Pension funds in Britain might envy the flexibility in property investment enjoyed by their counterparts in the Netherlands.
They will be particularly aware of the differences now that the new Labour government in Britain has used its first Budget at the beginning of July to make radical changes to the corporate tax system.
By contrast, look at the recent moves by Dutch public sector workers' pension fund, ABP - the world's second largest, with funds under management of well over Fl 200bn ($96.1bn). Newly independent from direct government control, the fund is reducing its investment in fixed-interest securities, which used to account for around 90% of the total, and aiming for higher returns by increasing its exposure to equities and to property. The property proportion, previously around 6%, is now up to 8% and set to rise to 10% over the next year or so.
But ABP will not be achieving this shift simply by buying properties. Rather the reverse. Its future property investment is likely to be indirect rather than direct. The process was underlined in 1995 when it decided to transfer directly-owned properties in the Netherlands into subsidiaries, specialising respectively in retail, office and residential real estate. ABP's overseas property exposure is already represented partly by a 12.5% stake in Fl 13bn property company Rodamco (the former open-ended property investment fund), and it also has direct minority stakes in Rod-amco's European and North American operations plus other stakes.
This indirect property exposure via a range of vehicles has its advantages. Risks can be spread by bringing other investors into the different vehicles. Local expertise can be acquired by joint ventures with local partners. Property exposure in specific areas can be increased or reduced not only by buying or selling properties, but by adjusting the stakes in the different vehicles.
This flexibility is possible only because investment companies such as Rodamco enjoy total tax transparency. Whether ABP owns a property direct or via a stake in a corporate body such as Rodamco, the income from the property flows through to ABP without prior deduction of tax.
The British pension funds have been denied this level of flexibility by the UK corporate tax regime. They do own shares in listed property companies. But it is unlikely to be a tax-efficient investment route.
The problem stems from the imputation" system of corporate taxation in the UK. Ahead of the Budget, domestic companies paid corporation tax of 33% of their taxable profits. They also had to account for tax at a rate of 20% on the dividends they distributed. But this tax on dividends, effectively paid on behalf of the shareholder and known as Advance Corporation Tax (ACT), could be offset against the company's own corporation tax charge. And shareholders who were not liable to tax -- like approved pension funds in the UK -- received a tax credit with their dividend which could be used to claim back from the taxation authorities the tax that had already been paid by the company in respect of the dividend.
Confused? An example helps. Suppose a listed company earned profits of £100m on which it paid corporation tax of 33% or £33m. That left profits available for distribution of £67m. And assume (though it would be unlikely in practice) that the company distributed the whole of that £67m by way of dividend.
The company had to pay ACT of 20% on that dividend. On £67m, that amounted to £16.75m. Why? be-cause £67m plus £16.75m equals £83.75m. And £83.75m is the sum before tax that would leave £67m after tax at 20%. The company could, however, offset that £16.75m of ACT that it had paid on the dividend against its corporation tax liability of £33m. So the sum went like this: Corporation tax due: £33.00m; less ACT already paid: £16.75;-Leaves mainstream corporation tax to pay: £16.25
Now take the argument a stage further and assume that the shareholders in the company were all pension funds which might therefore, collectively, claim back the whole of that ACT of £16.75m paid on the dividends of £67m that they received. Their total receipts would have been £83.75. Put another way, if a company in which they invested distributed the whole of its profits in dividends, the most the pension funds could have received was 83.75% of whatever the company earned before corporation tax. The remaining 16.25% of the company's pre-tax profits was permanently lost in mainstream corporation tax.
Next, assume that the company in question was a property company which derived all of its £100m pre-tax revenue from rents on investment properties that it owned. If our pension funds owned those properties direct, the whole of that £100m of rental income would have flowed through to them without deduction of tax. But if we had a two-stage ownership process, with the properties owned by a company and the pension funds owning that company as shareholders, the most the pension funds could have received from that £100m of rental income was £83.75m.
That was bad enough. But the latest UK Budget has abolished at one stroke the pension funds' right to claim back the tax that had been paid on dividends. At the same time it has marginally reduced the corporation tax rate from 33% to 31%.
So a pension fund that owns properties direct still receives £100 for every £100 of rental income from the properties. But it receives a maximum of £69 per £100 of rents from properties held via a company.
UK pension funds will find it far more difficult than their Dutch counterparts to spread their property risk via participations, joint ventures and the like, and more complex (and probably less satisfactory) risk- and profit-sharing structures will have to be devised.
Michael Brett is a freelance journalist and author of "Property and Money""