this case, an additional U.K. tax entity.
In conclusion, with careful structuring, REITs can invest in U.K. real estate through a number of different acquisition routes and in ways that largely preserve the tax attractiveness of REITs for their investors.
David J. Evans is a real estate partner and Susan Crawford a tax partner of Ashurst Morris Crisp, an international law firm based in London with other offices throughout the world. The views expressed herein are not necessarily the views of Ashurst Morris Crisp. The authors gratefully acknowledge Rogers & Wells, LLP of New York, who gave valuable assistance in the preparation of this article.
i By this we mean U.S. real estate entities, be they investment/opportunity funds, mutual funds or REITs.
ii "Real estate assets" here corresponds with that definition in I.R.C. § 856(c)(5)(B).
iii See Revenue Ruling 74-191, 1974-1 C.B.170.
iv The ability of a non-U.S. corporation to become a QRS is not completely free from doubt.
v Unlike the U.S., rents in the U.K. are paid by the tenant to landlord exclusive of service charges (which are paid by the tenant to the landlord separately) and taxes (which are normally paid by the tenant to the state direct).
vi Retail sector REITs may well have higher caps.
vii Often because unsecured corporate debt facilities may impose leverage ratio restrictions.
viii The desire on the part of most U.S. real estate funds to take on indigenous management seems almost universal.
ix I.R.C. § 856 (c)(4)(B).
x I.R.C. § 856(i).
xi Treas. Reg. § 301.7701-2.
xii I.R.C. § 332.
xiii I.R.C. § 331.
xiv Each quarter of the taxable year is the point at which the REIT asset tests are applied, the 10 percent voting securities test being only one of them [see Sec. 856(c)(5)].
xv Preferred stock subsidiaries are companies that are not subsidiaries, per se, of the REIT but are companies in which REITs have a substantial investment in non-voting securities.