Jun 272014

This is the first of two articles where we take a closer look at the type of asset that goes into a REIT’s property portfolio. While the answer is perhaps obvious (property of course!), there are certain restrictions that wouldn’t normally apply to other commercial landlords. Furthermore, it isn’t so obvious that a REIT can hold property indirectly through other investment vehicles such as unit trusts, OEICs and partnerships.

In this article we shall concentrate on the type of direct investments that one would expect to see in a property portfolio – the bricks and mortar. Indirect investments will be the subject of the next article.

The property rental business is tax exempt

First of all, recall that a REIT is a company that invests in property, and is exempt from corporation tax on both rental income and capital gains. In short, a REIT is a tax exempt property fund. However, while this might suffice for a quick explanation of what a REIT is, we need to look closer into the legislation if we are to identify the type of assets that benefit from the exemption.

A REIT’s activities can be split into two distinct parts1:

  • The property rental business – this is the part that benefits from the tax exemptions2; and
  • The residual business – which is everything else. This part is not tax exempt, and profits and gains are subject to UK corporation tax in the usual way3.

We shall find that certain types of property related investment fall on the wrong side of the line. These types of activities aren’t actually forbidden – the company is free to carry them out, provided that this doesn’t impact on the two main conditions that the business must satisfy. These are4:

  • The profits test – at least 75% of the company’s total profits must be derived from the property rental business;
  • The assets test – at least 75% of the total value of the assets must relate to the property rental business (valued on a fair value basis).

Together, these two tests constitute the balance of the business condition, which we looked at in a previous article.

What do we mean by a property rental business?

This is answered in the legislation. A property rental business is described as being “every business which the company carries on”, whether in the UK or overseas, for “generating income from land”5, including every transaction entered into for that purpose. And “generating income from land” means6:

“exploiting an estate, interest or right in or over land as a source of rents or other receipts.”

In short, the business of a REIT is just what one would expect it to be – renting out property. Note that it doesn’t matter whether the REIT itself holds a freehold or leasehold – all that matters is that it has some property interest that is capable of being let out to tenants in return for rent. This is of course, subject to a number of qualifications as we shall see later on.

We can also draw a number of other conclusions from our statutory analysis.

Domestic or Overseas Property

The legislation makes clear that there is no bar to investing overseas7. As far as the UK is concerned, the tax exemptions still apply, but foreign tax is still applicable.

Depending on the location of the property, rental income could be subject to withholding tax and capital gains tax may apply. Furthermore, one consequence of the REIT being exempt in its own home jurisdiction is that relief from foreign taxation may not be available, either under the UK domestic legislation or under a Double Tax Treaty.

Commercial or Residential

Until recently, REITs were considered to be primarily designed for the commercial sector. However, it is important to note that there has never been any prohibition on investing in residential property. This has been the position from the very beginning when REITs were first introduced to the UK in 2007. Going back to the legislation, the key is the holding of a property interest for the purpose of generating an income from land. In fact, the legislation is explicit when defining a single property as being8:

“…designed, fitted or equipped for the purpose of being rented, and it is rented or available for rent, as a commercial or residential unit.”

However, at the time of writing this article, no residential REIT has listed on the stock markets – all REITs have been in the commercial sector. The reason is due to the practical hurdles that were perceived to exist in setting up a residential REIT. As a response, the Government introduced a series of reforms in 2012, which included the following changes to the rules:

  • Abolishing the 2% entry fee;
  • Permitting REITs to trade on junior markets, such as AIM;
  • Introducing a new class of institutional investor which includes charities and social housing associations. The presence of such investors will not adversely impact the REIT’s non-close company status;
  • Allowing a three-year grace period to meet the non-close company requirement – especially important for start-up situations.

(You can read more about some of these changes here.) It will be interesting to see whether any new residential REITs appear on the market as a result of these reforms.

What is excluded from the property portfolio?

Certain types of business or income are specifically excluded from the property portfolio. They will not form part of the tax exempt business, and will therefore be subject to corporation tax in the usual way. The exclusions are9:

  • Incidental letting of property held in connection with a property trade;
  • Letting out temporary surplus accommodation normally used for administrative purposes. This only applies to short term lets (3 years or less) and where the space let out is small compared to that occupied for administrative purposes;
  • Properties that are owner occupied in accordance with generally accepted accounting practice. This would include not only occupation by the REIT itself, but also by other group members and companies whose shares are stapled to the REIT (or to other group members);
  • Services provided to overseas tenants, where such services would not normally count as a being part of a rental business if provided in the UK;
  • Certain structured finance arrangements such as rent factoring;
  • Rentals from caravan sites where the operation of the site constitutes a trade;
  • Rent from certain “infrastructure” investments such as electric-line wayleaves, oil and gas pipelines, wind turbines and mobile phone and other telecoms networks;
  • Rentals from a limited liability partnership when the latter is in the process of being wound up;
  • Where a REIT invests through a joint venture, one excludes property letting from the joint venture company to members of its own corporate group as well as to other members of the joint venture.

It used to be the case that income from investing in other REITs fell outside the tax exemption. However, this has recently changed – it is now possible to invest in other REITs, and even through a chain of REITs10.

As stated previously, none of these types of business activities are actually forbidden. The company is free to carry on any of them, provided that the profits and asset values do not go over the 25% limit stipulated in the balance of the business test. 

What is included in the property portfolio?

Any other type of property not on the excluded list, as long as it is capable of being rented out. Above, all, the REIT must own at least three properties11. This means that:

  • It isn’t possible to let out a single building (but see below);
  •  A REIT cannot invest solely in co-investment type structures where each investor holds a part share in the property. This is because a “part share” can never constitute a single property – it is always going to be part of a unit. Even if a REIT owned 9 investments, each one being a one-third share in a separate building, the condition wouldn’t be satisfied. The investments can’t be added up in this way – nine part shares from nine different properties will never make a single property, let alone three.

On the other hand, it is possible to split a single building into separate units, with each unit being considered as a separate property in it’s own right12. For example, the following types of investment are permissible even if they are the only asset in the portfolio:

  • Shopping centres – which may consist of a single structure that is split into the various units let out to retailers;
  • Student accommodation such as halls of residence or flats. Provided that the students have exclusive access to their rooms or flats throughout the rental period, each unit will count as a separate property;
  • Similarly, a residential care home may qualify as a multiple-property;
  • Multi-storey office blocks, where the stairwells and common parts are designed so that each floor is capable of being occupied by a separate tenant.

The proviso is that there must be at least three units within the single structure that has been split in this way.

Note that the condition relates to the number of properties, not the number of tenants. So it is even possible to have a portfolio consisting of three separate properties occupied by a single tenant. For example, a large financial institution in the City of London could be housed in several buildings – alternatively it could occupy just one building, but with the various floors segregated from each other.

Property development

When REITs were first introduced, a number of companies such as Helical Bar stated that they wouldn’t be joining the regime due to the high level of development work involved in their business. Although property development is a permitted activity, the rules can be complicated – the following is a short summary13.

First note that if a property is developed with a view to selling on completion, it is normally regarded as a trading asset under general tax principles. Consequently, any profits or gains can never be exempt from corporation tax.

However, if the intention is to let the property on completion, it is part of the property rental business. Furthermore, the development is included as an asset for the balance of business test even before it is completed and is yet to generate any income14.

So far so good. However, there are two occasions when an exempt development property becomes taxable:

  • The property becomes a trading asset and is subsequently sold. The gains are treated as income  and are taxed because the property no longer qualifies for the exemption15;
  • The property remains an investment asset but is sold within three years of completing the development work. In these circumstances, any gains are taxable if the development costs amount to more than 30% of the property’s fair value at the time that it was first acquired, or otherwise entered into the REIT regime16.

It is not hard to see why some companies with substantial development activities have chosen not to convert to REIT status.

What happens on selling a property?

The sale of a property raises a number of issues that can impact the company’s tax status:

  • How does the removal of an investment property from the portfolio alter the balance between the rental business and the taxable part? In short, is the balance of the business test still satisfied?
  • What about the remaining properties in the portfolio? Are there any assets whose relative value have substantially increased as a result of the sale, and does this breach the 40% condition? 
  • What is the position when there are just two properties remaining after the sale?

We shall look at these three issues in turn.

Selling a property and the balance of the business test

The idea is that as a result of selling the property, the proportion of the rental assets has now decreased. If this slips below the 75% threshold, we have a breach of the balance of the business condition.

However, there is in fact no breach of this condition, no matter how many investments are sold17. This is because cash held by a REIT is effectively treated as an asset of the rental business18. So when a property is sold and replaced by the sale proceeds, there is no overall change in the proportion of the rental assets.

This is actually a recent addition to the rules. Until 2012, the sale proceeds were only treated as property assets for a maximum of two years. In other words, a REIT would have had two years in which to make a new investment with the cash, or otherwise distribute it to shareholders. The new rule gives a greater amount of flexibility – one should not be forced to make a new investment if there are no suitable opportunities available.

For the purpose of the REIT legislation, cash is defined to be money on deposit – which can be in foreign currency – together with “safe” securities such as gilts19. However, the income generated from these assets is not regarded as rental income, and so falls on the wrong side of the line for the purpose of the balance of the business test. However, given the low rates of return available on cash, this is perhaps not a huge disadvantage in the current investment climate.

Selling a property and the 40% rule

This rule states that no single property can represent more than 40% of the total value of the property rental business20. The idea is to mitigate the risk of any single investment dominating the portfolio. This risk is more likely to materialise as more and more properties are sold off. What is the position if the effect of realising an investment is to breach the 40% rule?

Surprisingly, the answer is that nothing drastic happens! The company isn’t automatically thrown out of the regime and has three years in which to make matters right. The solution would be either to sell the offending property or to acquire new investments21.

However, this get out of jail card needs to be used sparingly. Once it has been used, one should take care not to have to use it for another ten years – otherwise there is a serious risk of being thrown out for good22.

Selling a property – from three properties to two

This is not a complete disaster either. As with the 40% rule, the company has three years in which to make matters right23. Note that selling the third property can also cause a breach of the 40% rule. However, the rules make clear that only one breach is counted24.

End of Part One

In this article we have concentrated on the direct investments that a REIT can hold – the bricks and mortar that one would expect a commercial landlord to rent out to tenants. This isn’t as straightforward as it would be for a normal landlord, as the rental business has to be maintained in accordance with the conditions stipulated in the REIT regime. In particular, investment decisions such as whether to sell a rental asset need to take account of the potential to tip the balance of the business in the wrong direction.

What about other types of property investment? Can a REIT invest in other REITs? Can it enter into partnerships or joint ventures? The answer to these questions is “yes it can” but, as one would expect, this is not an unqualified “yes”. The type of indirect investments available to a REIT, and the nature of the conditions attached, will form the subject of the next article in this series.


  1. CTA 2010 ss 519, 522.
  2. CTA 2010 ss 534, 535.
  3. CTA 2010 ss 534(3), 535(6).
  4. CTA 2010 ss 527(2)(d), 527(3)(d), 531(1), 531(5).
  5. CTA 2010 s 519(1), CTA 2009 ss 205, 206.
  6. CTA 2009 s 207(1).
  7. CTA 2010 s 519(1)(b).
  8. CTA 2010 s 529(4)(b).
  9. CTA 2010 ss 519(3), 598(3), 604 605.
  10. CTA 2010 s 605(2) Class 7 which is now modified by CTA 2010 ss 605(1A), 549A.
  11. CTA 2010 s 529(1).
  12. This is a consequence of the definition in CTA 2010 s 529(4)(b). See also HMRC Manual at GREIT02030.
  13. See the following sections of the HMRC Manual for further details: GREIT04510, GREIT04520 and GREIT04050.
  14. See HMRC Manual GREIT02075.
  15. CTA 2010 ss 555(1), (2), 556(1), (2).
  16. CTA 2010 ss 556(2), (3).
  17. There can of course be other breaches. For example, selling everything in the portfolio would breach the “three properties” rule.
  18. CTA 2010 s 531(5).
  19. CTA 2010 s 531(8).
  20. CTA 2010 ss 529(2), 529(4)(c), (d), (e). Furthermore, in valuing the portfolio one disregards any debt that has been secured against the assets.
  21. CTA 2010 ss 563, 569, 572, 575(1).
  22. CTA 2010 ss 575(2), (3).
  23. CTA 2010 ss 563, 569, 572, 575(1).
  24. CTA 2010 s 575(4).
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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