The introduction of the UK Real Estate Investment Trusts ("REIT") regime on 1 January 2007 has changed the UK's property industry landscape. The first REITs are the product of existing funds that have converted and, having made the transition, are now getting back to the ordinary business of managing their portfolios. This, of course, includes the disposal of properties or property-owning companies. It is thought that some of the new REITs may have deliberately held back on making disposals prior to their conversion so as to secure the benefit of an uplift in base cost in return for payment of a mere 2% REIT entry charge. They can, therefore, be expected to be reasonably active in this area for the immediate future. We are currently advising two potential purchasers, who are negotiating the purchase of the shares of property rich companies from REITs, of the additional tax issues they need to consider and protections they should request in this special situation.
As a very brief reminder, the REIT offers tax exemption on income and gains from investment property subject to qualifying conditions including as to the type of business carried on, the use of a UK resident vehicle and the listing of its shares on a recognised stock exchange.
At present, with only a small number of listed companies being converted to REIT status, it should be a straightforward matter to identify a REIT vendor but, as time passes and the number of REITs increase, this may require specific confirmation in the due diligence process. If a vendor is within the REIT regime, the potential purchaser should raise additional queries, including whether the property-rich company is wholly within the tax-exempt regime or whether all, or part, of its business falls outside the tax-exempt regime (and is treated as a business taxable in the normal manner).
Properties within a tax-exempt business
One major advantage of bringing a company, or group of companies, within the REIT regime, is that the chargeable gain base cost of properties held within the tax-exempt business at the time of entry is increased to the market value of the property at that time. This would be particularly attractive for a company with a low base cost in a property, and hence an inherent chargeable gain, without the benefits of the REIT regime. Although an entry charge must be paid, it is currently set at just 2% of the market value of the relevant property. Each company in a group REIT is responsible for paying its relevant entry fee which can be paid in instalments. A potential purchaser should therefore quantify how the market value (and hence the entry fee) was calculated, whether the entry fee (or part) is still outstanding and, to the extent the entry fee is still to be paid, how this will be dealt with when agreeing the price paid for the company. Specific warranties addressing these points should also be requested.
Similarly, it is also important to note that although the base cost uplift is not affected even if the company has left the REIT (for example on its sale to a non-REIT entity), the uplift is cancelled if the property is sold out of the company within two years of the company leaving the REIT regime where the company was in the REIT regime for less than ten years. This is an important point, particularly where the company holds a portfolio of properties, some of which the purchaser plans to sell within two years of acquiring the company. In this case the company could become liable for a much larger tax bill than was anticipated when the entity was purchased. Further information relating to the tax affairs of the company pre-entry into the REIT regime should also be reviewed, to enable full consideration of the impact of any future property sale to be assessed.
Selling a company out of a group REIT is one obvious way to trigger that company leaving the REIT regime. However, failure by the group REIT as a whole to comply with the necessary conditions can, in extreme circumstances, lead to the REIT regime ceasing to apply to the group as a whole from the end of the last accounting period before the breach took place. If a major breach was committed in the year in which the group initially entered the regime, this could effectively mean that the group had never actually been within the regime at all and, hence, there was never an uplift in base cost of the properties. This perhaps unlikely situation should be addressed by specific indemnities from the vendor group.
A purchaser should also seek the "usual" tax warranties and a tax indemnity that it would require on the purchase of shares of a non-REIT special purpose property-owning company. These will cover the tax treatment of the company before it gained REIT status as well as protect the purchaser as usual for taxes which are not exempt within the regime, such as VAT and SDLT.
Non-tax exempt company
Where a group REIT contains a non-tax exempt company, loss of the group's REIT status does not affect it. Such companies do not benefit from the uplift in base cost on entry of the group into the REIT regime and equally pay no REIT entry charge. However, it is still prudent for a purchaser to seek protection from the REIT vendor regarding the status of non tax-exempt group members. Warranties and tax indemnities should also be sought in a similar manner as if the company was not part of a group REIT.
Conclusion
It is important, from an early stage, to know if you are purchasing a property-owning company from a REIT. This is particularly the case as the tax treatment of the company may impact on the proposed purchase, future plans, and the protection that should be sought in relation to the transaction. REITs are not vendors to avoid, but they are vendors that require particular consideration and specific due diligence.