Changes to UK’s real estate investment trusts (REITs) regime have recently been introduced to remove unnecessary barriers to entry and make the regime more accessible and attractive to investors. The reforms follow a comprehensive government-led review, but further reforms are expected.
Overview of the REIT regime and its benefits
REITs are tax efficient property investment companies. Since the regime was introduced in 2007, most of the UK’s largest listed real estate companies have opted to become REITs, along with several new entrants.
Qualifying companies need to elect to claim REIT status – it is not automatic. If a company elects to become a REIT it will qualify for certain tax benefits, which broadly have the effect that taxes are only levied on investors when profits are distributed. The main tax implications of electing for REIT status are that income profits and capital gains of the qualifying property rental business of the REIT are exempt from UK corporation tax, whilst distributions of income profits and capital gains by the REIT are treated as income from a property rental business in the hands of investors. Generally, a 20% withholding tax applies on distributions to investors, subject to exceptions, including payments to pension funds and UK companies.
REITs are generally viewed as a tax efficient way of holding and investing in UK real estate. However, several conditions need to be met before a company can qualify for REIT status, which have prevented many property investment businesses from accessing the regime. Since the regime was introduced, lobbying by the property industry has successfully resulted in gradual relaxation of the conditions attaching to UK REIT status. The introduction of private REITs in 2022 has been swiftly followed by further measures to increase the opportunities for institutional investor-led REIT structures. The parallel changes to the UK tax regime in the last few years to bring non-resident investors within the charge to capital gains tax have also enhanced the relative attractiveness of the REIT as the investment vehicle of choice for collective UK property investment. The changes in the current Finance Bill 2023 promise to continue this trend by enabling further cost savings and more flexible structures to be launched.
Qualifying for REIT status
To qualify as a REIT a company must satisfy several conditions in relation to itself and its activities.
Company conditions
In relation to itself, in any accounting period, a company must:
- be solely resident in the UK for tax purposes;
- not be an open-ended company – that is, one where more shares are created as more money is invested;
- not be a close company – that is, broadly, one with five or fewer controlling parties. A company will not be 'close' just because it has a participator who is an institutional investor. The company can be close for up to three years after becoming a REIT;
- have only one class of ordinary share capital and may not issue any other class of shares other than non-voting relevant preference shares; and
- not be party to a loan which carries excessive interest or interest dependent on the results of the company's business, or a loan providing for an excessive level of repayment.
Prior to April 2022, a company could only qualify for REIT status if its ordinary share capital was listed on the London Stock Exchange or traded on a recognised exchange, including the Alternative Investment Market (AIM). Helpfully, as part of relaxing the conditions of entry, this condition does now not apply if at least 70% of the ordinary shares are owned by one or more institutional investors - a so-called ‘private REIT.
Business conditions
The company must have a qualifying property rental business (PRB). Broadly this means:
- it must hold at least three single properties or separately rented units;
- no single property may represent more than 40% of the total value of the PRB;
- none of the properties can be owner occupied; and
- the interest cover ratio in respect of the PRB must not fall below 1.25 – financing costs are restricted to a maximum of 80% of the PRB’s profits.
Although commercial and residential property investments can form part of a qualifying PRB, the regime has been predominantly used for commercial real estate investment. The conditions relating to what will qualify as a PRB, is another area where we have seen a welcome relaxation of the rules. From April 2023, where a REIT holds a single commercial property worth at least £20 million it now does not have to hold at least three properties.
There are also conditions regarding the company’s profits and distributions. At least 90% of the PRB’s profits must be distributed by dividend within 12 months of its accounting year end. The REIT’s primary business must be a PRB and therefore, profits from the PRB must be at least 75% of the company’s total profits. The value of assets held in the PRB must also be at least 75% of the total value of assets held by the company at the beginning of each accounting period. A REIT’s PRB can include income from investments in other UK REITs, provided the investing REIT distributes 100% of the distributions it receives from the investment to its investors. A REIT may incur tax charges if it makes a distribution to a corporate shareholder that is beneficially entitled to 10% or more of its shares or dividends, or controls 10% or more of its voting rights.
A group of companies can qualify for REIT status. The company at the top of the structure must satisfy the company conditions and the group collectively must satisfy the business conditions. A UK group that qualifies as a REIT may contain certain non-UK resident members.
Further reforms to the REIT regime
Given the extensive conditions to qualify for REIT status, there were understandably concerns that the regime was overly complex and significant barriers to entry existed. In response to widespread lobbying, the UK government is introducing further changes to the qualifying conditions. This summer, it is expected that the rule deeming a disposal of a property within three years of being significantly developed as being outside the company’s PRB will be changed so that the valuation used when calculating what constitutes a significant development will better reflect increases in property values.
The rules for deducting tax from property income distributions (PIDs) paid to partnerships are also going to be changed, so that certain distributions can be made without withholding, which it is hoped will increase the attractiveness of the regime to investments in real estate partnerships.
Requiring a REIT to be genuinely diversely owned (GDO) can also create significant barriers to entry, so it is a positive development that the UK government is proposing to amend the GDO condition to improve its operation for fund structures involving multiple pooling vehicles and ensure that where an individual investment entity forms part of a wider fund structure that entity can satisfy the GDO condition by reference to the wider structure, even if the entity itself would not satisfy the GDO condition.
Tax treatment of REITs
The tax benefits of REIT status are only available to a company’s PRB. Any profits from non-PRB activities will be taxable under normal UK corporation tax rules. Effectively, for tax purposes, where a REIT carries on non-PRB activities it is treated as two different entities – the tax exempt PRB and the non-tax exempt business. Special rules apply to determine how income and expenditure is divided between the two businesses.
Tax charges can arise if any of the conditions for qualifying for REIT status are breached, although some minor breaches can be disregarded.
Tax treatment of investors
Given that there is no tax at the level of the REIT, PIDs – distributions from a REIT in respect of its PRB – are subject to a higher level of tax than normal company dividends.
PIDs are subject to a 20% withholding tax, which is set against the investor's tax liability. There is a withholding tax exemption for UK corporation tax paying investors, and certain exempt bodies such as pension funds, local authorities, or charities. Non-resident investors may be eligible to a reduced withholding tax rate if relief is available under a double tax treaty.
UK-resident individual investors will pay UK income tax on PIDs – currently at a top rate of 45%. Corporate investors will pay UK corporation tax – currently at 25% – on REIT distributions.
The tax treatment of PIDs received by corporate investors contrasts with the normal tax position for dividends, which are usually exempt from UK corporation tax. However, unlike distributions from a normal company, the PIDs have not already been taxed at the level of the REIT.
The tax treatment of a REIT investment is broadly comparable with a direct investment in UK real estate. However, one disadvantage for individuals is that gains from disposals by the tax exempt PRB are taxed as income in the hands of the investor, rather than being taxed within the capital gains tax (CGT) regime.
The UK’s CGT rates are lower than for income tax – either 20%, or 28% for disposals of residential property. Reliefs, such as an annual exemption, may also reduce a CGT liability further. Capital allowances are not available to REIT investors and any capital losses from the tax exempt PRB cannot be offset against any capitals gains that investors may realise from other direct real estate investments. However, the normal CGT rules apply to UK investors in relation to any gains arising on the sale of their REIT shares. From April 2019, non-resident investors may also be liable to CGT, or corporation tax, on gains arising on the sale of REIT shares.
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