Growing international diversification and demand for more tailored investment solutions presents challenges to investors concerned with minimising the tax burden. John Forbes reports
Despite the impact on real estate markets of the liquidity crisis, real estate remains an attractive asset class for institutional investors. A briefing, ‘Transparency Versus Returns: the institutional investor view of alternative assets', which was published recently by PwC and the Economist Intelligence Unit, was based on a global on-line survey completed by 226 institutional investors and alternative investment providers worldwide, supplemented by face-to-face interviews with key respondents.
Of all the different asset classes within the alternatives sector, real estate had the highest number of institutions indicating an increase in their allocation, 41% of respondents, although somewhat paradoxically, real estate also had the highest number of institutions indicating a decrease in their allocation, 21%.
The increasing allocation to real estate as an asset class is not a new development. Weight of capital has been driving the markets for a number of years. This increasing allocation, and in particular the increasing proportion invested indirectly through real estate funds, has resulted in a burgeoning of different fund types. The managers of real estate funds who traditionally focused on the US for institutional investment have in recent years increasingly turned to European and more recently Asian institutions.
There has also been the interest in marketing real estate funds to high net worth individuals, either directly or through private banks. Ten years ago, funds investing cross-border were almost exclusively at the opportunistic end of the risk/return spectrum. In recent years we have seen the development of lower risk but lower return funds (core and core plus or value-added funds).
The range of options for investors wishing to gain investment exposure to real estate has also increased. The introduction of REIT-type vehicles in Europe has given investors the option to invest in a tax-efficient publicly traded property investment vehicle, either directly or through securities funds investing in REITs.
Varying degrees of liquidity have also become available through open-ended real estate funds. The flip side of liquidity is volatility as investors witnessed when share prices in quoted property companies tumbled across Europe last year, and also the issues facing the open-ended funds.
The range of target jurisdictions for investment has also expanded dramatically. In ‘Emerging Trends in Real Estate Europe', published jointly by PricewaterhouseCoopers and the Urban Land Institute, Moscow and Istanbul ranked top in Europe for risk adjusted returns. This is significant since the report is the largest survey of investor sentiment and measures the consensus view of nearly 500 respondents. It is also significant that investors rated the prospects for Asia as higher than for Europe. This globalisation of investment opportunities has resulted in the development of one-country and regional funds, but also global funds with very broad investment criteria.
One of the results of the expansion in the range of funds has been the development of a large variety of structures apparently on offer from the different fund sponsors. The increasingly diverse investor base has added to the difficulty in creating a fund vehicle that is attractive to the anticipated investor base from a taxation and regulatory perspective, and the sophistication of fund structures has increased significantly in response. The key problem faced by the investors is comparing and assessing the tax, legal and regulatory framework of these different options. The key problem for the fund manager is managing the structure once it has been set up.
As would be expected, according to the survey respondents in Transparency Versus Returns performance was, by a wide margin, the key criteria in selecting a service provider across the alternatives sector. However, when deselecting a service provider, performance (or lack of it) ranked equally with quality of compliance and risk management process, transparency and quality of reporting. While good performance can get you selected as a service provider, failings in other areas can lose you the mandate. Furthermore, institutional investors have been more tolerant of other weaknesses when returns have been strong. Their tolerance is weakening along with the returns. What is the relevance of this for fund structuring and tax?
Complexity adds to risk, and there is little doubt that fund structures have become more complex. As the range of investors expands, it is highly unusual to create a fund vehicle and structure that is equally attractive to all the expected investors and structuring at this level is usually a process of managing conflicting investor demands. Sophistication is often added by the use of parallel fund vehicles or feeder structures tailored to particular classes of investor.
A number of funds have taken this type of planning to a new level through the use of vehicles with separate cells for different classes of investors, with the cells providing a tailored tax and regulatory treatment for the investors in the cell.
Regulatory issues for investors, for example the ERISA rules that regulate investments by US pension funds and the VAG rules that impose restrictions on German insurance companies, can have a major impact on the structure selected from the fund vehicle right down to the asset level. As funds have become larger, managers have sought to attract a broader range of investors from a wider variety of jurisdictions. This has added to the impetus to create more tailored vehicles to provide the optimal tax treatment for investors.
Further complexity has been added by the development of real estate funds of funds, driven by an increasing range of assets in which they can invest. The growth in domestic real estate fund vehicles across Europe has created an opportunity for funds of funds to invest in local one-country funds. There has also been a growth in specialist property funds investing in a particular type of property asset, for example retail, logistics or hotels.
Tax-driven structuring below the fund also creates complexity. At the local country level, it is typical to own properties in separate single-asset companies (SPVs) that are funded to the maximum with related party debt. Having each asset in a separate entity provides the opportunity to exit by selling shares in the SPV rather than the underlying asset. These structures rely on double tax treaties to avoid taxation of gains on exit.
Double tax treaties generally give taxing rights in respect of real estate and immoveable property to the country where the property is located, whereas taxing rights in respect of shares, generally reside with the country where the owner is resident. There are exceptions to both of these rules, which need to be considered on a case-by-case basis.
A further benefit of structuring through share sales is to reduce transfer taxes. In many jurisdictions, lower rates of tax apply to share sales. Furthermore, tax is often due on net rather than gross values, although there are exceptions to this, such as Germany or Spain. Typically share sales are also not subject to value added tax. Using a holding company in the EU for making investments in SPVs within the EU also gives access to exemptions from withholding taxes under directives such as the Parent/Subsidiary Directive and the Interest and Royalty Directive.
Funding to the maximum with related party debt creates interest deductions to shelter profits from taxes on income, minimises capital duties by reducing the amount of equity funding in the entity and assists in minimising transfer taxes, again by reducing the amount of equity in the company. However, there are often thin capitalisation rules that restrict the amount of related debt, and transfer pricing rules that restrict the interest rate to an arm's length amount. In the past, these restrictions only applied to loans from non-resident lenders.
Within Europe, there have been significant changes to these rules, of which the most dramatic were the changes introduced in Germany in 2007. This is an area to which tax authorities generally are paying greater attention, so challenges are likely to become more common.
Using SPV structures in this way creates a number of areas of tax complexity. Structuring through SPVs significantly increases the number of entities in the structure, all of which need to have tax returns filed. Funds have run into issues when they have come to dispose of some of their special purpose companies whose returns are not fully up to date. Where a purchaser, when carrying out their due diligence, discovers, for example, that the companies in question have not submitted the prior year tax returns, then a number of issues can arise.
The purchaser may want a discount on the purchase price to reflect the risk element of the uncertain tax position, they may require warranties against the tax position, there could be a retention on the purchase price or, in the worst case, they could even pull out of the deal. Tax authorities are becoming more sophisticated and therefore greater challenges can be expected to more aggressive tax planning. It is also important to keep in mind that, when complex tax planning fails, it is not generally because the analysis of the law was incorrect, it is more often due to a failure of implementation and documentation.
To access the benefits of double tax treaties (and in the case of European investments, the EU parent/subsidiary directive), it is necessary to use a holding company in an appropriate jurisdiction. However, the tax authorities where the subsidiary is located typically require the parent company to have substance and not be a mere conduit. Entitlement to tax protection under double tax treaties and the EU Parent/Subsidiary Directive is fundamental to the tax efficiency of the structure.
The requirements for substance are determined by the tax rules in the country where the subsidiary is located. As such, it is determined by the countries in which investments are to be made. Germany is the most demanding in this respect, requiring both business substance, being a commercial rationale for the existence of the entity, and material substance, being the physical evidence of business operations such as an office, employees etc. It is also important that the holding company remains tax resident in the correct country, which typically means having board meetings there.
This adds to the cost and complexity, and creates an additional area of tax risk.
The structuring of the underlying investments has also become more complex as the range of target jurisdictions for investment has broadened. This is particularly true as funds expand their horizons into emerging markets in Europe, Asia and Latin America. As indicated above, when using a holding company in the EU for making investments in companies within the EU, the availability of tax exemptions under directives such as the Parent/Subsidiary Directive and the Interest and Royalty Directive gives a beneficial tax treatment not available when the investments are in countries outside the EU.
In emerging markets, tax legislation may be less developed and subject to more frequent change (albeit that, even in western Europe, particularly Germany, tax legislation has not been showing marked stability in the last few years). Interpretation of legislation in less developed markets can also be less predictable. In such situations, flexibility to allow structures to be changed if the goalposts move has a value as does simplicity. In the long term, this may be greater than the immediate tax benefit derived from a more complicated structure.
From the perspective of the investor, it is often difficult to decide which structure gives the best tax result. REITs are tax exempt vehicles and therefore do not suffer tax on their income and gains provided certain conditions are met. However, there is typically a withholding tax on distributions to overseas investors. Depending on the residence and tax status of the investor, the residence of the REIT and the percentage of the REIT held, the withholding tax may be reduced by a double tax treaty. The investor may be credited for the withholding tax against any tax suffered on receipt.
Further complexity is added if the REIT shares are held through a fund rather than directly. How does this compare with the tax efficiency of a fund investing directly in real estate? As discussed above, funds will typically hold assets through taxable local SPVs, but will minimise the tax through shareholder debt, and share disposals to avoid tax on gains on exit.
However, tax rules are changing to make it more difficult for funds to maintain the same level of tax efficiency. Furthermore, the most tax efficient result looking at the fund in isolation does not necessarily give the most tax efficient result in the hands of the investor, as illustrated by SPV sales above.
US investors have been major providers of capital to real estate funds, and it is therefore common to find funds with a mix of US taxable and tax exempt investors. With a typical structure for a fund, it would be possible to avoid tax on capital gains on exit by selling shares benefiting from the protection of a double tax treaty. However, the buyer in this case is inheriting the lower historical based cost so in effect the deferred tax liability is being passed on. The rational buyer will want a discount for a proportion of the liability (although in the overheated markets that prevailed until last year, many buyers were not rational).
For a US tax-exempt investor, any tax suffered in the fund is lost, so a discount for part of the tax is worth paying to avoid the larger actual tax liability on an asset sale. For a US taxable investor, the tax suffered on an asset sale may well be creditable against US tax suffered and therefore represents only a timing difference. Discounts for deferred tax represent an absolute cost. The two types of investor will therefore have a very different view of what is the ‘best' result.
Comparing the tax efficiency of different indirect investment options may be difficult for the investor. It is likely, however, to be more tax efficient than investing directly in property internationally unless the scale of investment is large enough to merit the institution adopting the same tax strategies as a fund. An institution adopting this approach is likely to have less experience in this area than a fund manager and is therefore exposing itself to either greater risk or higher costs from buying in the necessary expertise from a service provider. Both these need to be weighed against the potential tax efficiencies.
Although tax is only one factor that adds to the complexity of the way real estate investments are made internationally, it is an extremely important one. The benefits and risks need to be assessed when funds are set up and investments made. It is also important for the fund manager to consider how this complexity will be managed and how it will be explained to investors.
John Forbes is a partner at Pricewaterhouse Coopers in London and leads the firm's UK real estate practice
