When tax rears its ugly head
Sponsors of real estate funds are charged with structuring funds to suit their investor base. The desired tax position for a tax exempt institutional investor when appraising a real estate investment opportunity will usually be effective tax transparency. Can the investment be structured in such a way as to ensure that the favourable tax exemptions enjoyed in domestic regimes are achieved in cross border investments?
Funds will often be marketed to a wide investor base, meaning that compromises may have to be made along the way. Tax treaties and EU directives may go some way to assisting in structuring investments in a tax efficient way. However, the thin capitalisation legislation rolling out across Europe, coupled with historically low interest rates will often counter these benefits, resulting in a deviation from the ideal position. Whatever tax harmonisation programme is pushed forward by the EU it is very unlikely that it would go so far as to extend an exemption from tax in one jurisdiction to another so these issues look set to remain, at least in the medium-term.
However, just as tax regimes can be a barrier to investment, they can also act as an enabler, funnelling investment into certain areas. For example, by exempting non-resident investors from tax on capital gains, the UK enjoys healthy inward investment in real estate. The political and economic ramifications that would result if the exemption were to be abolished have meant that no government has ever been able to seriously consider removing it. Elsewhere, German and Dutch funds have invested heavily in US real estate since the late 1970s - the German and Dutch tax treaties with the US provide an exemption from withholding taxes paid by US REITs to investors in these jurisdictions. Of course, much of the investment would have happened anyway, driven by wider economic and commercial objectives, but there is evidence that the favourable regimes have helped stimulate investment further.
Conversely, many commentators argue that locations such as Russia should be prime locations for inward investment. So why aren’t European funds piling in? Whilst a significant factor must be the uncertainty as to how the Russian economy will develop, the returns are just not as safe as elsewhere - the legal system does not help and can contribute to the level of risk perceived by the fund sponsor. The tax and legal frameworks are not codified sufficiently to provide a level of comfort which is taken for granted by fund managers more used to investing in other, more established, jurisdictions, and it is a commonly held perception that local knowledge is a prerequisite for successful navigation to complete a deal. Similar issues apply to the new eastern European members of the EU. Can an institutional investor expose itself to this uncertainty and risk?
The Far East is another market which at the current time has the potential for higher returns than western Europe. However, the tax systems in these regions often do not address issues which are important to inward investors – for instance, the lack of tax consolidation regimes in many jurisdictions means that structuring to achieve effective tax transparency is often impossible. Like Russia, the legal system in the Far East is still relatively speaking – in its infancy, tax legislation is not highly evolved and there is a dearth of case law to support the legislation that does exist. These factors build a barrier to cross border flows.
Richard White is tax partner with Ernst & Young’s Real Estate Hospitality & Construction Group, and Max Probent is a senior consultant