When Chancellor Gordon Brown set about removing advance corporation tax credits in the last Budget, he didn’t realise that one of its effects would be to bring aid and succour to property speculators. At the same time, he also threw something of a spanner into the emerging debate about creating a “tax transparent” investment vehicle for property.
The removal of the tax credits created a mild typhoon in the press about the impact on pension funds. But little if any of the press comment focused on how the loss of tax credits would affect the behaviour of institutional investors. In fact, one impact is a perceptible shift in institutional investors’ willingness to put funds into property – after years when they shied away from bricks and mortar in favour of securities.
Part of the problem has always been that it is relatively simple to invest directly in property – by buying a specific building, for example – in a tax-efficient way. What was more difficult was to put money indirectly into property using a tax-efficient investment vehicle. The figures in the panel show the impact both before and after the Budget of a tax-exempt investor, such as a pension fund, investing indirectly in UK property through, say, a property investment company.
Before the Budget the property investment company would have paid corporation tax at 33% on profits before remitting dividends to shareholders. Corporation tax was partially off-set by a tax credit, but the investor still suffered from a “tax leakage” of 16.75%.
The Budget changed that position by decreasing the rate of corporation tax to 31% but removing the reclaimable tax credit. The net result is that the tax leakage on this kind of indirect property investment has leapt to 31% – or whatever rate of corporation tax pertains at the time.
So why should this be good news for property speculators? The answer is that the removal of reclaimable tax credits puts indirect investors in both property and securities on an even footing. There is now no tax advantage in investing in an indirect securities vehicle, such as an open-ended investment company (OEIC), over an indirect property investment.
Both now operate on a level playing field. Hence, the drift back to commercial property investment.
Yet this still leaves some unfinished business. Should there be a tax-efficient vehicle for investing in property? In other words, does it make any kind of sense to have one kind of tax regime for investors who put their money into individual properties and a less attractive regime for investors who want to spread their risk through an indirect investment vehicle?
And this issue is not just about tax. It is about creating more liquidity in property investment in the UK, which ought to be good both for the property business and the investors. So what are the issues and arguments.
The case has been put most cogently by Peter Kempster, a property finance partner at Nabarro Nathanson. He believes there ought to be a vehicle for indirect property investment which is “tax transparent”. This means that the tax code ensures gains and dividends are taxed as they are passed on to individual investors according to each investor’s own tax status.
Alternatively, Kempster sees the vehicle being taxed itself, but appropriate tax credits being passed on to individual investors so that the investors do not suffer from tax leakage.
The current position for investors wanting to put money into indirect property investment in a tax-efficient way is complex. Property investment companies, as we have seen, now incur a 31% tax leakage. Although investment trusts can hold property, at least 70% of their income must come from shares, securities or “eligible rental income” – for example, rents from Housing Investment Trusts.
Unauthorised property unit trusts, which currently hold around #4bn of property investments, provide a complex but tax-efficient method of investing in property. But unit holders must be UK-authorised pension schemes or UK-registered charities. The method of reclaiming tax is byzantine in its complexity. And the restrictions on eligible owners restricts the tradeability of the units.
Pension fund pooling vehicles were introduced by the previous government in 1996 as a form of unauthorised unit trust which can invest in property as well as securities and cash. But, as a general widely-tradeable indirect property investment vehicle, restrictions on ownership also make these a non-starter.
Finally, authorised property unit trusts may invest in property but there are a number of restrictions which make them less than ideal as a generally-tradeable vehicle. For example, 20% of assets must be held as a “liquid reserve” – in cash or shares rather than property. A maximum of 15% of assets may be in one property or 20% of income from one tenant. However, authorised property unit trusts may now be listed on the London Stock Exchange.
As Kempster says: “What is really needed is some mechanism whereby smaller investors in the pension funds and so on can invest together in property. We really need a vehicle that does not have such a restrictive ownership.”
The property business has not been slow to lobby the new government. The Investment Property Forum, a think-tank representing institutional property investments, has lobbied Treasury ministers and also the Department of Trade and Industry. And there are other murmurings about doing something about the issue. Last year, the Securities and Investment Board published a consultation paper about extending OEICs to real estate.
Kempster believes that a model for a British (and, possibly, ultimately a European indirect property investment vehicle) may be the real estate investment trusts (REITs) that operate in the US.
“The US REIT industry is large, specialised and sophisticated,” he says.
Critically, REITs are tax transparent but they must be widely-held to avoid small groups of investors turning them into private clubs. Similarly, they must distribute at least 95% of their income.
“The key point is that REITs are traded in sufficient volume to make them a liquid investment,” says Kempster. “We don’t have that in the UK.” More liquidity could be good news for investors – and also turn the wistful smile now appearing on property speculators faces into a broad grin.
But will Gordon Brown buy the idea? Evidence from the first Budget suggests that his approach to corporate taxation may be discreetly tough. For the time being, property investors should not build their hopes too high.
Peter Bartram is a freelance journalist.