One of the major changes in real estate investment in recent years has been the gradual but seemingly inexorable move from direct to indirect investment, particularly by institutions. Although a significant element of this investment has been into purely domestic property vehicles, each year sees further pan-European fund offerings targeted wholly or partly at institutional investors. Although the majority of these funds are still opportunity funds targeted at US institutions, they are starting to attract European institutions as investors. Furthermore, many fund managers are now creating vehicles targeted at European institutions. In terms of the very largest transactions, the pan-European funds are perceived as dominating the market.
One of the key problems faced by institutions is comparing and assessing the tax, legal and regulatory framework of the variety of structures on offer from the different fund sponsors. At first sight, there would appear a plethora of options available. In reality though the funds are generally assembled using the same building blocks. Successfully structuring a pan-European real estate fund requires a three-tier approach – addressing investor issues, structural issues and local country issues.
At the investor level, the first stage of the approach focuses on creating a fund vehicle that is attractive to the anticipated investor base from a tax and regulatory perspective. Investor issues include familiarity, flexibility, the entity’s ability to accept investors’ capital, regulation and taxation. In practice, it is highly unusual to achieve a result that is equally attractive to all expected investors and structuring at this level is usually a process of managing conflicting investor demands. Sophistication can be added by the use of parallel fund vehicles or feeder structures tailored to particular classes of investor. Regulatory issues for investors, such as the ERISA rules that regulate investments by US pension funds and the VAG rules that impose restrictions on German insurance companies, can have a major impact on the structure selected, from the fund vehicle right down to the asset level. Typically, property fund structures in the market promoted by European sponsors comprise of one main fund vehicle perhaps with additional feeder vehicles, whilst the funds offered by US sponsors have favoured multiple fund vehicles for different types of investors.
From a tax perspective, it is important for investors that profits received by the fund are not subject to tax; either in the fund vehicle itself or by withholding tax on distributions made. To achieve this funds are typically structured as tax exempt (such as a Luxembourg SICAF or an entity in a tax haven such as Jersey) or as a tax transparent vehicle (such as a UK limited partnership or a Luxembourg FCP). The use of tax haven entities has largely fallen out of favour as they are unattractive to many investors and create very significant problems. For example, if investments into France are envisaged the use of tax havens can give rise to an annual tax of 3% of the gross value of the real estate each year. Although there are potentially ways of structuring this, they are complicated and tend to leave a trail of problems on exit. It is far more common for funds to be structured as tax transparent vehicles. Generally these have been in the form of limited partnerships (US, UK, Dutch or German) or as contractual fund vehicles such as the Luxembourg FCP. The latter has the advantage that similar fund legislation exists in other European jurisdictions and may therefore be attractive to investors that have a problem investing in partnerships, such as French investors. Luxembourg is the location of choice for these holding structures. From the point of view of the sponsor, a key disadvantage of the FCP is that it is a regulated vehicle under the supervision of the CSSF in Luxembourg. Many investors see this as an advantage rather than a drawback, although it does have administrative and cost implications.
Until now, the sponsors’ ideal vehicle: an unregulated, tax transparent fund vehicle in Luxembourg, has not been available. This has potentially changed. On March 9 this year, Luxembourg passed a law creating the framework for a new securitisation vehicle that may either be a corporate entity or a tax transparent fund in form. Provided that it is issued by private placement the vehicle will be unregulated. The definition of ‘securitisation’ is widely drawn, and investors should not be surprised if they soon see funds structured to take advantage of the new regime, either as a fund vehicle or a holding structure.
The second tier is dealing with structural issues. These arise from the fact that the fund vehicle itself is typically tax exempt or tax transparent. Whilst this is useful in terms of minimising entity level taxes and taxes on distributions to investors, it has certain drawbacks. Typically, these entities will not be eligible to benefit from any bi-lateral double tax agreements. In addition, they will not be able to benefit from the European Union parent/subsidiary directive, which provides for the payment of dividends free of withholding tax between companies within the EU. Overcoming this is usually achieved via a taxable sub-holding company, often in Luxembourg, which benefits from treaty access or the EU directive. Luxembourg has a key advantage over other jurisdictions due to the variety of tax planning opportunities for the repatriation of funds to investors. It is important to note that many of these planning tools were developed for opportunity funds and tend to focus on capital gains rather than income. There is no “one-size-fits-all” approach, and core plus and income funds typically require more complex planning. Investors should question the sponsors to ensure that the structuring at this level is appropriate to the type of fund rather than simply something with which the sponsor is familiar from past experience.
In order to benefit from the European Union Parent/Subsidiary Directive and double tax treaties to eliminate withholding tax on dividends, and to eliminate capital gains on the disposal of shares, the tax authorities where the subsidiary is located typically require that the parent company has substance and it is not a mere conduit. This entitlement to tax protection is fundamental to the tax efficiency of the structure. The requirements for substance are determined by the tax rules in the country where the subsidiary is located. As such it is determined by the countries in which investments are to be made. The case is easier to make when the two key parts of the structure are in the same country. Although there are distinctions between real estate and other investment assets at the fund level, it is at the local level that the fundamental differences appear. In general, investment in securities involves limited direct exposure to the tax regime where the asset is located. This is not true for real estate, for two reasons: Firstly, most countries have very specific, and often complex rules for the taxation of real estate. Secondly, double tax treaties leave taxing rights with the state in which the property is located.
As a result, investors must pay much closer attention to local tax laws. Depending upon the type of fund and the expectation of investors, the fund sponsor may need to put a significant effort into determining the appropriate local holding structures and tax consequences prior to establishing the fund.
John Forbes is a tax partner at PricewaterhouseCoopers in London and leads the firm’s UK Real Estate Tax Practice