Clause 65

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

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Photo of David Gauke David Gauke Shadow Minister (Treasury) 4:45 pm, 16th June 2009

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.