Clause 65

Finance Bill – in a Public Bill Committee at 4:45 pm on 16th June 2009.

Alert me about debates like this

Real Estate Investment Trusts

Question proposed, That the clause stand part of the Bill.

Photo of Jimmy Hood Jimmy Hood Labour, Lanark and Hamilton East

With this it will be convenient to discuss the following: that schedule 34 be the Thirty-fourth schedule to the Bill.

Photo of David Gauke David Gauke Shadow Minister (Treasury)

It is a pleasure to serve under your chairmanship once again, Mr. Hood.

Clause 65 and schedule 34 deal with real estate investment trusts—REITs. Those of us who served on the Committee that considered the Bill that became the Finance Act 2006—I do not know how many here today had the that pleasure, other than myself and my hon. Friend the Member for Fareham—will recall the legislation that introduced REITs, which came into force in January 2007. REITs were introduced with the intention of allowing investors to make indirect liquid and diversified investments in real estate in a way that attracted a similar tax treatment to direct investment. REITs were important in that they avoided the double taxation experienced by investors in other listed property companies.

Schedule 34 contains provisions relating to the REIT regime, and I have one or two questions for the Minister. If I may, Mr. Hood, I shall take the opportunity to ask about certain aspects of the reform of the REITs regime not included in the schedule, although I appreciate that that issue will be considered in the other place and, indeed, we may return to the REITs regime on Report.

Under paragraphs 3 and 4 of the schedule, REITs can offer convertible, non-voting preference shares in addition to the current categories of permitted investments, such as ordinary share, non-voting preference shares and convertible loan stock. It might help if the Minister were to explain the reasons for that extension.

The Government announced last year that they would stop property-rich groups such as operators of hotels, pubs and retail businesses restructuring and converting to REITs. I understand why the Government did that, but it is clear that the Government are not using schedule 34 to prevent conversion of landlords that let property to pubs, rather than operate them as tied houses. Rent from pubs is to be treated as rental income and not trading income. We have no objection to that liberalisation, but it would be helpful if the Minister explained what representations were made for the change, how many businesses the Government believe will be affected, and why the change has been made, given their steps to prevent property-rich groups from restructuring and converting to REITs.

My main point is an issue on which the Government have received representations—the requirement for REITS to distribute at least 90 per cent. of their property income annually—and I know that the British Property Federation raised it. Given the current state of the economy, the housing market and the real estate market more widely, and at a time when credit is not easily available through banks, is it good stewardship to distribute 90 per cent. or more of property income annually, as REITS are required to do? Property companies need cash at the moment, first to strengthen their balance sheets, and secondly because, in the event of an upturn in the property market, which may or may not be imminent—I do not want to speculate—REITs will want to buy new properties and retaining cash would be helpful to them. In addition, the rental market is weakening,  cash flows are under pressure, and REITs may need to build up cash reserves to persuade lenders of their ability to sustain borrowings.

In such circumstances, the Government could take steps, which they have not taken in schedule 34, to provide greater flexibility in the REIT regime. The British Property Federation has suggested three ways in which that could be done. First, distributions paid by a firm could be paid in the form of new shares—stock dividends—and they could count towards the mandatory distribution requirement. Secondly, the mandatory distribution could be deferred by, for example, three years from one year to four years. That would provide REITS with some current flexibility. Thirdly, and perhaps less radical, because breach of the 90 per cent. requirement results in a tax charge and the risk of expulsion from the regime—that is not automatic, but a REIT would be vulnerable—perhaps it would be possible, as a short term measure, to consider whether breach of the 90 per cent. requirement could simply result in a tax charge without the risk of expulsion from the regime. The Government have received representations on that, and perhaps the Minister will help by giving the reason for not going down that route. We will consider returning to the matter on Report.

I want to raise a second technical point about REITs—the anti-avoidance provisions relating to interest payments. Property income distributions may be liable to a withholding tax, depending on the recipient, but interest payments tend not to be liable to tax. For that reason, which is a perfectly good one, the PFCR—profit financing cost ratio—rule, which is an anti-avoidance provision, prevents REITS from restructuring their arrangements in such a way that distributions are made through interest. We fully understand the need for that, but two points have been raised by the BPF in the context of how that rule may act in a way that was not intended.

First, a REIT might hedge market value movements in debt with a derivative contract. There are perfectly good commercial reasons for doing so: so that a profit or loss involved in repaying debt is matched by a loss or profit in a derivative contract. However, the PFCR does not take account of any profit on debt, but does take account of matching loss on the derivative. Consequently, the loss is counted as a financing cost which may be considerable and cause the REIT to be in breach of the PFCR.

The second circumstance in which the same thing may happen is when market value movements in the debt and the derivatives used to hedge the debt are deferred—the costs involved are deferred until the debt or derivative is repaid or closed out. That can have a distorting effect because all the cost then occurs in one year. It could be that over a period of time a derivative is entered into but the cost all crystallises in one year, which may have a distorting effect in that year. The effect of such distortion is that the REIT may have a penalty charge as a consequence of entering into perfectly sensible hedging arrangements, or of market values moving in a particular way.

I would be grateful to know whether the Government have looked at the definition of financing costs and whether they would consider amending it to address those issues. I appreciate that the Minister has not had notice of all those points, but any light that he can shed on them would be of benefit to the Committee.

A more general question is about the Government’s strategic vision for REITs. When they were introduced, there were great hopes that they would take off as a product. That they have not is not to do with failures in the original drafting of the REIT legislation, which schedule 34 seeks to address. These nagging concerns are perfectly reasonable, but there is a concern that the Government are simply not addressing the REITs regime, that it is sitting on the back burner and has not received the focus that it might have.

REITs have clearly worked in encouraging conversion of existing listed commercial property companies. That has happened, but REITs have not attracted new entrants, as was once hoped would happen. I appreciate that this is a difficult time for the property market, but it is also an opportunity. For example, perhaps the best way of addressing banks’ holdings of unwanted exposure to properties and of finding equity investment would be to create REITs. Indeed, there is some evidence that in the period following a recession, which hopefully we will be in shortly, the equivalent of REITs in countries such as France and Japan tended to prosper. I ask whether we are prepared for that, and whether the Government are showing sufficient flexibility in respect of the REIT regime to benefit from what may be a considerable opportunity.

A point that has been made whenever we have debated REITs, certainly in 2006 and subsequently in various orders where we have amended the regime, is that there is a great opportunity for them to become significant players in the private residential rented sector, and that they could provide professional management that is not always available otherwise. There is an opportunity for greater liquidity for people who want to invest in the private rented market rather than go down the buy-to-let route, particularly given that the reputation of buy to let may well have taken significant damage in recent months. There is an opportunity there for REITs, but it may be necessary to take a more proactive view of the regime.

That is not a criticism of the original regime. However, organisations such as the British Property Federation feel that more could be done to ensure that we have an active and thriving REIT sector in the UK.

Photo of Stewart Hosie Stewart Hosie Shadow Chief Whip (Commons), Shadow Spokesperson (Treasury) 5:00 pm, 16th June 2009

The hon. Member for South-West Hertfordshire reminds us of 2006 when the REIT regime was introduced. He will also remember the very strict criteria for the creation of the real estate investment trust. There was a residential criterion, a minimum profit distribution criterion and a criterion that the REIT had to have a full stock exchange listing. The trust could not be a company traded on the alternative investment market or the off-exchange market, and it could not be a private company.

New section 136A(3)(a) states that the regulations may

“treat a specified person, or a person in specified circumstances, as forming part of a REIT group”.

New section 136A(3)(b) states that the regulations may

“provide for a specified provision which applies in respect of members of a REIT group also to apply” to others. I want to ask the Minister whether those others, who have been deemed to form part of a REIT group, would also be obliged to follow the same conditions  that have been set up for a REIT proper? I am talking about the size of the company, the stock exchange listing, and so on and so forth. I just want to understand for myself how someone can be deemed to be a REIT or part of a REIT if they do not meet the other conditions that were set out in 2006.

Let me go a little wider and ask the Minister the same question that the hon. Gentleman just asked about the strategic vision for REITs. It was clear at the time, I think, that because there was a requirement for REITs to have a full listing on the stock exchange, they would tend to buy high-yield residential and commercial property and there was less incentive, or almost no incentive, for the small-scale investment trusts to build in the for-profit sector rented accommodation in local areas, which is something that I was very keen to see. I know that the Minister at the time said that that was an issue that would be kept under review.

Will the Minister tell us whether there is an intention to remove some of the restrictions, particularly the full stock exchange listing criterion, to allow smaller entrants into the REIT field? The reason for that would be to provide the core profit for housing in the private rented sector which is so desperately needed. Moreover, it will be very helpful if he can answer my specific question on paragraph 7 on connected persons so I can understand how someone connected to a REIT can be defined as part of a REIT group if they do not meet the original criteria.

Photo of Stephen Timms Stephen Timms Financial Secretary (HM Treasury) (also in the Department for Business, Innovation and Skills)

The origins of the UK real estate investment trust model go back to Kate Barker’s review of the housing market, which recommended that there was merit in considering a vehicle that was based on the US REIT model. Such a model has been introduced elsewhere, as the hon. Member for South-West Hertfordshire rightly mentioned, to encourage increased institutional investment in housing. We implemented that proposal and extended its scope to include commercial property. The main objectives of the model, which was launched at the beginning of 2007, was to promote greater efficiency in property investment and to provide smaller-scale investors with access to commercial property returns.

We have seen that the model works well. Some 21 companies so far have announced that they have become UK REITs, including most of the big listed UK property companies. The scheme is still less than three years old, and we expect other companies to join in the future, as investors become more confident in the UK REIT market.

Effectively, the regime removes the tax distortion between investing in property directly and investing in property indirectly by exempting both income and gains made on property from corporation tax provided that the company or the group meets some specified conditions.

We announced in the pre-Budget report that the Bill would amend the conditions to be met by a company or group in the UK real estate investment trust regime to ensure that those conditions could not be circumvented by the artificial creation of new group structures. The conditions include the requirement that at least 75 per cent. of total profits must come from the rental of property to tenants. We confirmed our intention to legislate in the Budget.

Schedule 34, which is introduced by clause 65, amends part 4 of the Finance Act 2006 to introduce a power for the Treasury to make regulations concerning the use of artificial structures to circumvent the existing UK REITs legislation. The regulations, which are available in draft form alongside the clause, are to be made by the affirmative procedure. Regulations to exclude owner-occupied properties from the REITs regime have also been made using existing powers under schedule 6 to the 2006 Act.

Schedule 34 also amends the 2006 Act so that section 98 of the Income and Corporation Taxes Act 1988 is disqualified for companies or groups of companies seeking to join the REITs regime. That will allow a business with tied premises—a pub business, for example—to treat the rental income from those premises as part of the property rental business of a REIT. Tied premises are those where a company supplies goods to a third party for sale on a premise that the company rents to the third party. Before the amendment, such income would not have been treated as rental income. That created an arbitrary barrier to the REITs regime, which schedule 34 removes.

In addition, following discussions with the industry, schedule 34 makes minor amendments to UK REITs legislation that will have effect on and after 22 April 2009. They address some of the points raised by the British Property Federation, although there are other points that it wishes to promote, a number of which have been mentioned by the hon. Member for South-West Hertfordshire. The minor amendments allow UK REITs to issue an additional type of share; provide a consistent definition of asset; clarify how apportionment of funds between the tax-exempt and non-tax-exempt part of the business should operate; and ensure that the regime’s requirements do not create unnecessary barriers to entry.

The hon. Gentleman asked about the extension to convertible preference shares. The extension allows REITs to use such shares where they previously could not, and is made in response to a consultation with the industry. On the general question whether we can do more to help REITs, it is certainly true that UK REITs, along with other parts of the economy, are struggling in the current economic climate. We have announced a wide range of policies to support businesses through what is a difficult period for them and, indeed, for households. The measures will provide help to all parts of the UK economy, and I expect UK REITs to benefit as well. I am less certain that there is a need for very targeted help for UK REITs beyond what we have done to support businesses in general, but we are very happy to listen to representations that people may wish to make to us.

Photo of David Gauke David Gauke Shadow Minister (Treasury) 5:15 pm, 16th June 2009

One of the BPF’s proposals that I have outlined may involve the deferral of tax revenue, but the other two are likely to be fiscally neutral. Indeed, one of them may raise some revenue. The Government may therefore be able to address the issue without a cost, so I urge the Minister to look at the matter very closely.

Photo of Stephen Timms Stephen Timms Financial Secretary (HM Treasury) (also in the Department for Business, Innovation and Skills)

We will certainly be happy to look at those representations. No amendments have been tabled, but we will, of course, look at proposals.

The hon. Gentleman also asked why we had not relaxed the profit financing cost ratio restriction. The restriction on gearing helps to ensure that profits are  available to be distributed in the first place, which helps to protect both the Exchequer and the investor, but we will continue to talk to the BPF on the detail of the profit financing cost ratio. He made the point that stock dividends do not cost anything and asked whether there had not, therefore, been an opportunity for the Government to act. Allowing REITs to issue stock dividends as part of their mandatory income distribution could harm some investors. For instance, any investor who elected to receive cash would see their percentage stake in the company reduced by those electing to receive stock. There is a debate to be had on that proposition.

Photo of David Gauke David Gauke Shadow Minister (Treasury)

I acknowledge the Financial Secretary’s point, but does he not accept that REITs will have their own incentives to keep investors happy and that the management of a REIT would be careful about pursuing a route that could cause them disadvantage with an investor, because of commercial pressures if nothing else? I acknowledge his concern, but that flexibility would probably not result in the management of a REIT acting recklessly, as far as the interests of investors are concerned.

Photo of Stephen Timms Stephen Timms Financial Secretary (HM Treasury) (also in the Department for Business, Innovation and Skills)

I take the hon. Gentleman’s point. My point was simply that there are issues to be weighed when considering a change of that kind, and the effect on investors is one of them. It is not necessarily a showstopper, but it needs to be taken into account.

The hon. Gentleman asked why the Government had not allowed deferral of part of the distribution requirement. It is important to note that each of the conditions of the regime is in place for good reasons. The requirement to distribute 90 per cent. of the profits from the property rental business within 12 months of the end of each accounting period helps to ensure that profits are distributed to shareholders who then pay tax on them, and it also helps to ensure that the investor gets a good deal.

We touched on the use of REITs for residential property investment, but there are difficulties with that in the current economic environment. Doing much about that problem would require significant changes to the regime, and we could then run into some EU state aid difficulties, which is another factor to be borne in mind.

Photo of Stewart Hosie Stewart Hosie Shadow Chief Whip (Commons), Shadow Spokesperson (Treasury)

All of the criteria for being a real estate investment trust, such as the profit distribution and the residential qualification, are met, so what EU state aid barrier could there be that would be different for residential property than exists for commercial REITs?

Photo of Stephen Timms Stephen Timms Financial Secretary (HM Treasury) (also in the Department for Business, Innovation and Skills)

The current difficulty is the cost of setting up a REIT for investment in residential property. The model currently works fine for commercial REITs, but there is a cost problem for setting up a REIT for residential investment, and changing that so that is was more attractive for residential investment could lead us into difficulties with EU state aid. The barrier is a cost barrier, but fixing it could cause problems with state aid. Certainly, there would have to be some work to address that.

The hon. Member for Dundee, East asked whether other connected persons would be obliged to follow the REITs conditions. We want the connected person to be part of the existing REIT, rather than a separate REIT, so they would not need to meet all the conditions of the regime. The purpose of that legislation is to prevent a group artificially meeting the requirements of the regime by bringing into the REIT any part of the group that has been artificially removed. I hope that that is helpful and commend the clause and schedule to the Committee.

Question put and agreed to.

Clause 65 accordingly ordered to stand part of the Bill.

Schedule 34 agreed to.