Peter Kempster
With commercial developments growing larger in scale and rents climbing higher, the question of who can afford to own such valuable capital assets inevitably occurs. This is more than a rhetorical question. Potential investors hesitate to undertake a substantial reduction in the diversity of their portfolios; managers of all but the largest funds complain that they cannot afford to join the club; and the consequent small number of potential participants results in problems for vendors of large properties, and a lack of liquidity in the market.
The commercial solution is obvious: form a club of investors who can share the high cost of the investment between them, and then establish a market for their interests. But this apparently straightforward approach of unitising the investment runs into legal quicksands on the question of establishing a suitable structure.
Lawyers underline two problems. First, marketing the investment scheme is bedevilled by the statutory restrictions on issuing invitations to participate and Stock Exchange requirements for the listing of property vehicles holding a limited range of investments.
Second, the concept of multiple ownership of property — at least in this form — does not fit comfortably into the UK tax system. The result is that tax costs can be unacceptably high.
On the first problem some progress has been made. The work of the Barkshire Committee, the replacement of the Prevention of Fraud (Investments) Act 1958 by the Financial Services Act 1986, and the new Stock Exchange criteria for listing of single-property schemes have all proved potentially useful developments.
As to the second, hopes are high that, once the property industry has decided how it wants to operate in this field, amendments to the tax system will remove anomalies and perhaps even confer some advantages. But that is ignoring a chicken-and-egg conundrum.
How can the property industry decide how to proceed between SPUTs, SAPCOs, PINCs and the like unless it understands the tax implications? The purpose of this article, accordingly, is to air some possible solutions.
The tax problems
Investment in a property by a number of interests requires the creation of some form of vehicle to hold the property. One possibility is a company, with the investors as individual shareholders. Otherwise, a trust will result under English law. The commercial context requires a formal trust structure constituting a “unit trust scheme”, with the investors as unit holders.
The main tax problem arising from the creation of a vehicle stems from the fact that, when the property is sold at a profit, the investors do not receive a direct share of the proceeds. Instead, they hold investments (either shares or units) in the vehicle which has realised the gain.
The vehicle itself will suffer tax at around 35% on the gain, leaving 65% available to the investors. When, however, the investors realise their profit by disposing of their shares or units, they will themselves realise a taxable gain.
This means that the vehicle’s post-tax net gain of 65% is now reduced by a further 35% tax charge. In the end, therefore, the investor secures only 42.25% of the appreciation.
This double charge is a familiar feature of investments held via a company: it also applies to property unit trusts. This is because, although authorised unit trusts are usually exempt from tax on their capital gains, the Department of Trade adamantly refuses to grant “approved” status (under the Prevention of Fraud (Investments) Act, now replaced by the Financial Services Act) to property unit trusts. Thus, the unapproved unit trust is treated for the purposes of tax on capital gains as a company (s 93, CGT Act 1979).
What we need is some method by which the tax authorities will ignore the intervening vehicle and treat (and tax) its gains as those of the investors. In other words, the so-called “tax transparency”.
Single-property unit trusts
This could be achieved if property unit trusts were to be granted “authorised” status by the Department of Trade. The trust’s gains would then be tax exempt under s 81 of the Finance Act 1980.
A similar improvement would result from implementation of the Barkshire Committee proposals on changes in the tax rules to accommodate SPUTs. Another “transparent” Barkshire Committee proposal is that eligibility for any capital allowances on the property (for example, a Docklands office development) should pass pro rata to the investors, rather than lodging with the trustees.
The Inland Revenue have, in the past, given approval for such treatment to a number of property unit trusts investing in enterprise zones. This is now prevented by the new s 354A(2) Taxes Act 1970 (inserted by the first of the 1987 Finance Acts), although we understand that existing schemes will be saved by Treasury regulations yet to be announced.
Turning from unit trusts to companies, how can these achieve tax transparency? Let us compare two commercial solutions to property securitisation — the two-tier share capital SAPCO (exemplified by Billingsgate City Securities); and PINCs.
Single-asset property companies
In essence, the first tier of SAPCO capital consists of preferred shares carrying rights equivalent to direct ownership of the property: a percentage of the rental yield and of the pretax proceeds of sale of the property. The second tier comprises ordinary shares with residual rights, including the remainder of the sale proceeds but net of all tax payable on the disposal.
The double charge is not eliminated; it is merely shifted away from preference shareholders and on to ordinary ones. Looked at only from the viewpoint of the preference shareholders, however, the disposal is tax transparent (provided the post-tax sale proceeds are sufficient to meet their preferred rights).
Property income certificates
The tax transparency of PINCs depends partly on the Inland Revenue’s agreement as to how they will treat certain features of the scheme. In outline, the investors hold both a PINC and an issued share in a property management company.
These two items are effectively permanently “stapled” by transfer restrictions in the articles of the company and the deed granting the PINC. The deed is unilaterally executed by a paying agent (such as a bank) which is also the landlord of the company; the company in turn being landlord to the occupiers of the property.
The PINC-holders are entitled to receive sums from the paying agent equivalent to the rents received by the paying agent from the company; whose rental payments are, in turn, linked directly to its receipts from the occupiers. On disposal of the property the PINC-holders are entitled to receive a sum from the paying agents equivalent to the proceeds of the sale.
There are, of course, numerous sophistications to allow the property investment to be geared; to allow the PINC-holders to remove the paying agent; and to allow the original vendor of the property to retain an interest (perhaps as a substantive investment, perhaps to avoid a clawback of capital allowance).
The tax treatment, however, always hinges on the principal rights of the PINC-holders. Although the income and capital receipts are locked into the returns from the property, they do not derive from the property nor from the shares of the property management company. They derive instead from the paying agent’s contractual liability under the deed granting the PINC.
This is where the Revenue’s expressed opinions come into play, to ensure favourable treatment for what otherwise might be a somewhat contentious interpretation of the tax implications of income and capital payments under the PINC deed.
First, the Revenue have accepted that the PINC income payments can be netted off by the paying agent against the rent received from the company.(*) (The two, it will be recalled, are equivalent. No taxable sum is therefore left with the paying agent.)
Second, the income payments do not constitute distributions (ie dividends paid) by the paying agent. At the same time, there does remain a requirement to deduct basic rate income tax from these sums (as they constitute “annual payments”).
Third, on disposal of the property, the sums paid to the PINC-holders can be netted off against the sales proceeds in computing the paying agent’s taxable gain (hence there is no double charge). Last, the capital payment to the investors does not, once again, constitute a distribution by the paying agent.
The 1987 Finance Acts
This year’s pair of Finance Acts contain certain provisions which may well change the investment tax equations.
Companies (and unauthorised unit trusts) have previously paid a lower rate of tax on their capital gains than on their income profits. This distinction has been abolished, so that a uniform rate of 35% applies.
When a company pays a dividend, it has to account to the Inland Revenue for advance corporation tax of around 37% of the cash dividend. Previously, it had been allowed to offset ACT against its tax liability only on its income profits; that has now been extended to allow offsetting against tax on capital gains as well.
Finally, there is no change in the rule that the cash dividend is tax-free income to a corporate investor. Such an investor can then pay the money on to its own shareholders without accounting for any ACT (although they are still entitled to a tax credit equivalent to the underlying ACT).
The combined effect of these elements could produce some new strategies. For example, if an investment company realises an investment and, instead of retaining the proceeds distributes them by way of dividend, then (after offsetting the ACT) there is a residual tax charge in that company of only 11% and no tax charge on the corporate investor receiving the dividends.
As you will have already guessed, however, there are snags. Investors face pages of anti-avoidance legislation designed to counteract the tax advantages of abnormal distributions, dividend stripping, losses from depreciatory transactions and so on.
The rules may be changing but, overall, they do not become any simpler.
(*) See The Law Society’s Gazette, VOL 84 1987 p1394