Schedule 34 — Real Estate Investment Trusts

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Photo of David Gauke David Gauke Shadow Minister (Treasury) 6:00 pm, 8th July 2009

I beg to move amendment 17, in page 289, line 23, at end insert—

'Stock dividends

3A (1) Section 107 (conditions for tax-exempt business) is amended as follows.

(2) In subsection (8) omit "(a) by way of dividend, and (b)".

(3) After subsection (8) insert—

"(8A) In this Part and for the purposes of section 973 of ITA 2007, a distribution of the profits of the property rental business shall include—

(a) an amount distributed by way of dividend, and

(b) an issue of shares to which section 249 (1)(a) of ICTA applies and in case a falling within (b). the amount of the distribution shall be the cash equivalent of share capital determined in accordance with section 412 of ITTOIA 2005, but otherwise Chapter 5 of Part 4 of ITTOIA 2005 shall not apply.".

3B (1) Paragraph 6 of Schedule 17 is amended as follows.

(2) In paragraph 6 (4), delete "by way of dividend and (c)".

(3) After paragraph 6 (4) insert—

"(4A) In the application of section 107 (8A) for 'profits' substitute 'UK profits' as defined in paragraph 6 (4).".

(4) Section 142 (1) of TCGA 1992 is amended by inserting "or section 107(8A) (b) 2006" after the reference to "ITTOIA 2005".'.

Photo of Michael Lord Michael Lord Deputy Speaker (Second Deputy Chairman of Ways and Means)

With this it will be convenient to discuss the following: Amendment 18, in page 289, line 23, at end insert—

'Conditions for tax-exempt business

3A (1) Section 107 (conditions for tax-exempt business) is amended as follows—

(2) In subsection (8)(b) after "before", insert "the third anniversary of ".

(3) The amendment made by sub-paragraph (2) has effect for distributions in respect of accounting periods beginning on or after 1 January 2008 and ending on or before 31 March 2010.

3B (1) Schedule 17 is amended as follows.

(2) In paragraph 6 (4) after "before", insert "the third anniversary of".

(3) The amendment made by sub-paragraph (2) has effect for distributions in respect of accounting periods beginning on or after 1 January 2008 and ending on or before 31 March 2010.'.

Government amendment 47.

Amendment 15, in page 290, line 24, at end insert—

'Profit: financing-cost ratio

5A (3) Section 115 (4) is amended as follows.

(4) In subsection 115 (4) (a) after "costs giving rise to", insert "credits or".

(5) In subsection 115 (4) at end insert "but exclude—

(f) financing costs falling within (a) to (e) above which are exceptional due to their size or incidence.".'.

Amendment 16, in page 290, line 29, at end insert—

'Termination by notice: Commissioners

6A (1) Section 129 is amended as follows.

(2) In section 129 (2) (c) at end insert "but a breach of the condition in section 107 (8) where the company is in financial difficulties shall not be treated as serious".

(3) The amendment made by sub-paragraph (2) is to be treated as always having had effect.'.

Photo of David Gauke David Gauke Shadow Minister (Treasury)

This group of amendments relates to real estate investment trusts, or REITs, which were introduced with effect from 1 January 2007. Their introduction was, in part, a response to Kate Barker's review of housing supply and the need to promote greater efficiency and flexibility in the UK property investment market. Two and a half years after their introduction, it is possible to make some evaluation of the effectiveness of the new REIT regime. It is clear that large property groups have obtained REIT status, but there have been no new REITs, and in particular none covering residential property. It would be fair to say that the economic climate has not been ideal for the creation of new REITs, but there is clearly a debate to be had on whether the fact that REITs covering residential property have not come into effect is down to the economic problems or defects in the tax system.

Since we debated the matter in Committee, the House of Lords Select Committee on Economic Affairs has commented, in its report on the Finance Bill, that REITs

"have failed to live up to expectations" .

Paragraph 245 of that report states:

"It is difficult to conclude that this partial failure is wholly due to the economic circumstances and not also in part to structural defects in the system. Moreover there has been little attempt to respond flexibly or significantly in their design to the difficult economic context."

The group of amendments that we are considering is an attempt to encourage the Government to respond flexibly and significantly. Indeed, the Government have made some progress on that front. In Committee, I raised possible ways of providing some flexibility in design, based on proposals made by the British Property Federation. Since that date, the House of Lords Select Committee has recommended that the Government

"look again with greater sympathy at the proposals by the representative bodies."

To assist, we have today tabled four amendments, which, as I say, are based on the British Property Federation proposals. We are pleased to see that in one case the Government have followed suit, at least partially, and tabled an amendment seeking to address one of the concerns that we identified.

Broadly, we seek in our amendments to address two issues. The first issue relates to the current requirement that REITs distribute 90 per cent. or more of property income, because in the current economic circumstances it is very helpful if companies can retain cash. Credit is clearly difficult to access, and companies need to build up balance sheets—in particular, to keep banks lending to them. If and when the property market picks up, a REIT with sufficient cash might be able to make several acquisitions.

Amendment 17 seeks to address the issue of a mandatory distribution of 90 per cent., which has to be done in one year, by deferring it for four years. It would be only a temporary measure, and any profits arising in accounting periods ending after 31 March 2010 would be subject to the current distribution rules, but it would provide REITs with flexibility.

Amendment 18 would provide for distributions to be paid by new shares rather than by cash, and there should not be a revenue implication: shareholders receiving a stock dividend, which is a distribution for these purposes, would be automatically subject to tax, as they would be with a normal property income distribution in cash. We therefore press the Government to look sympathetically at the amendment.

Amendment 16 is a less radical proposal, but it addresses the same area and would retain the 90 per cent. test. Any breach of it would not result in the risk of expulsion from the REIT regime, as that would be expensive for the REIT, but would involve corporation tax being paid on the undistributed profits. The argument that the Government tend to make against all such proposals is that there is an issue of investor protection, but when institutions are looking for investors to invest in a REIT, there is strong commercial pressure to make use of such provisions only when necessary. It is a commercial judgment that, one might strongly argue, could be left to the REITs rather than to the regulations, so we would be grateful for the Government's response to those points.

The second issue relates to the profit-financing cost ratio. Property income distributions are subject to a withholding tax of 20 per cent., unless the recipient is a UK charity, pension fund or corporate. Payments of interest by a REIT, however, may not be subject to withholding tax, and there is therefore the clear possibility of a REIT distributing income through interest payments as an avoidance measure. The profit-financing cost ratio is an attempt to address that. It is an anti-avoidance provision aimed at preventing REIT investors from structuring their investment as a loan.

Broadly, the PFCR rule provides that the amount of a REIT's tax-exempt profits must be at least 1.25 times the size of the financing costs that are related to the REIT's tax-exempt business. There are, however, a couple of problems with that. First, a REIT might hedge market value movements in a debt with a derivative contract. The PFCR rule does not take into account any profit on debt, but it does take into account a matching loss on the derivative. The loss is counted as a financing cost so the REIT might breach the ratio as a consequence of market movements.

Secondly, the aggregate of all movements in a derivative contract is deferred until closing out occurs, and that could lead to a distortion of the ratio in one particular year. Amendment 15 seeks to address those specific problems.

As I mentioned earlier, Government amendment 47 addresses the issue of the profit-financing cost ratio by allowing HMRC to waive rules in particular circumstances—when a REIT is in severe financial difficulties, the circumstances arose unexpectedly and the company could not reasonably have taken avoidance action. I have communicated with the British Property Federation, which welcomes movement on the issue but is concerned that the particular circumstances that I have mentioned are somewhat restrictive, difficult to interpret and vague.

As a consequence, Government amendment 47 may not be effective enough in addressing what both sides of the House agree is a potential problem. I would welcome comments from the Minister on that, because we think that amendment 15 would provide REITs with greater certainty and clarity and address the specific problems raised by the British Property Federation, rather than having the apparently broader flexibility involved in HMRC's waiving the ratio, although in restricted circumstances that would be difficult for the REIT to understand. The Minister may well be able to provide guidance and clarity on the issue; as it stands, however, we are not sure that Government amendment 47 is as successful as amendment 15.

Photo of Ian Pearson Ian Pearson Economic Secretary, HM Treasury 6:30 pm, 8th July 2009

We believe that Government amendment 47 will be effective, and I shall explain why in a moment. As the hon. Gentleman will know, the British Property Federation and others have welcomed the amendment, which has arisen as a result of continued discussion with the industry in the post-Budget period. It makes a further change to the regime to ensure that its rules on financing costs achieve their original objectives without creating any unintended effects.

Government amendment 47 will allow the charge to tax to be waived when the commissioners of Her Majesty's Revenue and Customs think that a company is in severe financial difficulties and that it could not reasonably have avoided breaching the profit-financing cost ratio owing to unexpected circumstances. That ensures that the tax charge can be waived if a REIT that has not borrowed excessively breaches the profit-financing cost ratio because of a fall in its profits and/or an increase in its financing costs that have led it into severe financial difficulties.

The amendment does not seek to define "severe financial difficulties". However, in case extra clarity should be needed, it provides HMRC with a power that may be used to specify in regulations criteria to be applied by commissioners in determining whether to waive the charge. The hon. Gentleman will be aware that currently there are 21 companies in the REITs regime. We believe that that number is manageable. However, if "severe financial difficulties" needs to be defined, the powers are there. We believe, however, that the phrase is pretty broadly understood.

Opposition amendment 15 would relax the requirements of the profit-financing cost ratio by bringing in credits in respect of debtor relationships and by excluding financing costs that are considered

"exceptional due to their size or incidence."

However, it is not clear to the Government why the size or incidence of a financing cost should be considered to make it exceptional and why that would make it an appropriate item to exclude from the profit-financing cost ratio. We also believe that the Government amendment, by seeking to protect the ratio while ensuring that it does not lead to any unintended consequences for companies in severe financial difficulties, is a more targeted and preferred measure.

Amendment 16 concerns the requirement of the REIT to distribute 90 per cent. of its profits from the property rental business to shareholders by way of a dividend. That helps to protect the investor and the Exchequer by ensuring that profits are distributed to shareholders who pay tax on them. The amendment seeks to ensure that if a company in financial difficulty fails to meet this distribution requirement it would not be treated as a "serious breach" of REITs rules. REITs legislation states that the consequences of multiple serious breaches of the rules are that REIT may be given notice by HMC to leave the regime. In the context of the distribution requirements, "serious" is not defined. However, if a company is in financial difficulties there is scope under the legislation for that to be taken into account in deciding whether to issue a termination notice. We therefore believe that there is no need for the amendment.

Amendment 17 also relates to the 90 per cent. distribution requirement. Its purpose would be to allow a REIT to issue stock, instead of cash, in order to meet the 90 per cent. requirement. Allowing a REIT to issue stock, rather than cash, as part of this requirement could risk harming the investor, particularly if stock is issued to shareholders on a mandatory basis. A mandatory issue of stock as part of the distribution requirement would reduce the size of the cash dividend received by each shareholder without increasing the value of their shareholding. There would also be a risk of imposing a tax charge on shareholders that could not be covered by the cash part of the distribution. If stock is issued on an optional basis, those electing to receive cash could still see their shareholding diluted by those electing to receive stock. However, I understand the point that the hon. Gentleman makes, and I can say in response that officials will continue to meet those in the industry to discuss this issue.

Amendment 18 is intended to provide REITs with an extra three years to distribute the profits from their property rental business. We cannot accept the amendment because we believe that allowing REITs an extra three years to make these distributions would harm the Exchequer and investors, many of whom have invested in REITs because of the expectation that they will receive frequent distributions.

Government amendment 47 takes a targeted approach, and it has been welcomed by the property industry. We cannot accept the Opposition amendments, but we will continue to keep the regime under review and remain in dialogue with the industry on these issues.

Photo of David Gauke David Gauke Shadow Minister (Treasury)

I am grateful to the Minister for his comments about continuing to look at the stock dividend issue. I am still not entirely convinced by his view that his amendment is better than ours, but we should be grateful that we at least have an amendment. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Amendment made: 47, page 290, line 24, at end insert—

'Profit: financing-cost ratio

5A (1) In section 115 (profit: financing-cost ratio), after subsection (3) insert—

"(3A) The Commissioners for Her Majesty's Revenue and Customs may waive a charge in respect of an accounting period where they think that—

(a) the company was in severe financial difficulties at a time in the accounting period,

(b) the result of the sum specified in subsection (2) is less than 1.25 in respect of the accounting period because of circumstances that arose unexpectedly, and

(c) in those circumstances, the company could not reasonably have taken action to avoid the result being less than 1.25.

(3B) The regulations may specify criteria to be applied by the Commissioners in determining whether to waive a charge."

(2) The Commissioners may waive a charge in respect of accounting periods ending before the day on which this Act is passed.'.— (Ian Pearson.)