The new harsh economic reality will add additional tax challenges - and opportunities - for the real estate fund management industry, say John Whitehead and Siobhan Godley
The European tax landscape is one of continual change, so the challenge for the European fund manager remains to keep abreast of tax changes, as well as manage tax risks in existing structures. Also, the increased accessibility of tax efficient property holding structures, as well as range of real estate fund vehicles, presents an opportunity to minimise tax leakage and maximise fund returns.
If taken as a whole, the EU can be considered a high tax area. Based on research carried out by the European Commission (EC), the overall tax ratio amounts to 39.9% of GDP - 12 percentage points above the US. This headline rate is background for some of the trends in European taxation over the past decade as EU member states have tried to increase their own competitiveness in attracting inward investment.
Tax rates vary substantially across the EU, with rates being historically higher in the ‘old' pre-2004 EU 15 member states. Over the past 12 years, there has been a downward trend in headline rates of corporate income tax, with the average rate across the EU 27 member states of 36.3% in 1996 declining to 23.6% during 2008. However, this reduction in headline tax rates has been coupled by other approaches to maintain their taxable base.
Transfer pricing legislation has tightened in order to prevent tax leakage from related party cross-border transactions with documentation requirements in several countries becoming more onerous with a tightening of penalties for non-compliance. Although the newer member states may be some way behind the old in terms of rigour in the transfer pricing area, it may only be a matter of time before they catch up as they adopt OECD models.
A further development indicative of a measure taken by jurisdictions to protect their taxable base is the introduction of earnings-stripping rules to reduce the deductions available for interest payments on a territorial basis. Any rules of this type are naturally complex to apply and interpret.
As a result, the introduction of earnings-stripping rules in Germany in 2008 has been widely commented on and these rules have become fundamental when structuring real estate investment there. The UK pre-budget report has announced the introduction of a worldwide debt cap which, depending on how these provisions are ultimately enacted, might have implications for structuring inbound UK real estate investment.
Aside from the tax that is levied on a territorial basis, a key consideration for any European fund manager is their choice of fund vehicle. This is of critical importance in attracting third-party investors in terms of choosing a vehicle that is tax-efficient from a pan-European perspective, and one that is sufficiently familiar to investors to ensure a smooth investor due diligence process.
As capital-raising for European real estate funds has grown, so too has the choice of fund vehicles through which capital has been drawn down. As well as transparent limited partnership vehicles, a wide range of transparent, opaque and hybrid fund vehicles have been used, with those established in Luxembourg, the Netherlands and the Channel Islands remaining popular choices.
Luxembourg and the Netherlands remain the most popular choices of EU fund vehicles because of the extensive treaty network enjoyed by both jurisdictions as well as the favourable holding company regimes permitted under their domestic law. In particular, the range of fund vehicles in Luxembourg is extensive and it has remained the jurisdiction of first choice for a number of fund managers. However, it is critical that business substance can be maintained by these types of fund vehicles in order to benefit from double-tax treaty benefits and those available under EU directives.
When considering choices of fund vehicle and management arrangements in an EU context, it is also important to consider their potential longevity in light of potential challenges under EU state aid provisions. As an example, the tax-exempt advisory companies of Luxembourg corporate funds, which had been commonly used to structure management fee arrangements through Luxembourg, were challenged under EU state aid provisions.
Those companies benefited from a 1929 holding-tax regime that was abolished (with grandfathering for existing entities until 2010) in order to comply with EU rules. If not already doing so, fund managers that have structured their fees through such exempt Luxembourg companies now need to consider restructuring their arrangements so as to mitigate the risk of adverse taxation once they will be taxed under the standard tax regime.
On top of the more generic tax planning, the introduction of REIT regimes has been used as a strategy by some countries to attract inward investments, with relatively new regimes now available in the Netherlands, France, Germany, the UK, Poland, Italy and Belgium. However, these regimes have been characterised by restrictions with respect to leverage, asset diversification as well as types of real estate activities that have presented barriers for certain types of investors.
On top of this, the conversion charges payable on entering certain REIT regimes have reduced their attractiveness for existing investors. Nonetheless REIT regimes do offer some interesting possibilities in the context of European real estate fund investment such as the possibility of EU pension funds benefiting from the Dutch REIT regime.
While discussions are taking place between the European Commission and member states as to whether the REIT concept could be widened to encompass all EU member states, it is not clear whether there will be sufficient appetite among EU member states to agree on a Europe-wide REIT. The introduction of this type of vehicle would be ground-breaking for the structuring of pan-European real estate funds and might change significantly the types of fund structures adopted by European fund managers.
An area of increased focus has been fund executives restructuring their carried interest returns in a tax-efficient way, with funds adopting many of the techniques previously seen in private equity funds. In the UK, carried interest planning will become even more attractive following the pre-budget report in light of the prospective increase of tax rates on income for more highly paid executives and the announced increases in national insurance effective from 2011.
Regardless of the tax optimisation that has been modelled by choosing tax-efficient structures, the key to success in managing tax leakage in a European fund context will be in ensuring that these structures are properly established and that tax risks are managed on a continuing basis.
A common model is for the product development team at a fund manager to move on from their successfully launched fund to the embryonic phase of a new business opportunity. The challenge in this model is to ensure that there is a seamless handover to those who will be running the fund on a day-to-day basis as to the tax features of the fund and where any tax risks may lie. Examples include the importance of maintaining tax residence, attending and documenting board meetings and complying with overall corporate governance.
Another practical area for the fund manager to focus on is VAT compliance and potential VAT exposures in a cross-border real estate structure. VAT administration can be complex and failure to plan properly can lead to tax leakage, where irrecoverable VAT is incurred that could have been avoided, or penalties where VAT registration is overlooked. The risks in this area increase as real estate funds move from a single-country focus to pan-European and this should be an area of priority as funds expand their target investment markets.
One current area of active debate for fund managers is how a fund can be unwound at the end of its fund life or how the fund can be extended rather than terminated. In the current economic environment, the latter approach is becoming increasingly commonplace given the contracted real estate transaction market, as well as the lack of appetite for fund managers to sell at the current asset values where carried interests may not have vested as expected.
What should not be overlooked here is the window of opportunity presented by this decision to both re-examine the local asset holding structure, fund vehicle as well as carried interest planning. Over the typical five-seven year fund life there are likely to have been some significant changes in taxation that may make different structures more attractive for a particular fund.
In addition, carried-interest planning may have moved on such that it may be attractive to consider whether new structures could be considered for structuring all or part of the carry in a fund. During this window of opportunity where active discussions are taking place with investors and legal advisers, fund managers should take the time to consider whether any particular features of a fund can be made more tax efficient and whether any restructuring could be undertaken without undue cost.
So what will come next? In the tough economic climate, there will be increased international competition as member states try to attract inward investment to revitalise their real estate markets - simply put, we may see the trend continue to reduce tax rates on a headline basis. However, as tax revenues decline there will also be pressure for countries to maintain their taxable base.
Easy wins in this area for tax authorities might be to challenge taxpayers in the transfer pricing/thin capitalisation area as well as clamping down on structures that might be considered artificial from a tax-planning perspective. In this type of environment, the importance of careful implementation and constant monitoring of real estate fund structures should not be overestimated.
John Whitehead is a partner and leads the UK real estate tax team at Deloitte LLP
Siobhan Godley is a director specialising in international real estate funds and real estate transactions