Melville Rodrigues: A new UK fund structure, please

The real estate industry should urge the government to enhance the UK’s competitiveness as a fund domicile in a post-referendum world, argues Melville Rodrigues

The UK would benefit from a closed-ended, unlisted, tax transparent/exempt real estate fund with tradeable units. UK fund managers are currently forced to consider other jurisdictions for such a fund to address institutional investor needs. There should be parity with a fund solution onshore. 

Investors often look to invest indirectly in UK real estate via such funds. They are targeting sector-focused, medium-term real estate returns from specialist managers as part of a diversified portfolio.

Key requirements for the fund would be that investors commit within the limited investment horizons of closed-ended funds, and hold units that can be traded prior to fund expiry. In particular, unit trades should not be inhibited by transfer taxes. Investors would not be expecting the fund to be open-ended, recognising that many of these need to hold cash, bonds and equities as a liquidity buffer, which can erode returns.

Another key requirement would be that the fund is not listed, given that the performance of shares in listed real estate funds can be volatile, affected by supply and demand for listed shares, and the correlation with net-asset-value performance being distorted.

In addition, the fund should have the flexibility to attract domestic and international capital from a range of investors, including UK tax-exempt and taxable investors. UK pension funds and other tax-exempt investors generally pay no or little tax on income and capital gains when they own real estate directly, and if committing indirectly they expect equivalence and the fund to be tax-transparent or exempt.

Fund managers are forced to consider other jurisdictions if wanting to serve these needs. UK pension funds and other tax-exempt investors generally pay no or little tax on income and capital gains when they own real estate directly and, if committing indirectly, expect equivalence. Other jurisdictions offer closed-ended, unlisted, tax-transparent/exempt funds with tradeable units – for instance, unit trusts in Jersey and Guernsey, and the Fonds Commun de Placement in Luxembourg.

Managers wishing to establish a closed-ended, unlisted, tax-transparent/exempt fund with tradeable units holding UK real estate typically consider the use of non-UK funds. This is unfortunate when the underlying real estate, the managers and investors are all located in the UK, but the funds have to be operated outside the UK, and thereby subject to associated operational costs. Also, the funds have to address the challenges of multiple legal, tax and regulatory regimes, including maintaining sufficient substance offshore.

The industry should lobby the UK government to level the playing field between UK and non-UK residents from a tax perspective. There is now effective parity of treatment arising from income and capital gains between UK and non-UK investors when they hold UK real estate directly. An equivalent parity, in terms of UK tax, should apply between UK and non-UK fund vehicles.  

Successive governments have sought to maintain a competitive tax regime for UK-domiciled funds. Government policy has focused on little or no tax being paid at the fund level, ensuring that investors are taxed in the same way as though they had invested in the fund’s underlying assets directly – although recognising that, in the case of real estate funds, income tax on property income distributions is withheld on payments to taxable investors.

The government’s investment management strategy aims to enhance the UK’s share of fund domiciles. The government and the Financial Conduct Authority (FCA), intend to work with the funds industry to create an environment in which managers can deliver the best possible outcome for investors, businesses and the UK economy. Government is looking to strengthen the UK’s brand for asset management, and enable managers to respond effectively to Brexit.

The UK prides itself on a robust legal and regulatory regime. Trustees and fiduciaries of UK pension funds would presumably prefer indirect commitments via funds and managers regulated by the FCA.

Industry and government bodies have worked together to create new legislation (see table below).

However, the existing closed-ended, unlisted UK fund vehicles – limited partnerships (LPs) and exempt property unit trusts (EPUTs) – have to operate within severe restraints. LP units are not tradeable, as transfer tax on LP units is levied at up to 5% on the underlying UK (non-residential) real estate. The transfer tax ensures that investors do not circumvent stamp duty land tax by (SDLT) by disposing the underlying real estate via LP units. For EPUTs, the only permissible unit holders are UK (and certain qualifying non-UK) pension funds and other tax-exempt investors. EPUTs are effectively tax-free at the fund level and a 0.5% transfer tax applies. Tax-paying investors are prohibited, so they cannot be combined with tax-exempt investors.

The gap in the UK fund landscape needs to be addressed. The industry and the government should identify a holistic legal, tax and regulatory fund structure which addresses several issues: 

• The fund being tax transparent or exempt. Should managers be entitled to elect between these options?

• Applicable investors should be limited (for example, as they are for Co-ACS), and the fund should be beyond the scope of ordinary retail investors – who are catered for by REITs and PAIFs;

• Should managers be obliged to distribute returns akin to UK REITs and PAIFs? The fund – like each fund example above – should be permitted to invest in real estate outside the UK, and thereby capitalise on the UK’s future trading opportunities;

• There should be appropriate tax anti-avoidance provisions. For example: ensuring the fund complies with a genuine diversity of ownership condition; withholding tax on fund distributions; ensuring investors do not circumvent SDLT by disposing the underlying UK real estate via fund units, and (given treaty arrangements which apply to non-UK investors) the UK retains its taxing entitlements.

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The industry should lobby and collaborate with the government on a new fund structure to improve the competitiveness of the UK’s real-estate fund-management business. 

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