REITs to Be Introduced from 2007

Introduction

Following a preparatory draft of September 26 2006, the Ministry of Finance has presented its long-awaited draft bill on the introduction of real estate investment trusts (REITs). The introduction of REITs in order to secure Germany's competitive position on the international property and finance markets was the subject of considerable prior discussion. In view of this, the coalition parties expressly included REITs as a new asset class in their coalition agreement.

In addition to securing Germany's status as a financial centre, the introduction of REITs offers an opportunity to promote the development of domestic property markets, which are currently benefiting from favourable interest rates. The proportion of German commercial property owned by occupiers amounts to around 73% - almost three times the comparable US figure. Even compared to the United Kingdom, a direct competitor in terms of the almost simultaneous introduction of REITs, the difference in ownership levels still amounts to about 20%.

REITs offer German companies an opportunity to market their property portfolios by realizing hidden reserves while qualifying for tax relief. REITs also allow the public sector to transfer property investments to private ownership. As a result, both institutional and private investors can gain access to otherwise idle property portfolios by acquiring shares in a listed public limited company. The object of such capital investment is the property itself, which represents a stable asset. For tax purposes, this is equivalent to making a direct investment in property, whereby the tax-exempt status envisaged for REITs offers a particular benefit. Compared with a direct investment, a REIT's portfolio structure makes it possible to reduce the risk considerably.

The parliamentary legislative process has just started but already involves a substantial number of requests for modification, in particular from the Bundesrat (the upper house of Parliament) with its first statement of December 15 2006. Therefore, amendments, deletions and additions are to be expected. Nevertheless, this draft raises expectations of a productive legislative process, which is by no means usual in the case of tax legislation.

Requirements

Based on the so-called 'REIT Framework Act', the draft bill creates a new law which includes the key parameters for structuring REITs. The act contains special regulations for REITs in addition to the general provisions of the Companies Act and the Commercial Code, which are still applicable in all other respects. It also describes the basis of and requirements for the tax privileges accorded to REITs. The favourable tax treatment for REITs also involves amendments and additions to numerous tax law provisions, especially the Income Tax Act and the Corporation Tax Act.

In the view of the Ministry of Finance, the REIT Framework Act should come into effect retroactively on January 1 2007. If Parliament is able to meet this ambitious target, REITs could be introduced in Germany at the same time as in the United Kingdom.

Basic parameters

The basic parameters for REITs are outlined in the following table.

Legal form

The legal form of a listed public limited company is mandatory for a REIT. The company must specifically include 'REIT' in its name and be entered as such in the Commercial Register. At the same time, the name 'REIT' is to be protected. The minimum share capital of any REIT may not fall below €15 million. A REIT must have its statutory registered office and main place of business in Germany. In this respect, tax-optimized structures based on double tax treaties must be ruled out. Relocation to another European country while retaining the relevant tax benefits is not permitted.

This means that the Ministry of Finance has decided against allowing non-listed REITs, a decision that must be welcomed in view of the enhanced tradability of share certificates. However, the high costs of obtaining stock exchange listing and the necessary market promotion present a hurdle that should not be underestimated.

Organization

According to the draft bill, no investor in a REIT may hold more than 10% of the share capital. Furthermore, over 15% of the shares (calculated as a percentage of the share capital) must be permanently free floating (25% at the time of listing). Shares belonging to investors that hold less than a 3% share in a REIT are classed as free floating. For the purpose of calculating this threshold, the provisions under the Securities Trading Act regarding the addition of direct and indirect shareholdings apply.

Each REIT is responsible for complying with this minimum free-float ratio. To enable REITs to control adherence to these limits, the draft includes a supplement to the disclosure requirements pursuant to the Securities Trading Act. Each year, REITs must provide the Financial Services Supervisory Authority with evidence of compliance with the minimum free-float ratio. Failure to do so over a period of three years will result in the loss of tax-exempt status.

Conversely, compliance with the maximum shareholding in a REIT is the responsibility of each investor. In the event that a shareholder holds more than 10% of the share capital in a REIT, it retains its dividend entitlement and voting rights. However, it may not exercise any rights beyond those to which it would be entitled if it held less than 10%. This has no direct implications for the REIT itself, particularly in terms of tax exemption.

The draft bill appears to indicate that the 10% investment ceiling is limited to direct investments. It must therefore be assumed that an investor may exceed this limit if indirect holdings are included. Consequently, voting rights attributed for the purposes of the Securities Trading Act are irrelevant in ascertaining the investment ceiling.

A REIT may borrow funds amounting to no more than 60% of the company's assets. Loans must be raised at prevailing market conditions. It is therefore possible for REITs to optimize profits based on the leverage effect offered by partial debt financing.

Based on the draft bill, the object of a REIT is limited to:

• acquiring and holding titles or rights in rem to domestic or foreign property, excluding properties erected before January 1 2007 with a residential use of more than 50% (known as 'inventory residential properties');
• managing the same on a rental, leasehold or leasing basis, including any necessary ancillary activities, and disposing thereof; and
• acquiring, holding, managing and disposing of shares in property companies.

To meet this requirement, no less than 75% of the assets held by a REIT must consist of property. There are no restrictions on investing in property abroad. Therefore, it is possible to determine the property ratio and distribute investments across various locations at the company's discretion. Moreover, REITs may hold indirect interests via private property companies also. Additionally, shares of property corporations may be acquired in jurisdictions outside Germany. 'Property' comprises land, titles equivalent to land and similar rights under the laws of other countries. REITs can therefore acquire land situated in Germany, either directly or indirectly, by purchasing hereditary building rights.

REITs may also restructure their property portfolios, with 'prohibited property trading' representing the limit for such activity. This occurs if, within a five-year period, a REIT receives gross revenue from disposals which exceed one-half of its average property portfolio . This calculation must include disposals involving assets held by the REIT's subsidiaries. Prohibited property trading ultimately leads to the loss of tax privileges. This nevertheless constitutes a very generous provision, especially in view of the extremely narrow parameters for trade-tax exemption in the property management sector. It is hoped that this generous regulation will survive the legislative process.

REITs are entitled to allocate up to half of the sales proceeds generated in this way to reserves. Within a period of two years, such reserves can be transferred without any impact on profits by offsetting them against the purchase and manufacturing costs accruing from reinvestment.

Income requirements

Based on the draft bill, REITs are obliged to derive at least 75% of their gross income from the property rental, leasehold or leasing business, or from the disposal of property. Sales proceeds are to be classed as privileged gross income for the purpose of the 75% limit.

In addition, REITs are allowed to provide property-related services for third parties. Unlike activities relating to their own investment portfolio, services for third-party investment portfolios may be provided only via 'REIT service companies'. These are limited companies which must be structured as wholly owned subsidiaries of a REIT. Income from property-related services may not exceed 20% of the gross income generated by REITs.

Profit distribution and accounting

The income tax exemption granted to REITs is linked to a mandatory distribution requirement stipulating that at least 90% of distributable profits must be distributed to the shareholders. Profits are ascertained in accordance with a slightly modified version of the principles set out in the Commercial Code (individual company accounts), in that only straight-line deductions for depreciation may be applied when determining the distributable profits of a REIT. In this regard, the Ministry of Finance has decided against application of International Financial Reporting Standards (IFRS) to determine profits. However, the bill does make special allowance for a profit distribution over and above the actual profit stated in the balance sheet. As a result, amounts deducted for depreciation may also be distributed to shareholders on the condition that no provision for the retention of cash flow deriving from depreciation is included in the company's articles of association. This technique ultimately creates an opportunity for REITs to distribute their entire operating cash flow to shareholders. Since it is also possible to distribute the cash flow accruing from depreciation, the distribution possibilities are almost identical to those available to closed-end property funds.

However, the disadvantage does remain that the assessment of distribution is based exclusively on the concept of profit as defined under company law, which means that the restrictive provisions of the Commercial Code (the purchase-cost principle, prudence principle and realization principle) must be observed. Realizing profits by disclosing hidden reserves, as would be possible if IFRS were applied, is not permissible for the purpose of distribution assessments. Yet in the case of asset and income ratios, the draft bases its requirements not on individual company accounts according to commercial law, but on consolidated financial statements according to IFRS. This ultimately means that REITs are obliged to prepare consolidated financial statements in line with IFRS, as well as individual company accounts based on commercial law.

REITs are entitled to allocate up to half of their disposal gains to reserves. If this option is utilized, the profits available for distribution are reduced accordingly, (ie, by the amount of the disposal gains allocated to reserves or transferred to reinvestments).

Tax Treatment

Income tax

REITs non-taxable

From the date on which a REIT is listed on the stock exchange and entered as a REIT in the Commercial Register, it is exempt from paying either corporation tax or trade tax. Apart from the requirements outlined above, full tax exemption from income taxes is linked to no additional conditions. The trade tax exemption that normally applies to property management activities (in the form of a greater reduction) and the related requirements for this exemption do not apply in the case of REITs and are therefore irrelevant. Tax exemption ceases to apply in case of:

• loss of stock exchange listing;
• prohibited property trading;
• failure to maintain the free-float ratio over three consecutive years; and
• borrowing of more than 60% of the REIT's total assets over three consecutive years.

If, in an individual case, only one of the asset or income limit requirements is infringed, the tax authorities have the option to impose a fine on the REIT. Therefore, an infringement does not lead inevitably to cancellation of the tax exemption. Instead, the draft bill envisages a mechanism based on graduated penalties. Provision is even made for gradual withdrawal of the tax exemption. In this way, the tax authorities are accorded discretionary powers (the parameters are regarded as recommendations). As a general rule, tax exemption is not cancelled with retroactive effect, but becomes effective from the beginning of the financial year in which the relevant event occurs.

Taxation of shareholders

Income is to be taxed exclusively at shareholder level, subject to prevailing taxation practice. The tax implications are therefore effectively equivalent to a direct investment in property.

However, REITs are public limited companies, which means that only dividends are treated as capital gains as defined under Section 20(1)1 of the Income Tax Act and are therefore subject to income tax when received by shareholders. Standard dividend taxation (half-income method and tax exemption for limited companies based on Section 8b of the Corporation Tax Act) is ruled out in the case of profits distributed by REITs. In each case, the dividends paid are subject to full income tax when received by shareholders and full corporation tax when received by corporate entities.

General taxation practice also applies to sales transactions. In the case of private investors holding shares in REITs as personal assets, gains on disposals are not taxable unless they meet the requirements of Section 23 of the Income Tax Act (private sale). Section 17 of the Income Tax Act applies if the shareholding constitutes a major interest. As a result, shareholders may essentially receive gains on disposals tax free, subject to compliance with these limitations. If shares are held as assets by a company, any related gains on disposal are fully liable for income or corporation tax and do not qualify for special treatment in the event of any subsequent trade tax liability.

The usual provisions relating to dividend distributions and disposal gains - that is, the half-income method (Section 3(40) of the Income Tax Act), as well as tax exemption under the holding provision for limited companies (Section 8b of the Corporation Tax Act) - do not apply.

Transfer tax

In terms of transfer tax provisions, there are no special features to be noted when transferring property directly to a REIT or from a REIT to third parties. Such transfers are subject to land transfer tax. This does not apply if property portfolios in Germany are sold by way of acquisition or sale of shares in private companies. In line with general practice, the acquisition of less than 95% of the shares within a five-year period remains exempt from land transfer tax. In view of this, it is also possible to create a REIT as a trade-tax-exempt vehicle by virtue of a change of corporate form. Land transfer tax can also be avoided in this way.

Structuring Options

Formation alternatives

REITs can be formed either by founding a new enterprise or by converting an existing company. Unlimited partnerships and limited companies qualify for conversion in accordance with the Corporate Conversion Act.

Property contributions

In addition to disposing of property by way of an asset deal, the draft bill offers REITs a share-deal option. To this end, REITs may also purchase property by acquiring all or some of the shares in holding companies, whereby domestic and foreign property may be purchased via so-called 'private property companies'. These are private companies with a restricted field of activity similar to the requirements for REITs. In this context, German-based holding companies structured as limited partnerships are of particular practical relevance.

As purchasing property via private companies is illegal in some countries, the draft bill opens up another possibility for REITs. They may optionally acquire shares in 'foreign special-purpose entities', namely limited companies owning land situated abroad. According to the draft bill, limited companies of this kind must be wholly owned subsidiaries of a REIT. Restricting this option to ownership presumably eliminates indirect acquisition of so-called 'foreign leasehold interests' by a foreign special-purpose entity - at least in the case of rights equivalent to hereditary building rights.

As the acquisition of shares in domestic corporations is excluded, 'umbrella REITs' may not be formed.

Tax relief on disposal of investment property

Another special privilege envisaged by the draft bill is the tax relief accruing upon the transfer of investment property to a REIT, provided that it has been held for many years by a company as part of its asset portfolio. This has blanket application - it applies not only to property contributions, but also to normal property sales. Parliament plans to tax only one-half of the disposal gains, based on Section 3(70) of the Income Tax Act. However, this requires that, at the time of sale, the property have formed part of the fixed assets of a domestic company belonging to the taxable seller for more than 10 years. This 50% tax exemption applies only for a limited period to contracts concluded between January 1 2007 and December 31 2009.

In such instances, attention must be paid to the fact that REITs may not dispose of the relevant property within four years of the conclusion of the contract. Otherwise, the 50% tax exemption will cease to apply with retroactive effect.

Relief for residential property

Unlike the ministerial draft, the draft bill does not include the option to acquire inventory residential properties. Mixed-use properties with a partial residential use of less than 50% and residential property completed after December 31 2006 may be purchased. Such limitations equally apply to acquisitions of partnership interests or shares for investments in foreign property holding companies.

Outlook

The introduction of REITs will provide a significant boost for the property market. The tax advantages of essentially non-tradable property will be coupled with the ongoing tradability of listed shares. This will give rise to tangible tax savings for investors as distributed profits will be taxed once rather than twice. As a result, the entire property market will have greater opportunity to diversify property investments, and even entire property portfolios, and offer them on the market. Special benefits and incentives will present themselves to both closed-end property funds and public limited property companies.

It is hoped that Parliament will re-integrate inventory residential property in the range of approved investments and persist with the early introduction of REITs.

International Law Office