Maximising alpha: where tax fits in
Why is this an issue? At first glance, it may seem odd to consider tax in the context of the risk-adjusted return for an investment. However, in determining how far the actual return from an investment exceeds the expected return for a particular level of risk, tax is one of the least considered or understood elements of the risk. How far is the return driven by tax risk, and is the tax risk commensurate with the all the other risks associated with the investment?
In order to understand the significance of tax, we need to first consider four key changes that are currently driving the real estate industry. The first is increasing volume. Markets are currently driven by weight of capital. We need to look at the impact of demographic change and the effect that has on pensions provision globally. The consensus view appears to be that the allocation of pensions money to real estate as an asset class will grow significantly over time. The money has to find a home, which is the driving force behind the other major features of our industry at the moment.
We need to consider the impact of the increasing importance of cross-border capital flows. We are now a truly global real estate industry. US pension funds are huge indirect investors in Europe. Europe is also bracing itself for another huge influx of Australian money.
We need to consider the impact of the increasing importance of indirect investment, including the huge shift from direct investment. The growth of real estate funds over the last 10 years has been spectacular. In the UK, real estate funds overtook the quoted sector in terms of total assets at the end of 2002 and the trend continues. The funds themselves are changing. They are becoming bigger, more global and moving down the risk-return spectrum. Ten years ago, or even five years ago, what people aspired to was a pan-European closed-ended real estate opportunity fund. Now it's a global open-ended core fund.
The final key trend is increasing complexity. Investors are innovating in their search for ways to maintain returns. They are experimenting with new countries, such as the emerging markets of central and eastern Europe or India and China. They're experimenting with new asset types, property-rich operating businesses, infrastructure investments or the grey area between debt and equity through mezzanine loans, securitisation and property derivatives. They are experimenting with new vehicles, with the increasingly complexity of funds and also through the opportunities created by the expansion of REITs in Europe and Asia.
Is the tax risk associated with new markets and new products being considered properly? An alternative reaction to the pressure on returns is to move into lower risk but lower return funds (‘core' and ‘core plus' or ‘value-added' funds), some of which, in the case of recent launches, have been open-ended or listed vehicles. Has the tax position also moved down the risk / return spectrum to match the fund?
What has this meant in terms of the ways that funds are structured, and what is the significance in considering tax risk?
One of the results of the expansion in the range of funds, and in particular the expansion of the core and core-plus segments of the market, has been the development of a large variety of structures apparently on offer from different fund sponsors. This is very different from the traditional real estate opportunity funds model. Within the opportunistic sector, fund structuring has tended to follow the private equity model. The basic structuring is now well known, and there is limited upfront "below the fund" structuring. On the other hand, the transactions have become increasingly highly engineered and complex.
In terms of structuring the complexity tends to be in the deals rather than the funds. In the core and core-plus segments of the market, the transactions have been, as would be expected, more straightforward and lower risk. The fund structuring has become significantly more complex.
A key problem faced by the investors is comparing and assessing the tax, legal and regulatory framework of the different fund structures on offer. Although, at first sight, there would appear to be a plethora of different options available, in reality the funds are generally assembled using fundamentally the same building blocks. Successfully structuring a cross-border 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 three-tier approach, the focus is in creating a fund vehicle that is attractive to the anticipated investor base from a taxation and regulatory perspective. Investor issues include familiarity, flexibility, entity's ability to accept investors' capital, regulatory and taxation issues - if any - in the hands of the investor. In practice, it is highly unusual to achieve a result that is equally attractive to all the 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. The last year has seen this type of planning taken to a new level through the use of vehicles with separate cells for different classes of investors, with the cells providing a tailored tax and regulatory treatment for the investors in the cell. Regulatory issues for investors, such as, for example, 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. As funds have become larger, managers have sought to attract a broader range of investors from a wider variety of jurisdictions. This has added to the impetus to create more tailored vehicles to provide the optimal tax treatment for investors.
One particular development from this has been that the interest in creating structures for investment by high net worth individuals has attracted the attention of executives at fund managers resulting in much greater attention being paid to the structuring of carried interest and co-investment arrangements so that the managers also achieve a better post-tax return.
In terms of choice of fund vehicle, the key determining features are generally the tax and regulatory treatment. 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 by the fund. In order to achieve this, funds are typically structured as tax exempt (such as a Luxembourg SICAV 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 as fund vehicle has largely fallen out of favour for European funds, as they create very significant problems if investments into France are envisaged as 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 around this, they are complicated and tend to leave a trail of problems on exit. Generally, these have been associated with older funds.
However, the changes referred to above have seen a revival in the use of tax haven entities. Entities traded on a recognised stock exchange are exempt from the French 3% tax, so avoiding this issue even if the company itself is located in a tax haven. For example, the AXA Property Trust, which was launched in 2005, is a Guernsey company listed on the main market of the London Stock Exchange. The 3% is particularly a problem associated with France (although it should be noted that Greece has a very similar tax). Funds investing outside the EU, for example, in Asia, have not been constrained by the tax and therefore tax haven entities have been more widely used as the fund vehicle.
For the reasons discussed above, 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 funds legislation exist in other European jurisdictions and it may therefore be attractive to investors that have a problem investing in partnerships, such as French investors.
There is a further advantage, discussed below, in having the fund vehicle and the holding structure beneath it located in the same jurisdiction. Luxembourg is the location of choice for these holding structures. From the point of view of the sponsor, a key potential disadvantage of the FCP is that it is a regulated vehicle under the supervision of the CSSF in Luxembourg. Some investors see this as an advantage rather than a drawback, although it does have administrative and cost implications. Regulated vehicles have proved popular for core and core plus funds, and for funds offered on a retail basis to the public.
The second tier of the three-tier approach 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 bilateral double tax agreements which their country of domicile may have that reduce or eliminate taxes on interest, dividends and share sale gains. In addition, for funds investing in the European Union, they will not be able to benefit from the EU Parent/Subsidiary Directive, which provides for the payment of dividends free of withholding tax between companies within the EU.
Overcoming this is usually achieved through the use of a taxable sub-holding company, usually in Luxembourg, which benefits from access to treaties and the 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 therefore tend to focus on capital gains rather than income.
There is no "one size fits all" approach, and core, core plus and income funds typically require more complex planning. In order to benefit from the 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 (for example, offices and employees) and is not a mere conduit. Entitlement to tax protection under double tax treaties and the directive 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.
Although there are distinctions between real estate and other investment assets at the fund level, it is at the local level, the final tier, 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:
q most countries have very specific, and often complex rules for the taxation of real estate; and
q 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 might need to put a significant effort into determining the appropriate local holding structures and tax consequences prior to establishing the fund.
So what is the conclusion to be drawn from this? The fundamental point is that tax risk needs to be matched to other risks, so that the tax risk being taken is consistent with the nature of the fund, the nature of the investment and the nature of the investors. Because of the nature of the funds and the approach that this entails, the complexity, main benefit and thus also the risk can be expected to be found in different aspects of the fund. In core funds investors should concentrate on the fund structure, in opportunity funds concentrate on deal structure.