So that's all Reit then?

This article constitutes an update on the REIT developments relevant to the hotel sector since the enactment of the Finance Act 2009 (“FA 09”) and the publication of the long anticipated anti-avoidance rule to be brought into force by way of a statutory instrument under the FA 09.

New anti-avoidance rule for REITs

REIT legislation as it stands allows a hotel (or pub) group to be split so that the REIT part of the group can let property to the non-REIT part of the group and then account for the rental income as income arising from a property rental business thus qualifying for REIT status. HMRC seems now to have decided such split group lettings are objectionable and therefore should not attract REIT tax benefits. Fortunately, in my last article, I did warn that HMRC would be focusing on artificial splits of the brain and bricks in the hotel sector but I left open the extent to which modified forms of the OpCo/PropCo structures could still be used. I comment further in this regard below.

To be fair it appears that HMRC have introduced this anti-avoidance rule to counter REIT proposals rather than to unravel current REIT structures. Thus the anti-avoidance rule only affects new prescribed arrangements entered into on or after 6 May 2009.

The basic structure of the anti-avoidance rule

A REIT group will be deemed to include any entity with which there is an arrangement and the purpose or one of the main purposes of the arrangement is to achieve/maintain REIT status (“prescribed arrangement”). By bringing the tenant company within the REIT group, the prescribed arrangement will not be able to satisfy the balance of business test (75% of income being passive rental income) were it not possible otherwise.

Although the basic test is wide, an arrangement will not be prescribed if:

1. the arrangement has been effected solely for genuine commercial purposes. The extent to which the following would be considered genuine commercial purposes is unclear and therefore dialogue with HMRC will be necessary to clarify: (1) the basic desire to create a specialist hotel REIT when faced with an industry where the management agreement (as opposed to lease) structure is widespread; and (2) the wish to isolate different types of assets into particular parts of a structure, thereby controlling long term risk and enhancing potential to borrow money. The extent to which this limb is not merely the flip side of the definition of prescribed arrangements, at least in the minds of HMRC, is also unclear. Surely, there must be a difference between this and the basic trigger test – can it not be a commercial purpose to seek the capital and other (including tax) efficiencies of REIT status? That said, the commerciality aspect may not be that important given the alternative escape route of arm’s length terms below; or (and the use of the alternative, rather than the additional here, is important)
2. the arrangement is made, or is such as would reasonably be made, between persons dealing at arm’s length. Clearly, arrangements between a REIT and a completely unassociated entity will not be caught under this limb. Genuine tenanted hotel arrangements will survive. However, arrangements between members of the same “group” would be expected to be at risk. That said, it is also arguable that provided proper benchmarking of both contractual arrangements and terms is carried out, then even the “in house” can survive – provided there is no attempt to divert what should properly be taxable intermediary profit e.g. by elevating the rental costs of Opco. Of course, this escape route raises the question of the availability of the benchmarking for intermediary companies and the level of service they provide.

Simplification of the owner-occupation restriction

The second and independent rule is that owner-occupied properties cannot contribute to the balance of business test (75% of passive rental income). The existing rule on this has been tightened somewhat. Now, a letting is considered owner-occupied in accordance with generally accepted accounting practice without any need for a specific control relationship between landlord and tenant.

What does this mean and where does it leave the Opco/Propco split?

Under both IAS 40 and SSAP 19, properties leased intra-group are considered owner-occupied in relation to consolidated accounts. There must of course be overlap between what is covered by this rule and the anti-avoidance rule.

However, the particular point of interest is that this owner-occupation rule leaves open the opportunity that with single company accounts (including single company REITs) under IAS 40 (“Intl GAAP”“UK GAAP”remains), but not SSAP 19 (), property let to group members investment property and not owner-occupied. Thus a single company REIT could treat a letting to a 51% to 100% Opco/subsidiary as a qualified business for the purposes of the balance of business test provided it uses Intl GAAP. It is difficult to see why the distinction should depend on whether the REIT produces group accounts and whether these accounts need to be made under Intl GAAP or UK GAAP. But a distinction there is. That said, the potential to avoid this rule may be merely theoretical as my conclusion below suggests.

Conclusion

The difficulty with the use of the owner-occupation accounting concept to exclude intra-group lettings being exploited by REITs is surely widely known and it may be one reason for the introduction of the anti-avoidance rule described above which must be considered separately. For instance, if a restructure is carried out so that there is a requirement for single company accounts only to be produced under Intl GAAP, the anti-avoidance rule will still be a potential catch all clause waiting in the wings.

To reiterate the conclusions in my previous article which still hold true, some managed hotel arrangements are likely to be affected. Interposition of a genuine/third party intermediary with, at least, a 50% “economic” (both in equity and share of profits) interest in OpCo is likely to work – see diagram.

Such an arrangement would not be considered as owner occupied and given the economic interests of the third party, the structure should not be considered prescribed as they should be at arm’s length. Further, the extension of the role of Opco to that of asset manager for the purposes of enhancing returns would consolidate the view that the structure is designed with a view to achieving genuine commercial objectives. That said, the greater Opco’s role the lower tax exempt rental profit moving up to the REIT will be.

If a third party has an interest in the OpCo that is less than 50%, the owner-occupation provision will come into play and any efforts made to avoid the owner-occupation provision may be exposed to the risk of being considered as a prescribed arrangement save that, again, ensuring arm’s length contracts and terms are put in place will help a structure escape from being considered a prescribed arrangement.

Thus I think we can conclude that the Propco/Opco model for REITs is not dead!

What now?

The anti-avoidance clause has not been brought into force as yet but is intended to affect prescribed arrangements made on or after 6 May 2009. As a starting point, the necessary path for all those interested in setting up a hotel REIT must, as previously, be to establish early dialogue with HMRC. Clearly these new rules provide another element to the discussion that should take place with HMRC when a REIT is being set up. Indeed, it would not be a surprise if the new rules/regulations had been introduced by HMRC in order to give them a bigger bargaining chip in the negotiation of REIT status. That said, the availability of the arm’s length escape route suggests the chip is not as big as HMRC might hope.

This article first appeared in Hotel Report.