Real Estate Investment Trusts or REITs is a well known internationally known appropriate business structure yet South Africa only adopted its tax law as of April 1st, 2013 and its stock exchange listed or publicly listed trading rules to accommodate REIT’s as of May 1st, 2013.
Since then many property groups not only converted to a listed REIT but also restructured their balance sheets to remove the debt linked to a unit or a share. Now, on September 6th, the first American Depositry Receipt (ADR) status was granted to a South African listed REIT. One ADR unit equals 10 REIT units on the Johannesburg Stock Exchange. Despite the ZA Rand being at a 3 week high, the more recent currency exchange is circa R10=1U$D.
Real Estate Investment Trusts (REIT)
REIT’s are tax transparent or tax through flow investment vehicles that invest in and derive their income from real estate properties and mortgage, without necessarily paying tax on their trade result. To qualify for the South African REIT dispensation, a the REIT (either a company or a trust) must be tax resident in South Africa and be listed as an REIT in terms of the JSE (Johannesburg Stock Exchange) listing requirements.
REIT profits are distributed as tax deductible expenses (effectively pre-tax income) which is then received and taxed in the investors’ hands as taxable dividend income. As of 1 January 2014 the SA dividend withholding tax at 15% or the treaty governed rate where the investor is resident in a treaty country, will apply to nonresident investors.
Albeit that the REIT is a SA tax resident company and JSE listed, it may also raise funds abroad, as tradable units, as explained later.
Tax and other benefits associated with a REIT
Treasury, as the official arm of the SA government regulating local REIT industry, has accepted the international best practise allowing SA REIT’s to be subject flow-through taxation, greater liquidity and capital flexibility allowing for higher pre-tax yields to be earned by the discerning local and international investor.
• Investors with a long term investment horizon deems normal or naked property investments as a complicated asset class, illiquid and inflexible asset class. With so many factors, including management and tenant risk issues to consider when investing in properties, well regulated REIT’s are seen as an simple and easier tax efficient diversifier which can be now be held as part of a balanced portfolio where long-term growth is sought, yet both liquidity and minimum income streams are prerequisites. JSE rules requires that 75% of gross income reduced by operating expenses but before deducting qualifying distributions, to be declared as the annual cash distribution to unit or shareholders;
• SA REIT’s tend to follow international best practise and is thus well known by the international investors, allowing fund managers to raise capital wither within or outside South Africa. JSE listed REIT’s are subject to both JSE and REIT regulations;
• Being a tax neutral entity or tax transparent REIT’s achieve tax efficiency as tax is payable in the hands of the end investor (i.e. REIT are normally tax free) and subject to the tax rate of the investor;
• REIT distributions are not considered interest, and is effectively distributed as taxable dividend, which is exempt REIT distributions from dividend withholding taxes i.e. South African tax resident investors receives the gross taxable dividend. Effectively the after tax income is determined by the investor’s tax profile and not by the corporate nature or tax profile of the dividend payer, as in the case of listed shares;
• Being JSE listed allows regulated industries restricted to publicly traded shares, to invest in a higher and more secure BEFORE tax income stream REIT’s, whereas normal shares return after tax income streams subject to board of director’s interpretation of excess cash available. Tax free entities such as NGO’s (aka as PBO’s in SA tax law) may prefer before tax income streams as they enjoy favourable tax exemption status;
• Older taxpayers enjoying higher annual tax threshold exemptions will be able to benefit from their own, normally lower effective tax rate, whereas listed shares return income after substantially higher tax rates where applied;
• Investors are able to gain exposure to immovable property with a smaller initial outlay, and without facing the illiquidity associated with this investment class as the REIT’s share are liquid or tradable i.e. more liquid than its underlying property portfolio;
• REIT’s provide the opportunity to invest in a diverse portfolio of expertly managed by well-known property or property fund managers;
• Investors looking to gain exposure to the property market without large initial outlays can invest smaller amounts thus access the property market from an earlier stage
• REIT’s trade like regular shares, albeit that linked unit structures allowing for loans linked to shares are allowed, the unit or share can be traded through a JSE registered stockbroker. The interest paid on the debt element of a linked unit, is re-classified as a taxable dividend i.e. no annual interest exclusion will be available to investors and no non-resident interest withholding taxes will be applicable yet as of 2014 the taxable dividend will be subject to dividend withholding subject to treaty limitations;
• Most property funds are now delinking debt and equity, preferring to capitalise debt into units or equity as distributions to units, enjoy the same tax deduction benefit as was the case in for interest bearing debt in the previous regimes;
• Where debt is delinked from the unit, the base cost for capital gains tax (CGT) purposes will be equal to the price paid for the linked unit;
• The internationally recognised South African REIT structure allows property loan stock (PLS) companies and property unit trusts (PUT) to now trade and operate under a single regulatory umbrella, as a listed REIT, being either a company or a trusts;
• SA law currently provides that REITs primarily represent the JSE listed property investment class assets. REIT law and regulation also allows for controlled “property” companies in relation to REIT.
o The controlled companies are essentially subsidiaries of a REIT and the word property was recently removed by 2013 tax law, allowing for controlled companies and not only tax law defined property companies where immovable property contributes more than 80% of the net asset value. The 75% of rental income remains to be a tax law requirement. Rental income includes amounts received from the use of immovable property including penalty interest, dividends from other REITs or controlled companies (both local and foreign subsidiaries) but EXCLUDES asset management, deal and underwriting fees, interest income, dividends and distributions from non-REIT companies and the proceeds (capital and dividends) from minority stakes (less than 10%) in other property investment companies;
o For purposes of determining its own taxable income, a REIT and its underlying controlled company in relation to said REIT, may deduct from gross income any amounts which represent a qualifying distribution, which need not necessarily be payable in the same tax year; yet
o Neither the REIT (nor controlled company in relation to a REIT) may not create an assessed loss in deducting distribution, which exceeds taxable income before the deduction of qualifying distributions;
• A REIT (or controlled company in relation to a REIT) is exempt from CGT (capital gains tax) in respect of the disposal of its immovable property, shares in another REIT or shares in a controlled company, however the REIT may also not claim capital allowances (depreciation) on the cost of the immovable property it holds. Where capital allowances were claimed under previous regimes, the allowances will be recouped and probably taxed at 28% within the REIT as the equivalent amount of cash can’t always be distributed in the same tax year, which could increase the effective tax rate to +50% for individual investors in the subsequent or year of actual distributions of the proceeds on the sale of a property. Most investors will probably not be aware of this tax inefficiency yet tax written off properties held before a REIT status is obtained should be carefully considered by the old regime fund managers;
• The unit holder in the REIT will only pay CGT when the REIT share is sold and unlike unit trusts, the capital again of the underlying fund is not taxed as a flow-through to unit holder as CGT event in the same tax year it was ignored by the underlying fund;
• Albeit JSE listed and SA tax resident, a REIT can be tradable abroad, normally through an ADR (American Depository Receipt) programme. Only one SA REIT has achieved this, yet another tow will be registering ADR’s in the new future.
o The Redefine Group now has over the counter ADR status, allowing for each USA ADR or receipt, equivalent to 10 JSE listed REIT shares, a ratio very close to the current exchange rate difference between the ZA Rand and USA Dollar;
o An USA ADR programme will allow mainly US investors to freely buy and sell REIT, creating and ensuring liquidity in a foreign market without necessarily meeting USA listing requirements. An ADR programme will not necessarily lead to USA listed status;
o ADR programme can either attempt to raise foreign or USA capital or merely be to ensure dollar based tradable liquidity for non-resident REIT investors. Currently level 3 ADR is typically required to raise new capital in the USA;
A level 1 ADR programme allows for over the counter non-listed foreign share trading in the USA, where as
A level two programme entails a listing, but no new shares are issued and so no capital is raised. The ultimate is obviously
A level three programme which allows for NYSE and or other USA exchange listing of new shares to raise capital in the USA market.