REITs as Applied in South Africa
13 April 2015
Posted by: Author: Craig Miller
Craig Miller discusses
South Africa’s uniform REIT regime
The REIT (real estate investment trust) is an international
standard which permits investors to invest in property assets through a vehicle
which largely provides for tax transparent treatment.
More than 25 countries in the world use similar REIT models. Following the introduction of section 25BB
into the South African Income Tax Act in 2012, South Africa has now also
adopted a uniform REIT regime.
legislation inevitably results in unforeseen issues arising which may in time
be corrected with amending legislation.
This article sets out the basic parameters of how the income tax regime
applies to REITs including an identification of some issues as they pertain to
merger and acquisition transactions and an application of the corporate rules.
the introduction of section 25BB, South Africa had two forms of publicly traded
property investment entities namely property-loan stock companies (PLS’s) and
property-unit trusts (PUTs). Both PLS’s and PUTs were funds that invested
directly into property however, these funds were unevenly regulated and subject
to different tax treatments including the fact that the PLS’s were regulated in
terms of the Companies Act whilst the PUTs were regulated in terms of the
Collective Investment Schemes Control Act.
addition, a degree of uncertainty prevailed over whether PLS’s were legitimately
entitled to deduct interest on the debenture component of linked units issued
to investors. In terms of the REIT
regime, both PLS’s and PUT’s are largely treated in a similar manner for income
A REIT is a
company (as defined for income tax purposes) that owns and operates
income-producing immovable property. The
definition of a REIT in the Income Tax Act refers to a company which is South
African tax resident and whose shares are listed on the JSE as shares in a REIT
as defined in terms of the JSE Listings Requirements. Consequently, a South
African REIT also needs to comply with the JSE Listings Requirements for REITs which
broadly require that it:
at least R300m on of property;
its debt below 60% of its gross asset value;
75% of its income from rental or from property owned or investment income from
indirect property ownership;
a committee in place to monitor risk;
not enter into derivative instruments that are not in the ordinary course of
distribute at least 75% of its distributable profits available for distribution
to its investors by no later than 6 months after the end of the financial year.
It is interesting to note that distributable
profits per the Listings Requirements is simply described with reference to
‘gross income’ as defined in the Income Tax Act less deductions and allowances
other than a qualifying distribution.
Exempt income is included in this description of ‘distributable profit’
although in practice it is unlikely that a REIT will derive regular amounts of
exempt income given the manner in which section 25BB is framed.
Listings Requirements place significant emphasis on REITs being able to satisfy
certain requirements of the Income Tax Act.
For example, the directors of a REIT are obliged to each confirm that to
the best of their knowledge, the REIT should be entitled to deduct a so-called ‘qualifying
distribution’ for income tax purposes.
Tax attributes of the South
African REIT regime
Tax ‘flow through’
There are three key definitions contained in section
25BB of the Income Tax Act which are vital in understanding the tax
implications of the current REIT regime. These are ‘controlled companies ’,
‘property companies’ and ‘qualifying distributions ‘. The interaction of these
three definitions effectively allows a REIT to achieve tax neutrality.
A ‘controlled company’ is a subsidiary of a
REIT as contemplated in terms of International Financial Reporting Standards.
A ‘property company’ is a company in which a
REIT (or a ‘controlled company’) owns at least 20% of the shares and where, in
the previous year of assessment, at least 80% of the value of that company’s
assets was attributable to immovable property.
A ‘qualifying distribution’ includes dividends paid
or payable, or interest incurred in respect of linked debentures, by a REIT or a
‘controlled company’ (but not a property company). In addition 75% or more of the gross income of
the REIT or ‘controlled company’ must be attributable to rental income in the
current year, if that REIT or ‘controlled company’ was established in that year.
In any other instance, the 75% rental income rule is applied to the preceding
year of assessment.
A REIT or a ‘controlled company’ can deduct for
income tax purposes all ‘qualifying distributions’ to shareholders, which
deduction may result in the entity not being subject to tax.
'Qualifying distributions’ received by
shareholders are not exempt from income tax and consequently, depending on the
nature and tax profile of the shareholder concerned, may be taxable in their
hands (pension funds, for example, will not be subject to tax on such
Dividend tax will be imposed on ‘qualifying distributions’
to foreign shareholders subject to a reduction in terms of an applicable double
Other tax attributes
A REIT is
not subject to capital gains tax on the disposal
of immovable property, or shares in a ‘property
derived from a financial instrument, held by a REIT or ‘controlled company’
must be included in the income that entity.
REIT regime issues in the context
of mergers and acquisitions
In the context of an acquisition by a REIT of
shares in a company which owns immovable property but is not a REIT for income
tax purposes (described below as a ‘non-REIT’), it needs to be considered whether
the REIT may deduct interest incurred on external debt funding applied to
acquire the shares in a target company (which for these purposes we assume to
hold only immovable property). Ignoring
commercial considerations in relation to this fairly common occurrence, often
the shareholders of the target company in these circumstances would be
motivated for income tax reasons to rather sell the shares in the target
company to the REIT as opposed to a sale by the target company of each of the
immovable properties which may, inter
alia, attract CGT including dividend tax at a rate of 15% on the after-tax
distributions to the shareholders.
Typically, outside the REIT environment, an
acquiring company may simply borrow to acquire shares in a target company and,
provided the requirements of section 24O of the Income Tax Act are satisfied,
claim a deduction of the interest incurred.
Alternatively, an acquiring company may acquire the shares in the target
company via a vendor or bridge loan following which the acquiring company or
its subsidiary may procure permanent funding which is applied to acquire the
assets of the target company in accordance with section 45 of the Income Tax Act,
thereby ensuring roll-over relief in the hands of the target company. The target company would typically declare a
dividend of the cash proceeds it acquires in exchange for disposing of its
assets, back to its ‘new’ parent company and this consideration would be
applied to ultimately settle the vendor or bridge loan. On the basis that the
permanent funding was applied to acquire operating assets, the interest
incurred should rank for deduction in the hands of the company borrowing to
acquire the operating assets. In both
scenarios, section 23N of the Income Tax Act would apply in limiting the
deduction of interest to a percentage of so-called ‘adjusted taxable income’. (Section 23N applies in relation to
‘acquisition transactions’ contemplated in terms of section 24O and to
‘reorganisation transactions’ contemplated in section 45 of the Income Tax
Act.) Currently, the formula provides
for a deduction of approximately 39% of ‘adjusted taxable income’ and the
starting point for this calculation is the taxpayer’s taxable income.
In the context of a REIT, two issues
immediately arise. Firstly, on the basis
that a REIT and its subsidiaries (the controlled companies) would typically
seek to reduce taxable income in the form of qualifying distributions, the REIT
or controlled company concerned may derive a relatively low amount of taxable
income. This would immediately have an
adverse impact on the ability of the taxpayer to deduct interest in accordance
with section 23N. However, it is
noteworthy that the formula for determining adjusted taxable income permits a
taxpayer to include an additional amount equal to 75% of the rental income
earned from the direct letting of immovable property. Consequently, to the extent that a REIT is
contemplating an acquisition with the use of borrowed funds which could be
subject to the application of section 23N, it should carefully consider which entity
in the group may result in the formula yielding the most advantageous tax outcome
in seeking to deduct interest. (For example, a subsidiary of a REIT which acts
a mere holding company for other property owning companies, may receive dividends
which constitute ‘rental income ‘for the purposes of determining its
‘qualifying distribution’, however these dividends would not constitute income
earned from the direct letting of immovable property for section 23N purposes.
Consequently, it is likely that its
adjusted taxable income will be low resulting in an inability to deduct
interest subject to the provisions of section 23N at this level.
Secondly, to the extent that a REIT (or a
controlled company) applies its receipts from direct rental income or dividends
from other controlled companies to repay the capital of the debt, the REIT
could derive taxable income on the basis that it would apply an amount of income
which is taxable, to settle an amount which is not deductible for income tax
Both of these considerations would apply in the
context of a REIT or a controlled company which borrows to acquire shares in a
In the context of section 45, a ‘group of
companies’ in section 41 of the Income Tax Act does not include a portfolio of
an investment scheme in property that qualifies as a REIT. i.e. the previous
PUT vehicle. Consequently, section 45
may not always apply in the context of a transfer of assets within a REIT group
However, on the basis that capital gains arising
from the disposal by a REIT or a controlled company of immovable property are
exempt from income tax it is unnecessary that, upon acquiring control of the
shares in the target company, section 45 is made applicable where these assets
are subsequently transferred to a REIT or controlled company. To the extent that section 45 does not apply,
the limitations imposed under section 23N would become redundant. The issue
then confronting the REIT is how the cash consideration arising in the hands of
the target company is recycled within the group to settle the vendor or bridge
loan. Typically, these loans would need
to be settled within a short period of time.
To the extent that the target company declares a dividend from these proceeds,
this amount may constitute a ‘qualifying distribution’.
A ‘qualifying distribution’ is curiously defined
as, inter alia, a dividend paid or payable which is determined with reference
to the financial results of that company as reflected in the financial
statements prepared for that year of assessment if at least 75% of the gross
income derived by the REIT or controlled company consists of rental income in
the preceding year (where the REIT or controlled company have been in existence
for at least one year).
Although digressing somewhat, most (if not all)
REITs and property companies calculate their final year-end distributions
shortly after the close of the financial year, once the accounting records have
been finalised. This timing difference is potentially problematic as a REIT may
arguably only claim a ‘qualifying distribution’ as a deduction against income
in respect of the year of assessment in which that ‘qualifying distribution’
was made although the intention of the drafters appears to be that a deduction
for the ‘qualifying distribution’ arises in the year in relation to which the
dividend is determined with reference to financial results.
On the facts described above, the ‘qualifying
distribution will essentially be limited as a tax deduction to the taxable income
of the target company (now a controlled company), yet the amount of the
qualifying distribution could be subject to tax in its entirety in the hands of
its recipient. It may be preferable that
the target company considers buying back the shares held by its immediate
parent in transferring the cash to this company where the buyback is structured
to constitute a ‘dividend’ for income tax purposes. A share buyback is excluded from the
definition of a ‘qualifying distribution’ and section 10(1)(k)(aa) of the Income
Tax Act would apply in deeming the receipt of the buyback consideration in the
hands of the parent company to be exempt income. However, it would be important to consider
whether the buyback consideration (which although exempt, would form part of
‘gross income’) in the hands of the parent company is so significant that it
results in the ‘rental income’ of the parent company falling below the 75% of
‘gross income’ threshold in which case the parent’s ability to deduct a
qualifying distribution may in turn be compromised.
‘Asset for share’ transactions and ‘substitutive
share for share’ transactions
Section 42 of the Income Tax Act provides for
roll-over relief where a disposer of assets acquires a qualifying interest in
the company which has acquired the disposer’s assets. In the context of a listed entity such as a
REIT, a single equity share issued to the disposer could potentially suffice.
An ‘equity share’ would also include an
interest in a collective investment scheme in property which qualifies as a
REIT. Where a REIT still has linked
units in issue, the debt component of a linked unit would not constitute an
equity share. However, section 43 of the
Income Tax Act permits a company to essentially convert its debt instruments
into equity shares in a tax neutral manner. Consequently, it may be preferable
to convert the linked units into equity shares following which the section 42
transaction could be entered into.
When contemplating corporate formation
transactions involving an application of section 42 of the Income Tax Act,
REITs will also need to consider various tax issues such as whether they wish
to hold property assets subject to a joint venture through a corporate form, or
via an undivided direct interest in the actual property assets. If the assets
are held through, say, a joint venture company which is defined as a ‘property
company’, a REIT will receive a dividend from the after tax profits of property
company as the ‘flow-through’ treatment (which would otherwise apply to a REIT
or a controlled company (i.e. a subsidiary of a REIT)) will not apply to a
so-called ‘property company’. However,
if a REIT or a controlled company held a direct, undivided share in the
property asset, this issue would not arise as it could distribute its rental
income via a ‘qualifying distribution’ and hence the ‘flow through’ treatment
would be maintained.
In relation to a non-REIT, to the extent that
it acquires a minority interest in a ‘controlled company’, it would likely
receive a qualifying distribution which would be taxable in its entirety in the
hands of the non-REIT. If the controlled
company in turn held shares in an investee company, the receipt or accrual of a
dividend in the hands of the controlled company would be subject to tax which
in turn may be on-distributed as a qualifying distribution to its
shareholders. However, to the extent
that a non-REIT held the shares in the underlying investee company directly,
the dividend may have been exempt in its hands.
Unbundlings and liquidations
Pursuant to, or as part of, merger and
acquisition transactions, it may be desirable to transfer shares or assets
within the group via an unbundling of shares (i.e. in specie distribution) or a transfer of assets pursuant to a liquidation
of the disposing company.
Section 46 of the Income Tax Act, in certain
circumstances, allows a company to ‘unbundle’ shares held in another company to
its shareholders as an in specie distribution
on a tax neutral basis. In terms of section 46(6A), a REIT or ‘controlled
company’ is specifically excluded from obtaining any tax relief under section
46 when unbundling any shares held in another company. Consequently, any in specie distribution received from a
REIT or controlled company is subject to tax.
Section 47 of the Income Tax Act effectively
allows a 70% held subsidiary to be liquidated on a tax neutral basis. A
liquidation distribution is exempt from income tax as a consequence of the
normal section 10(1)(k) dividend exemption. However to the extent that it is a
‘REIT’ or a controlled company which is being liquidated, the dividend
exemption in the hands of the recipient will not apply and the ‘liquidation
distribution’ is subject to tax.
It therefore follows from the above that in
order to maintain tax transparency, a REIT or controlled company would be
required to on distribute any amounts received from other REITs or controlled companies
in terms of a liquidation distribution or an unbundling transaction, failing
which they may be subject to tax. Furthermore, it is likely that in most
instances the ‘liquidation distribution’ or in
specie distribution arising from an unbundling transaction would be capital
in nature. This seems to be at odds with the underlying intention of the
‘qualifying distribution’ rule which is directed at encouraging REITs and
controlled companies to distribute ordinary operating rental income to
shareholders (although it is conceded that the section was developed on the
basis that ‘tracing’ was not required provided that the deduction was limited
to taxable income).
the practical implementation of the current REIT regime has resulted in certain
anomalies, which need to be addressed and considered particularly within the
context of merger and acquisition transactions, the introduction of the REIT
regime should be welcomed as the basis to provide for meaningful growth in the
This article first appeared on the March/April 2015 edition on Tax Talk.
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