Achieving the right balance between a competitive EU law-compliant REIT regime and the appropriate level of protection of the local tax base is within the grasp of European governments, say Ronald Wijs, Roderik Beckers and Fraser Hughes
The governments of various European countries understand that the presence of a well-organised property regime offering liquidity and transparency is essential for their property industry. Various special tax regimes for listed REITs have been introduced over recent years, while other countries are updating their more mature regimes.
Although there is no formal European standard,(1) there are many similarities when comparing individual country REIT regimes in Europe. Notwithstanding the similarities between the European regimes, each European country imposes its own set of conditions and limitations.
If we take a closer look, we can see that many of the requirements for benefiting from a given REIT regime are motivated by governments' fear of abuse and their concerns about the loss of tax in the international context. The debates in the UK and Germany were to a large extent dominated by this fear and not primarily focused on the question of how to create a flexible, transparent and competitive regime. So, based on our experience in Europe, what would such an ‘ideal' REIT regime look like?
In defining the ideal REIT regime, we look at the following areas:
Taking these bullet points individually, each issue is explained and an ideal option identified.
Legal form: The REIT should preferably have the form of a stock company with limited liability that is recognised on a broad international platform (and not the form of a trust, or similar).
Listing and shareholders conditions: There is always the fear that REIT regimes will be abused by REITs operating as private structures. The simplest remedy for this is to impose a listing requirement. All other shareholders' requirements (like those in Germany, UK and the Netherlands) often substantially complicate the regime. The main reason for most of these shareholders' requirements is to avoid foreign shareholders being able to receive REIT profits at a very low tax rate (or free of any tax in the country of residence of the REIT).
Scope of activities: A REIT regime should, of course, be restricted to property investment activities. However, within the property classification, a REIT should be able to invest in a broad range of property assets.
The new German and UK regimes still suffer from too many regulatory restrictions (complicated asset tests, etc). For example, in Germany residential housing is excluded, and in both the UK and Germany there are serious restrictions on the holding of properties via partly-owned subsidiaries and partnerships.
In the Netherlands, the scope of permitted activities is still defined much too narrowly (only very passive property investment is allowed). EPRA & Loyens & Loeff sit on a broad panel of Dutch property professionals planning to lobby the Finance Ministry with regard to updating the current Dutch REIT structure. One of those areas of discussion is to include some development flexibility.
In addition to property investments, a REIT should be able to conduct certain related businesses (cleaning company, project development activities also for third parties, etc). These activities should, of course, not benefit from the ‘tax flow through' REIT treatment. The US concept of a ‘taxable REIT subsidiary' has proven to be successful and is followed by various European countries: in Germany, France and the UK it is possible to conduct taxable commercial activities within certain limits.
Leverage: Many countries impose specific REIT leverage restrictions, to avoid the distributable profit being eroded (which would reduce the withholding tax claim on the distribution of profit). In certain countries, for example the Netherlands, the leverage restrictions form a serious bottleneck for further growth and expansion. Countries such as Germany and the Netherlands impose leverage restrictions based on the tax book value of the properties, and refuse to see that such restrictions are totally out of line with the ‘restrictions' imposed by the market.
Ideally, a listed REIT should not be subject to special leverage restrictions. The French law makers seem to have understood this and France is the only European REIT regime without a specific REIT leverage restriction. If there is a strong feeling that a certain limit should be imposed on REITs, the normal local debt-to-equity ratios applicable to all companies should be applied, rather than a specific limit for REITs.
Distribution obligation: As a REIT is not paying corporate income tax, it is important that its profits are distributed to the shareholders (where these profits will be subject to tax). This is an incremental part of the tax philosophy of a REIT. However, it should not be a requirement that a REIT is obliged to distribute all of its cash. For example, in the Netherlands, a REIT is obliged to distribute 100% of its current profit (excluding capital gains), while at the same time, it is virtually impossible to depreciate on immovable property. A distribution obligation that covers around 80% of the distributable profit would be a better system, providing a REIT with a little more flexibility.
Conversion regime: Most European countries have introduced a special conversion regime (also referred to as ‘exit tax'), allowing a company to convert to a REIT and pay tax on the latent capital gains at a reduced rate of profit. France even introduced an innovative system whereby corporate entities are able to transfer real estate to a SIIC and pay tax on the capital gain at half the normal tax rate (conversion regime extended to transfers to REITs). Such a sophisticated conversion regime is an important tool to promote the growth of the listed REIT sector. The UK and Germany followed the French example in this respect.
International investments: A weakness in many European regimes is the lack of flexibility to invest cross-border. Many regimes are based on the idea that a local REIT will only invest in local properties and uncertainties arise as soon as investments are made in foreign properties (which is often done via corporate structures). The German, the UK and also the French regimes seem to suffer from this problem to a certain extent.
REIT tax treatment
A variety of systems are used to shift the point of taxation from the REIT to the shareholders (to exempt the REIT). The key question is how the tax claim on distributions to foreign shareholders can be safeguarded.
All European countries have implemented measures to avoid a situation in which the withholding tax burden on such distributions is too low (or even nil). There is a serious risk that there is friction between these provisions in REIT regimes and the principles of European law that prohibit discrimination against foreign nationals and residents.
France recently introduced a special tax on REIT distributions targeting foreign shareholders (this is a tax levied at the level of the French SIIC). It is questionable whether such tax will stand the test of EU law.
Government fear of abuse is main restriction on growth
The above discussion of the various aspects of the ideal REIT is, of course, open to debate and the perception of what is ‘ideal' may vary depending on the situation and the country you are in.
What is more important is that the governments of various European countries begin to understand that the fear of abuse of an individual REIT system and leakage of tax from the country is often the main reason why a given REIT system has not ‘taken off', has slowed down or has even experienced stagnation.
It is a common belief that legislators should spend more time on the elements that make a REIT regime successful, both at a national and international level. Recent work carried out by Piet Eichholtz on behalf of the European Property Federation's (EPF) EU-REIT initiative (see article page 60) focuses on the successes of the REIT structure around the world with a view to finding the way towards a common European model.
A well-thought-out system, which preserves the right balance between a competitive EU law compliant REIT regime and the appropriate level of protection of the local tax base, must be a feasible target for European governments.
France leads the way for European REITs
In this context, it is interesting to observe that France is an example of a country that has taken a more market-driven approach from the start. France did not only focus on protection of its local tax base. It seems that France started in 2003 by focusing on the key elements that would ensure that the French SIIC regime became a commercial and international success (ie, also attractive to foreign investors).
The French industry lobby and the French Ministry of Finance have developed a relatively simple and transparent REIT regime (compared with its neighbouring countries). The result of this is that the French quoted property market has grown substantially and fundamentals have improved considerably (a more dynamic market with bigger professional players).
The very positive ‘side effect' for the French government is a very substantial amount of ‘exit tax' paid by corporate taxpayers in connection with either their conversion into a SIIC, or the transfer of property portfolios to a SIIC. As a result of the distribution obligation, a steady flow of revenue inflow will continue into the ministry's coffers. On balance, the courage of the French authorities to implement a flexible regime will bring them more revenue than expected.
Only recently, France has used the first practical experiences with SIICs to combat perceived abuses. These are provisions for shareholder restrictions and a penalty tax which might slow down the international development of the SIIC regime.
However, the French system remains relatively simple and modern (compared, for example, with the UK and German systems) and will give the French REITs a competitive advantage over their European colleagues for years to come - the proof being that French SIICs are currently playing an important role in European cross-border acquisitions and mergers.
(1)Currently there is co-operation between a number of industry bodies including the European Property Federation (EPF) and RICS, among others, to investigate the benefits of an EU-REIT structure