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Report on session at the 9th Annual IBA Finance and Capital Markets Tax Conference in London

Monday 20 January 2020

 

Antti Lehtimaja

Krogerus, Helsinki

antti.lehtimaja@krogerus.com

 

Session Chair

David Jervis Eversheds Sutherland, London

Speakers

Albert Collado J&AGarrigues, Barcelona

Michaela Engel Noerr, Munich

David Hardy Osler Hoskin & Harcourt, New York

Barbara Worndl Aird & Berlis, Toronto

Rutger Zaal AKD, Luxembourg

Reporter

Antti Lehtimaja Krogerus, Helsinki

 

Introduction and overview

David Jervis introduced the speakers. He noted that among the factors influencing cross-border real estate investment structures were not only taxes but also the types and numbers of investors and regulatory issues. Investors are looking for solutions that provide for no more tax than if they held the assets directly, to minimise the tax on acquisition and exit, and to maximise the amount of deductions throughout the life of the investment. The panel would consider these issues and focus on exit and profit repatriation, first discussing from the viewpoint of each of the jurisdictions represented on the panel and second, by looking at three different case studies.

United States

David Hardy noted that, generally, a country's right to tax gains on local real estate is the epitome of source-based taxation. However, in respect of investment assets, the US takes a different view and through its system it invites foreign investors to invest into the US equity markets free of tax, to help the capital markets as well as the liquidity and pricing of US assets. To a limited degree, these same rules for investment assets may apply when investing in the US real property market. Due to interest and depreciation expenses during the investment period of the real estate investment, any taxable income realised during the operating period is generally not very significant even though there may be cash flow. The 2017 tax reform strengthened interest deductibility restriction rules; however, special election allows real property investments to be exempt from these new rules. There are, though, tax issues to be tackled during the holding period; namely, avoiding the interest withholding tax (WHT) on related party debt based on exemption under a tax treaty, or a domestic exception on portfolio investments, or avoiding branch profits tax. In addition, foreign investors will want to avoid the numerous tax reporting responsibilities that exist in the US. Gains on the sale of US real properties or shares in real property holding corporations are taxable, but there are numerous exemptions, such as those for up to five per cent holders of publicly traded shares of US property holding corporations and up to ten per cent holders of Real Estate Investment Trusts (REITs); foreign governmental funds investing other than through a ‘controlled’ commercial entity; domestically controlled REITs; and qualified foreign pension funds. A conventional US real property investment structure typically caters for the needs of both domestic US individuals and US pension and endowment funds as well as foreign portfolio investors and pension funds. On top of the structure is a collective investment vehicle such as a transparent Delaware partnership and below that it is standard practice to have one or several REITs.

Germany

Michaela Engel noted that during the last decade, German real estate portfolio deals have typically been structured as share deals with the target vehicle being either a German corporation or partnership or a Luxembourg/Dutch corporation. This is mostly because the German Real Estate Transfer Tax (RETT) applies to asset deals. In share deals, however, RETT does not apply if one investor acquires directly or indirectly less than 95 per cent in a real estate company. For partnerships, additionally only less than 95 per cent can be directly or indirectly transferred to new partners within a period of five years if RETT is to be avoided. Legislation drafted in 2019 proposed that such thresholds should in future be decreased to 90 per cent, with the watching period extended to ten years and the restriction to transfer to new partners within such period applied to transfers of shares in corporations to new shareholders. The new draft rules were published last year but postponed, to be decided during the first half of 2020. These proposed changes may make share deals less attractive to buyers in the future. However, from a foreign corporate sellers' perspective, share deals will still be subject to participation exemption, while in asset deals scenarios the seller will be subject to corporate income tax (at a rate of 15.825 per cent) plus possible trade tax (from seven per cent to 17.15 per cent) on capital gain. Trade tax is applicable also to rental income derived by a foreign investor where a permanent establishment (PE) is created in Germany. Germany typically restricts interest deductions to 30 per cent of the ‘tax-EBITDA’ if the annual net interest expenses are at least €3m. Finally, under domestic law, Germany levies a dividend withholding tax (at a rate of 26.375 per cent), which can be reduced under a tax treaty or the EU Parent-Subsidiary Directive. Germany has strict anti-treaty and anti-directive shopping rules, however, and even though the Court of Justice of the European Union (CJEU) has declared these rules contrary to European law, it is still difficult to get relief against dividend withholding tax. The German government and tax authorities are currently in discussion as how to deal with this following the outcome of the ‘Danish cases’ in the CJEU.

Luxembourg

Rutger Zaal suggested that it may be more interesting to talk about Luxembourg as an investment platform for real estate investments to other European countries rather than discussing investments into properties in Luxembourg. In the real estate investment market, there are both real estate funds and individual holding companies based in Luxembourg. When planning the platform, the issues referred to earlier by Jervis need to be taken into account; for example, when distributing funds, there is no domestic interest withholding tax. Another commonly used technique is to have multiple share classes that are redeemed in partial liquidation of the company, resulting in a zero withholding tax. In addition, based on recent case law, a repurchase of shares by the company from its shareholder is not deemed a dividend for withholding tax purposes.

Since 2019 Luxembourg has interest deduction limitation rules based on the EU Anti-Tax Avoidance Directive (ATAD 1) that disallow interest exceeding €3m or 30 per cent of the EBITDA. In structures set up in Luxembourg, typically shareholder loans granted by the Luxembourg company are financed with debt while the Luxembourg company has sufficient equity to cover its risks in relation to its financing activities. Generally, the interest deduction limitation rules should not apply to such financing activities, as the interest deduction limitation is aimed at so-called excessive interest expenses; that is, the excess of interest expenses over interest income.

There is a new tax treaty between France and Luxembourg, which has had surprising effect in French real estate investments through a holding company based in Luxembourg. The proposed changes of the German RETT rules (as mentioned by Engel) may affect Luxembourg-based structures. In addition, the United Kingdom's new capital gain taxation rules and Brexit will also affect Luxembourg-based holding structures. Finally, the signing and ratification process of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) will affect many Luxembourg-based structures.

Canada

Barbara Worndl noted that Canada taxes dispositions of ‘taxable Canadian property’ (TCP), which basically includes direct or indirect investment in Canadian real property, timber resource properties and mineral resource properties. Indirect investment generally means an investment through a corporation, trust or partnership where more than 50 per cent of the fair market value of the shares or interest is derived directly or indirectly from said properties. In the case of a disposition of a public entity-owning Canadian property, a non-resident needs to hold at least 25 per cent of the entity in order to be taxed. There is a 60 month ‘look-back rule’, so these rules cannot be circumvented by pushing cash into the entity prior to the sale. The tax rate on the capital gain on disposition depends on whether the property is treated as capital property or inventory. This determination is made based on common law principles. On a disposition of a TCP by a non-resident, the seller must obtain a clearance certificate from the government prior to the sale. In the absence of such a certificate, the purchaser must withhold 25 per cent of the gross sale price (in case of capital property) or 50 per cent of the gross sale price (in case of depreciable property or inventory). This mechanism allows the Canadian government to collect the tax from non-resident vendors of TCP. In practice, the certificate is generally not obtained prior to the date of the sale, and, as a result, the withheld amount is held in escrow until the receipt of the clearance certificate. Generally, the rate of tax payable by a non-resident corporation on the capital gain on the sale of TCP that is a capital property is only 12.5 per cent, or 25 per cent in the case of inventory. Rental income of non-residents is taxed in Canada without exemption under any tax treaty. This withholding tax on rental income can usually be managed with (head) leases of the property from the non-resident owner and a sub-let of the property to the third-party tenant. Provided that an election is made by the non-resident owner to file a Canadian tax return and pay tax in Canada on the net rental income (after deducting expenses including interest), the withholding tax payable by the Canadian entity on the head lease applies only to the net rental income and not to the gross rent.

Canadian real property investments are usually highly leveraged. This is due to the thin capitalisation rule (debt to equity ratio of 1.5 to 1) being the only restriction for interest deductibility. For the purposes of the thin capitalisation rule, only loans from specified non-resident shareholders (owning at least 25 per cent of the votes or value) are taken into account. For US shareholders, there is no withholding tax on interest payments and for other non-resident shareholders in most treaty jurisdictions, there is generally a ten per cent interest withholding tax. There is a 25 per cent withholding tax on interest payments to a person who is not entitled to the benefit of a reduced rate under a tax treaty.

Spain

Albert Collado described a typical ‘plain vanilla’ real estate investment structure where an EU-based fund invests into a Spanish real estate portfolio: the fund holds an EU-based holding company, which holds a Spanish holding company, which purchases Spanish property companies or establishes Spanish property companies, which will then purchase Spanish real estate. Spanish property companies obtain rental income on the properties they own. Rental income is subject to 25 per cent tax, as is the capital gain from the sale of assets. Capital gains on assets are also subject to local and indirect taxes. Spanish participation exemption rules may apply to the sale of the shares in property companies in cases where the rental activity carried on by the companies qualifies as a ‘business activity’. The law states that if there is at least one employee working full time on the rental activity then it should be deemed a business activity. However, it is not clear whether it is enough that there is one person dealing full time with the whole group's rental activities, or whether there should be one person for each of the property companies (and for anti-avoidance purposes, if the management of rental activities of a single property company is sufficient to qualify as a ‘full-time job’ for the manager).

Spain has 30 per cent interest barrier rules. However, unlike many other countries, dividends received (which are exempted income) are added to the basis for computing the 30 per cent threshold. In addition, there is an annual threshold of €1m calculated on a company-by-company or by a fiscal-unity basis. This must be taken into consideration when deciding whether or not to consolidate the Spanish group.

When considering dividend distributions by a Spanish holding company to an EU holding company it must be noted that Spain has tight anti-avoidance rules. In order to be able to apply zero per cent withholding tax to the distributions, there are three potential red flags to be considered: (1) there needs to be substance in the European holding company; (2) there needs to be a justification as to why this company is needed in the holding structure (business reasons other than tax?); and (3) the European holding company needs to be the beneficial owner of the dividends. If the EU holding company sells the shares on to the Spanish holding company in exit, there is currently a 19 per cent Spanish capital gain tax even if the rental activity is deemed a business activity, which should be considered discriminatory under EU laws.

To summarise, this structure is convenient for exit taxation, but there are some questions to bear in mind, including the justification for the property companies. Are they required to decentralise the risk or to obtain the participation exemption? Also, why a Spanish holding company? Is it, for example, to have managers to invest into a Spanish vehicle? Lastly, why is the EU holding company needed? EU-based alternative investment funds' and pension funds' exemption on interest withholding tax (if investing directly to Spain) now require regulator's certification of funds' status and funds' statement of whether or not they are transparent and to the extent they are transparent, the percentage of their investors that are resident in the EU.

United Kingdom

Jervis presented the UK real property investment taxation firstly from the point of view of a UK company. When purchasing an asset, stamp duty land tax (SDLT) is included in the acquisition cost. When up and running, rental income is taxed at the corporation income tax rate of 19 per cent (the proposed decrease to 17 per cent has been cancelled). The company can deduct tax depreciation (capital allowance), structures and buildings allowance and finance costs (restricted by the complex rules on hybrids and interest deductibility) from the taxable income. Dividend payments to the investors of the UK company are not subject to withholding tax while interest payments are subject to 20 per cent withholding tax (though it is possible to reduce the interest withholding tax all the way down to zero per cent under many of the double tax treaties concluded by the UK). Capital gains on sale of the property at exit by a UK company is subject to corporation tax of 19 per cent. The non-resident capital gain tax is levied also on non-resident sellers of shares in a UK property company. A typical structure used by tax exempts and private equity investors is a limited partnership, where the general partner holds the assets on behalf of the limited partner(s) based on the partnership agreement. The advantage is its flexibility; for example, one partner can be entitled to income and another to capital; and the carried interest can be easily facilitated. Limited partners are not entitled to participate in the active management of the partnership. The partnership is transparent for income tax purposes, so it is an attractive vehicle provided there is onshore management in the UK through the general partner. The main disadvantage is its liquidity. In addition, a transfer of a partnership interest may be subject to SDLT. Offshore property unit trusts (‘JPUTs’; as these are commonly established in Jersey) are a well-known vehicle type for ownership of UK properties. There were concerns that the non-resident capital gains tax would end these structures, but there is a possibility that JPUTs qualify as transparent entities for non-resident capital gain tax purposes, so non-resident tax-exempt investors may still hold UK properties through this structure.

The UK REIT is a well-known entity. REIT is exempted on income and gains. The new UK non-resident capital gain tax may make this entity even more popular as some tax-exempt non-resident investors (eg, offshore pension funds) can reduce the 20 per cent withholding tax on dividends through available tax treaty reliefs. Property authorised investment funds are the open-ended version of the REIT with limited tax leakage for exempt investors.

Case studies

Case study one - direct investment to a local property though a company in an EU jurisdiction

Engel mentioned that there are two important taxes to consider in this structure: (municipal) trade tax which ranges between seven per cent and 17 per cent (average 15 per cent) and is levied only where there is a PE in Germany. It is difficult to obtain extended trade tax exemption when leasing business fixtures. However, a mere leasing activity of German-located real estate is not considered a creation of a PE in Germany. Dividend withholding taxation is also avoided in this structure, provided that the foreign property company has a limited tax liability in Germany from it being a foreign company with no place of management in Germany. This requires that the majority of the day-to-day management decisions are not taken in Germany, and that it is not enough that formal managing directors of the company meet from time to time in the domicile country of the company and theoretically decide on some issues: it needs to be properly documented that day-to-day management decisions are taken outside of Germany. The local property managers' rights and obligations also need to be restricted. If this is not complied with -- for example, in relation to a property company in Luxembourg doing a partial liquidation -- the German tax authorities will deem the share redemption proceeds as a dividend subject to German withholding tax. The capital gain on the sale of shares in the EU property company would not be subject to German tax.

Collado pointed out that this is not a very typical structure in Spain, although it is becoming more common. The rental income, as well as capital gains on the sale of the property, is subject to a 19 per cent tax. Another advantage of the structure is the step-up in the acquisition cost of the property. The problem for a foreign company, whose assets are either mainly or entirely based in Spain, is tax residency. A decisive factor here is generally the seat of effective management, so it is vital to decide how this is organised and to make sure that everything is managed at the EU property company domicile jurisdiction. Another issue is whether a PE is created or not. As rental activity is deemed a business activity when at least one full-time person is dedicated to managing it, in this structure one needs to make sure that business activity is not created. Thus, management should be done by a sub-contracted third party. In larger groups' real estate investment arms, a separate regulated property manager company of the investment arm should qualify for this purpose. Some clients see the tax residency or PE risk in this structure as being less severe, as it increases the tax rate from only 19 to 25 per cent.

Zaal agreed that an EU property company (if domiciled in Luxembourg) would be taxed for rental income in either Germany or Spain. As discussed, it is essential to keep the management of the properties in these structures outside of the local country, which means that it should be in the property company's domicile country. In Luxembourg, there have been developments seen recently where there are people on the ground in Luxembourg, with an office, and regular board meetings attended in person. Significant effort is being made to ensure as much as possible that these companies will not be deemed to be managed in Germany or Spain but in Luxembourg; if successful, then both rental income and capital gains are exempted in Luxembourg (due to tax treaties with Germany and Spain). Typically, such property company is partly financed with debt. Under Luxembourg domestic law there is typically no withholding tax on interest payments, and the interest expenses would not be deductible (since the corresponding real estate income is exempted). When distributing profits, such distribution can be made either in the form of a dividend or by way of a partial liquidation or a share repurchase programme.

Case study two – investment through a Luxembourg platform

Zaal explained that, in this alternative, there are investors who invest in real property in different jurisdictions through a holding company in Luxembourg which owns local property companies in each jurisdiction. For Germany or the UK this structure is likely to be less attractive.

Worndl explained that this structure is not seen very often in Canada, as Canada taxes the Canadian property company approximately 13.25 per cent on the gain and there is also a dividend withholding tax. The WHT rate with Luxembourg is only five per cent, but there is uncertainty whether the benefits of this rate can be relied upon since MLI has come into force. In a recent case involving a Canadian company owning oil and gas properties, the shares in the Canadian company were sold by its parent company based in Luxembourg. The tax board in Canada held that there was an exemption for the capital gain in the tax treaty (for properties where the business of the company is carried on). The shares in the Canadian company previously had been owned by a US company, which had (internally) transferred the shares to the Luxembourg company. At the time of the transfer (prior to the start of drilling on the property), there was no gain, so no tax was paid on the transfer of shares in the US. The question in this case was whether the business of the Canadian company was carried out on the property and whether the general anti-avoidance rule would override that. Even if there were only five or six holes drilled on the property, the court held that the business of the company was carried on there, as it was the business of the company to find out whether or not the property had any valuable oil and gas assets. On the anti-avoidance point, the court held that transferring the shares of the property company to the Luxembourg holding company was not a misuse of the tax treaty and thus avoidance of tax, as the purpose of the tax treaty was to attract investment to Canadian resource real properties, and this was what was done by the investor and it was consistent with the purpose of the tax treaty. The Canadian courts generally have been generous in determining that treaty benefits will be available for investment structures through companies (typically in Luxembourg) owned by parties resident in a country other than that of the investment companies. The question in the future is will these structures be affected by MLI or the principle purpose test (PPT) and the introduction of treaties that say that treaties ‘cannot be used for treaty shopping’. The last thing to mention is that there is a land speculation tax for non-resident buyers with respect to residential properties in Ontario and British Columbia.

Hardy noted that this investment structure alternative is fairly tax inefficient from a US perspective. The local property company will be subject to 21 per cent corporate income tax on the disposition of the real property and the dividend distribution will likely be subject to withholding tax, depending on the applicability of the limitation of benefits clause of the tax treaty between Luxembourg and the US. Thus, it is better to have the local property company as either a branch of the foreign holding company or a domestically controlled REIT (not subject to tax on the operating income or gains). Second, if the Luxembourg holding company checks the box to be treated as a partnership for US tax purposes, the debt funding down to the property entity could be eligible for portfolio interest exemption if the ownership of the shareholders of the Luxembourg company would indirectly hold less than ten per cent of the local US property entity.

Case study three -- REITs

Hardy explained that REITs were adopted under US law in 1960 to facilitate the investments to real estate by portfolio investors without a burden of entity level taxation. There are certain rules: REITs must annually distribute 90 per cent of their taxable income; they must have at least 100 shareholders; and avoid the foreign personal holding company ownership concentration provisions. For the past 20 years these formal rules have been consistently circumvented and thus privately controlled REITs are now well understood and accepted vehicles in the US tax environment.

Jervis noted that in most jurisdictions that have REITs, the investments through that vehicle into real property work quite well in that particular jurisdiction, but problems arise when the REITs look to invest more widely. In the UK there are, however, some tax treaties that give taxation rights to the resident country of foreign publicly listed companies even if these are UK-property rich (such as Hong Kong, the Netherlands and Singapore). Thus, REIT investments into the UK from these countries may work quite well despite non-resident capital gains rules.

Collado noted that, in Spain, REITs have become very popular (75 registered). The REIT regime allows avoiding tax at the level of the company to the extent dividend distributed to shareholders owning at least five per cent of the shares in the REIT is taxed at an effective rate of ten per cent at least (otherwise the tax rate of the income of the REIT is 19 per cent). It is possible for a REIT to fully own another (unlisted) REIT with the same by-laws, allocation of assets and distribution obligations, and so on. It is also possible to have a foreign REIT or own a Spanish (unlisted) REIT, but the problem in that case is how to compare the similarity of the foreign (parent) REIT to the Spanish one. This can become particularly difficult in situations where the parent REIT's jurisdiction does not require public listing of the vehicle.

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