Chancellor stamps on special purpose vehicles
The UK’s chancellor, Gordon Brown dealt out a major blow to the UK property market in his Budget. As a result, this month will be a bumper one for transactions as investors work to conclude deals before the Finance Bill gains Royal Assent (expected to be mid to late July) when his changes take effect. After this date the main route for avoiding Stamp Duty at 4% will be closed and all purchasers will have to bear this burden – until a new approach is devised.
Stamp Duty is a transfer tax, payable by the buyer when a property is bought. All European countries levy such a tax. However, the rates vary from a nominal $175 (E181) in Russia to a prohibitive 12.5% of the purchase price in Belgium. In fact, where the rate is high, as in Belgium, there is a very strong incentive to avoid it and this is regularly done by holding properties in a special purpose corporate vehicle and transferring shares in the SPV. This may avoid all transfer taxes but creates significant complexity and a liability to embedded taxes within the SPV. But this is worthwhile where the immediate tax savings are significant.
Tax avoidance schemes for Stamp Duty were rare in the UK until Gordon Brown became Chancellor. He increased Stamp Duty steadily from 1% in 1997 to 4% by 2000 and this created a vibrant market for tax advice in this highly specialist market. Stamp Duty is an unusual tax in that it is levied on the documents implementing a transaction, not the transaction itself. This has made tax avoidance schemes relatively easy to devise. However, Brown also announced a fundamental reform of the Stamp Duty regime which will turn Stamp Duty into a tax on transactions and may also impose a 4% charge on substantial disposals of property rich companies or limited partnerships. These changes, which are subject to consultation, will not come into effect until Autumn 2003 at the earliest. This is a clever way to discourage further tax avoidance schemes because the tax authorities will probably be able to examine the substance of a transaction, not just its form, under the new rules while, in the meantime, investors don’t know what the new rules will be!
Property investors are estimated to have obtained savings of £600m (E932m) pa from avoiding Stamp Duty since the rate rose to 4%. But the UK Inland Revenue is much less tolerant of these things than their continental European counter-parts. When the French levied transfer taxes at close to 20% on property transactions, most deals were done through SPVs at 4.8%. Instead of closing the loophole, the French government chose to reduce transfer tax on all transactions to 4.8%. If the same thing occurred in the UK, Stamp Duty would be levied at 0.5%.
So what should investors in UK property do? No doubt some accountants and lawyers are working on new tax avoidance schemes as you read this; but avoiding tax on documents is much easier than a tax on transactions, where the substance of the deal can be identified. Most institutional investors will be reluctant to use avoidance mechanisms unless their success is virtually guaranteed. Furthermore, if the deal is challenged, it is crucial that the matter can be rectified quickly without a penalty and without adverse implications for business reputation.
Investors can avoid transfer taxes by investing in real estate through the public markets and in private indirect vehicles. No transfer costs are levied on such deals in Europe except the UK and in Ireland at 0.5% and 1% respectively. Many investors outside Benelux and Switzerland are sceptical about the public markets as a sensible route for real estate investment. My colleague Chris Saunders and I did demonstrate in IPE’s January edition that this is incorrect, but, notwithstanding, the diversification benefits in a multi-asset portfolio are greater from investing in the private markets.
In any event, public market and private fund investment only obscures the problem, they do not avoid it. Transfer taxes are still paid at the corporate /fund level when properties are acquired. There is only true avoidance if the portfolio invested in remains static, ie, no properties are added to it or sold from it. This is hardly realistic assuming more than core returns are required, except possibly for a shopping centre fund.
Transaction costs are a significant issue for property investors everywhere. Fees and notaries costs are typically add 150-300 basis points to the deal, in addition to the transfer tax. When these other costs are taken into account, UK property investors still have one of the lowest transaction cost regimes in Europe. But this is partly because the UK has the most liquid market. According to Jones Lang LaSalle, 43% of all property investment transactions in Europe occurred in the UK during 2000/1. On a market capitalisation basis, the UK’s share of the European market is 16%. The liquidity in the UK market is at risk from recent increases to Stamp Duty and the toughening of its enforcement. The 4% rate is especially onerous for debt-driven purchasers because it is a much higher proportion of their equity stake. And these leveraged buyers have been an important source of liquidity at times when the institutional investors are not so keen on property.
Gordon Brown’s proposals do contain a thin silver lining deep in the small print, but even that may turn out to be a mirage. Transactions below £150,000 in areas in need of regeneration were exempted from Stamp Duty in 2001. It turns out that these exempt areas are much more extensive than a cynical property industry had expected and include some relatively attractive areas, eg, Kings Cross in London. However, the European Commission has objected to the exemption because the locations do not accord with EU approved areas for regional assistance and so constitute illegal government aid! It may be another 18 months before we learn whether this objection will be sustained. Clearly, Stamp Duty will continue to be a topic of great interest to UK property investors for sometime to come.
Robin Goodchild is European director at
LaSalle Investment Management, in London