The Finance Bill 2009 - Economic Affairs Committee Contents


Memorandum by the Royal Institution of Chartered Surveyors (RICS)

  RICS (Royal Institution of Chartered Surveyors) is the mark of property professionalism worldwide. It covers all aspects of property, construction and associated environmental issues. RICS has 86,000 chartered members (FRICS and MRICS) and 55,000 members in other categories of membership (TechRICS, trainees and students) globally. It represents, regulates and promotes the work of these property professionals throughout 146 countries. RICS is governed by a Royal Charter approved by Parliament which requires it to act in the public interest. It is also a professional regulatory body approved by Government (HM Treasury).

Overview of the REITs Regime

  In December 2007 the Property Industry Alliance of which RICS is a member, published an analysis of the impact of REITs. This document argued that the launch of REITs in the UK represented a very positive step forward for the UK property industry, which will bring long term benefits to the UK.

  Market conditions will have reduced the potential impact that REITs could have had on the commercial property industry. It would be considered by many that REITs were introduced at the top of the market cycle and the commercial property market has continued to decline since then. These conditions have meant that share prices of REITs will almost certainly have fallen and it seems unfair to judge the success of the legislation against this background.

  To help ensure the success of REITs they must continue to evolve and grow. The Government must work with the property industry to ensure that all companies that would be appropriate to become REITs are able to do so. Legislation will need to change to ensure that smaller companies are able to take advantage of the REIT mechanism. There is also the area of residential REITs which should help the creation of a dedicated build to let sector and boost overall housing supply.

Finance Bill Issues

  The 2009 Budget made some positive but largely technical changes to UK REITs without taking significant action to increase the use of REITs within either the commercial or residential property sectors.

Anti avoidance measures

  The key change was the introduction of anti-avoidance provisions which will prevent restructuring within groups enabling companies to meet the conditions to join the REIT regime. These provisions are a welcome improvement and mean that owner occupied properties are excluded from the tax exempt business of the REIT.

  This anti-avoidance measure targets groups which are essentially trading groups that structure in a way that HMRC regards as artificial to satisfy the REIT conditions on a strict technical reading, rather than property investment groups. As such this seems to be a positive step which will ensure REITs are legitimate property investment vehicles rather than companies that own property, such as hotels or supermarkets, looking for a tax advantage.

  Although requiring businesses to be fundamentally based in property investment, the changes are unlikely to increase significantly the number of REITs.

  Convertible preference shares

  Measures in the Finance Bill will allow a REIT to raise funds by issuing convertible preference shares. This is a welcome measure which was intended to be included within the original REIT structure. It will allow REITs to raise funds by offering convertible preference shares in addition to the non-voting fixed rate preference shares which are currently allowed. This is a positive step that will make it easier for REITs to operate effectively.

  Other changes

  Several other minor changes have been made to the operation of REITs which RICS believe will help the system function effectively:

    — An accounting based definition for all REITs (applicable to groups and single companies) will be used to define "asset" when applying the "balance of business test".

    — Where a REIT disposes of a property used in the property rental business the funds from the disposal that are awaiting reinvestment can be treated, for up to 24 months, as an asset of the property rental business for the balance of business test.

    — Measures have been introduced to clarify the apportionment to be applied where the asset has been partly used for the purposes of the property rental business and partly for non-rental purposes.

REITS and the Credit Crunch

  As well as suffering in the same way as other companies during the credit crunch and the economic downturn, there will be a particular set of issues that affect REITs. RICS believe that the Government should be helping ensure the stability of the REIT market in the current climate and at the very least maintain it at its current size.

  Stock dividends

  Under the current rules, UK REITs are required to distribute 90% of their taxable income to shareholders in the form of cash payments. Other countries with a REIT regime, such as the USA, have taken steps to assist REITs during the current economic difficulties. In the US similar rules have been changed to allow REITs to make part of this distribution in the form of shares. The UK Government should change REITs legislation to allow the option of allowing stock to count towards the 90% distribution.

  Deferral of distribution

  The 90% distribution of taxable income currently has to take place within 12 months of the end of a REIT's accounting period. RICS believe that this period should be extended to help REITs which may be facing cash flow difficulties as a result of current economic conditions. A more sensible period may be 24 months rather than 12 months, giving much needed assistance to the sector.

  Financing costs ratio and the interest cover test

  Under the current regulations governing the financing costs ratio a REIT's gross profit (before financing costs and capital allowances) must be at least 1.25 times the interest payable on any debt. This interest cover test has caused particular problems in the current economic conditions where there have been difficulties accessing credit and banks have changed lending arrangements. In particular there have been difficulties with banks changing swap rates which has added extra costs.

  At a time where profits are likely to be falling due to a declining market more REITs will run the risk of breaching the financing costs ratio. This will lead to action by HMRC and although the company will be able to stay in the REIT regime, they will have to pay tax that they would otherwise not be liable for. This simply adds an extra cost to companies that are already in difficulty and the Government should consider amending regulations to increase the ratio.

Further Action needed on REITs

  There was no change in the Budget to the flexibility of the system or real action to increase the use of REITs in either commercial or residential property. There are a number of steps the Government should consider taking if they are committed to increasing the use of REITs as a form of property investment in the UK.

  AIM listing

  Under the current arrangements property companies have to be listed on a recognised stock exchange before they can become a REIT. This means that companies listed on the Alternative Investment Market are not currently eligible for conversion. Allowing this would increase the pool of companies which could potentially be REITs as listing on the AIM is cheaper and more suitable for small companies. This would be particularly important if REITs are going to be used in the residential sector. The Government should also consider allowing unlisted REITs, and the possibility of owner occupier REITs in areas where this could provide greater levels of investment—for instance hotels.

  Using REITs to encourage institutional investment and a build to let sector

  Changes should be made to the REIT regime to encourage their use in residential investment. The Government's response to the Barker Review of Housing Supply in 2005 stated that the REIT regime being implemented at the time in the UK would: encourage increased institutional and professional investment to support the growth of new housing.[1] Despite this desire from the Government there are currently no residential REITs in the UK.

  The need to attract extra investment was also highlighted by the recent Rugg Review into the private rented sector. In their response to this review, the Government states that more work is needed on creating the right environment for institutional investment in new supply for specifically built to rent properties. Alongside changes to stamp duty and the planning system, REITS have an essential role to play in this process.

  Reforms must be made to the REIT regime in order to encourage increased levels of investment. One of the barriers to the establishment of residential REITs is that in most cases the yield is to small for a company to operate effectively under the current REIT structure. To address this issue changes should be made to the gearing restriction to accommodate lower yields from residential property.

  Any residential REIT would be more reliant on income from sales of properties than a commercial property REIT. As a result the gearing restriction which is imposed by the 1.25 interest cover test is harder to satisfy then with commercial property. This happens because the profits section of the interest cover test only includes income profits and not capital gains from property sales. There are three potential ways to achieve this:

    — Allow residential REITs to include capital sale proceeds in the interest cover test.

    — Provide a lower interest cover limit for residential REITs.

    — Use a loan to value restriction rather than income restrictions.

  RICS has been working as part of the Property Industry Alliance (PIA) to encourage the Government to reform UK REITs. Further action to encourage the entry of residential property investment companies into the REIT regime should include changes which:

    — Reduce the cost of entry, including the 2% entry charge and listing costs.

    — Remove the requirement for all REITs to be listed on a recognised stock exchange.

    — Introduce some form of tax relief or deferral for those selling property to a REIT in exchange for shares in the REIT.

  As well as encouraging entry into the system, changes must be made to the REIT system to accommodate the business model of residential investment companies. Reforms must be made to:

    — Allow profits arising from portfolio "churn" to be treated as tax-exempt income of the REIT (provided properties are on average held for a sufficient period accepted as indicative of property investment activity);

    — Allow residential REITs a notional capital allowance deduction for the purposes of computing the profits of which 90% is required to be distributed each period, in recognition of the fact that capital allowances, which make the distribution requirement easier to meet for commercial REITs, are not generally available in the residential context.

May 2009



1   Recommendation 30, P80 http://www.hm-treasury.gov.uk/media/B/E/prb05_barker_553.pdf Back


 
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