A move towards European REITs?

Real Estate Investment Trusts (REITs) have long been a feature of the US real estate market. European countries have for the most part been less interested in creating listed tax transparent and therefore more liquid investment opportunities for those in the real estate sector.

France

2003 did however see the introduction in France of the Société d’Investissements Immobiliers Coteés (SIIC) Many French-listed property companies have opted for SIIC status, as have foreign investors such as Rodamco and Hammerson. SIICs looked to promote both French and foreign investment into real estate by introducing a number of innovations including an exemption from corporate tax on rental income and on capital gains.To qualify for such treatment, the SIIC must distribute to shareholders 85 per cent of the tax-exempt income and 50 per cent of the capital gain respectively.

Transformation into a SIIC does come at a price in that there is corporate tax (albeit at the reduced rate of 16.5 per cent rather than 35 per cent) on the difference between the market value of the assets conforming part of the SIIC and their fiscal value, calculated at the time the election is made to become a SIIC.

Not finished with the SIIC innovation, the French government has included provisions in the Finance Bill for 2005, further provisions, widely referred to as “SIIC 2” that will make the regime more attractive. First, the tax neutral regime that applies to mergers between corporate taxpayers is planned to be extended to mergers of one SIIC and another and a SIIC and a non-SIIC entity. Secondly the requirement that a SIIC or its subsidiaries have ownership rights to a building are to be expanded to qualify SIICs that hold property under finance leases. Thirdly there is a proposal that for a limited period (1 January 2005 through 31 December 2007) the reduced corporate tax rate of 16.5 per cent will apply not only to contributions of property into SIICs but also on contributions of property into publicly traded companies that have the same purpose as a SIIC. At the time of writing these further innovations are still in the legislative process but at least the first two are likely to come into force.

Luxembourg

The Luxembourg Fonds Commun de Placement (FCP) has become the vehicle of choice for many looking for a regulated but non-listed fund structure, particularly for Pan-European investments. Making it a priority to remain a jurisdiction of choice for fund sponsors and also for investors, Luxembourg has during 2004 introduced a new vehicle the Société d’Investissement en Capital à Risque (SICAR).

The SICAR will be subject to less regulation. There are for example no gearing restrictions. A SICAR will also be subject to minimal tax in Luxembourg. Investment income and most realised gains will not be taxable. Management charges will not be subject to VAT. There is a withholding tax exemption on distributions and redemptions by non-resident investors, whatever the level of the holding or the period for which it has been held. There is also an exemption from the net wealth tax.

A SICAR will be limited to investments made up in part of private equity and focused on assets with a risk profile similar to that typical for venture capital. The CSSF, Luxembourg’s regulatory body will also ensure that investors in a SICAR are institutional, professional or knowledgeable of the risks associated with the investments being made. The requirement that investments be of a “risk bearing” nature means, given the definition of that concept, that a SICAR will not be able to invest directly into property or indirectly passively hold it in most circumstances. Property development through a subsidiary will however be possible where it involves underlying risk. The risk profile of other types of activity has yet to be clarified.

UK

Particularly in view of the innovations seen in continental Europe over recent years, the British government has been under pressure from the property industry to develop a UK REIT. In March 2004 it launched its long and eagerly awaited consultation paper “Promoting More Flexible Investment In Property” raising the possibility of a UK REIT vehicle, tentatively named a Property Investment Fund (PIF). Giving less indication of the probable nature of the PIF than the industry had hoped for, the consultation paper raised a number of questions. These include whether a PIF should be closed or open ended, whether capital gains should be distributed to investors, whether PIFs could undertake development, what sort of borrowing limits should be imposed and what should the level of stamp duty and entry tax be for a PIF.

Investors waiting for the formation of a UK REIT vehicle will have to wait sometime longer for real progress

The consultation closed in July 2004 with expectations from the property industry that firm proposals would be shortly then be forthcoming. It appears however that investors waiting for the formation of a UK REIT vehicle will have to wait sometime longer for real progress. The Chancellor of the Exchequer’s Pre-Budget Report of 2 December 2004 states that the Government continues to believe that tax reform in this area has the potential to improve the efficiency of the UK property market. The Government has however confirmed that it does not plan to legislate in 2005 and that its next step will be no more than the issue of a further discussion paper with a summary of the 2004 consultation exercise results before the March 2005 Budget is presented. This is to form the basis for a further dialogue with property industry representatives. It is clear therefore that the UK does not yet intend to follow the example of the French and other European governments at least for the time being.

Germany

For much of 2004 the spotlight has been on the German Open-End Funds, their performance and transparency. Here it is voluntary rather than legal change that is the current focus of the German Open-End Funds. Four of the largest CGI, Degi, Deka and Difa have recently announced that they will each publish details of the market values of and the rents and yields from their portfolios.

It does however appear that additional legal reform and the creation of a new investment vehicle is a possibility for 2005. The German Finance Minister, Hans Eichel, has declared his wish to make a decision on REIT reform in Germany during January 2005. The Initiative Finanzstandort Deutschland (IFD) an advisory group containing government officials has been promoting the idea of a tax transparent REIT type model, to be known if adopted as the Immoinvest. There is speculation that the creation of such a vehicle will encourage many German corporates to transfer their property into such a vehicle. This in turn could bring the German government a windfall in transfer tax. At the time of writing, the IFD’s report has yet to be issued but this is certainly a potential development to watch as 2005 unfolds.

Other Legal Change to Promote Investment

With many European governments focused on improving the efficiency of their property markets, 2004 has been a year of positive change in many. The following are some selected examples.

Italy

Italy has for some years been attractive to international real estate investors. From a legal and tax perspective, temporary provisions enabling companies to revalue their property to more realistic market values upon merger and pay tax only on the value prior to the revaluation have been an important feature of 2004, although this is only permissible through December 2004. Italy has however implemented extensive tax reform during 2004 as at the beginning of the year a wide range of measures enacted with a view to bringing the Italian tax system more in line with the most advanced tax systems of other EU members came into force.

Many of the changes apply to all industry sectors and the property market will benefit along with others. An example of this is the reduction of corporate income tax rates. These were reduced from 35 per cent to 34 per cent in 2004 and will reduce further to 33 per cent in 2005.

Sweden

January 1, 2004 saw the introduction in Sweden of a law allowing the creation of property units that can be defined both horizontally and vertically. Already a number of buildings have been considered by the Lantmäterimyndighet (Surveyor’s Office) as fulfilling the criteria for three dimensional division.This innovation is no mere academic change. Mixed-use buildings can now be divided into separate titles thereby making each specific area potentially more attractive to an investor looking for exposure in a particular use sector. Indeed one of the criteria for division is that it is intended to lead to better administration of a building or to secure financing for it.

The real estate markets of the Czech Republic, Hungary and Poland have proven popular with investors during the last 10 years

Central Europe

The real estate markets of the Czech Republic, Hungary and Poland have proven popular with investors during the last 10 years. Commentators are predicting increased interest in these markets in 2005. This is in part connected with EU entry in 2004. This Legal and Taxation Issues 25 Investors waiting for the formation of a UK REIT vehicle will have to wait sometime longer for real progress required significant changes in the legal and tax regimes of all new entrant countries. Some of these changes have had a positive impact on real estate investments in these countries.

Each has for example had to implement the EU Parent/Subsidiary Directive. This has removed withholding taxes on dividends from local entities to their EU parent companies provided that the parent company has held at least 25 per cent of the shares in the subsidiary for at least 2 years. Corporate income tax rates have also been lowered -in Czech Republic from 31 per cent to 28 per cent in 2004, to 26 per cent in 2005 and to 24 per cent in 2006 and in Poland from 27 per cent to 19 per cent.

Not all the positive changes made will have immediate effect however. Some of the remaining restrictions on the acquisition of land directly by foreigners have been lifted but with long transition periods. EU citizens in the Czech Republic with residency permits can for example now purchase land although the direct ownership of agricultural and forest land will still not be permitted for a further 7 years. Restrictions have been similarly lifted in Poland but there the transitional period for agricultural and forest land will run for another 11 years.

Russia and Ukraine

For those with an appetite for investment in some of the developing markets in Europe, there are countries such as Russia and Ukraine to consider. Other than those corporations developing and acquiring property for their own needs, investors so far have not surprisingly comprised for the most part the more opportunistic. Both countries have in the last five years undertaken comprehensive land reform and have taken steps towards increasing the availability of land and building ownership.

Russia has already been of interest to real estate investors for some years. A number of funds have been active primarily in Moscow and St. Petersburg making investments in a range of sectors including: residential, office, retail and logistics. Although relatively few in number, these investors have enjoyed rates of return that were estimated in the spring of 2004 to be 13-14 per cent. Most of these investors have however been funds incorporated in jurisdictions other than Russia for although the mechanism exist to create Russian incorporated funds, they are not as flexible or user friendly, certainly for foreign investors, as funds set up in more familiar jurisdictions such as the Channel Islands.

Reforms of the administrative support system for real estate transactions have however been put into place during 2004 which should over time assist in simplifying the conveyancing process. Of more immediate impact however should be the change in the calculation of notarial fees for mortgages. Russian law requires that in order to be valid, every mortgage must be first notarised and then State registered. Until earlier this year, fees for the notarisation of a mortgage were 1.5 per cent of the value of the mortgaged property.This made secured lending an expensive option for a borrower particularly on large developments. Now notarial fees are capped at a rouble amount that ceases to create an issue in transactions. This should help to encourage debt financing in the real estate sector and will further assist all investors looking to leverage their investments.

Notwithstanding recent political events in Ukraine, a number of funds have been established to take advantage of perceived yields and to invest based on the land reform carried out over recent years. Most recently Ukraine has strengthened occupier confidence by introducing a regime for lease registration. It is hoped that this will be one factor contributing to increased confidence in the real estate sector.

Conclusion

2004 has seen further progress towards the creation and development of tax efficient real estate investment vehicles in Europe and a number of governments have, through legal and tax changes, improved the regime for investors in real estate in their countries.

The need for further reform and change and its detail varies from country to country. None can afford to ignore the importance of its real estate market and the advantages of increased efficiency. The indications are already there that 2005 is likely to bring further and exciting change.

Biography

Adrian Moore is an international partner in the Moscow office of the Baker & McKenzie law firm. Mr Moore is a law graduate of Oxford University. He is an English solicitor admitted to practice in England and Wales, and specialises in the fields of real estate and construction. He heads the Baker & McKenzie CIS Real Estate and Construction Practice. In 1998, Mr. Moore was recognised as the only attorney listed for Russia in the European Legal Group Guide to the World’s Leading Real Estate Lawyers, and in 2000 was one of the only three lawyers so honoured.