Though Germany has the largest fortune of real estate in Europe, only a small portion of those assets are held by real estate companies listed on the stock exchange. Real estate investment trusts (REIT) have been established successfully in North America, as well as in Australia, Japan and Singapore, as efficient, tax-transparent investment vehicles, yet only four of the 20 eligible countries of the European Union have clear, tax-efficient REITS in operation: the Netherlands, Belgium, France and Italy, which utilizes a hybrid structure. Somewhat surprisingly, the two largest economies in Europe, the UK and Germany, are still missing from that list.
Comparing Germany with other developed economies there is still an unsatisfied demand for opening real estate investments to the listed market. The German property industry has been lobbying for German REIT legislation for the past two years. A taxefficient structure would be a new investment vehicle for the German real estate market, attracting both domestic and foreign investors. An analysis prepared by the German Centre for European Economic Research (ZEW) and the European Business School (EBS) estimates that $140 billion of corporate and $130 billion of unleveraged residential real estate could be spun off into German REITs. The Initiative Finanzplatz Deutschland (IFD), a key lobby group for the creation of German REITs, similarly estimates that $150 billion of property assets could be floated by 2010. A study released by HSH Nordbank AG forecasts that up to 20 percent of investments in the German real estate market could fall to investments in German REITs.
The UK will introduce REITs on January 1, 2007. If Germany wants to compete with the other European markets, it will have to move soon. The new German government, formed as grand coalition by the Social Democratic Party (SPD) and the Christian Democratic Parties, had previously agreed that a German REIT regime would be introduced beginning in 2007. Whereas the UK recently published its draft legislation as part of its 2007 budget, the German government has yet to release any proposal concerning the shape or structure of the German REIT. Last year, a group of experts were put together in order to propose their concept. The competent governmental departments are still working on the project.
If Germany wants to compete with the other European markets, it will have to move soon.
What difficulties are hindering the introduction of German REITs? There are many, but the primary issues are political and taxrelated. Not long ago the political discussion regarding REITs in Germany was only positive. Since April of this year, however, some parliamentary members of the SPD have begun to mount opposition—in a nod to comments made last year by Franz Müntefering regarding private equity firms, a paper on German REITs published last month by the Social Democrats was titled “Locusts on the Doorstep?” The paper, along with the public statements of certain SPD lawmakers, suggests that REITs could have a negative impact on German residential tenants. They argue that more housing units would fall into the hands of private equity funds who would bump up rents in order to maximize profits before listing their investment vehicles on the public markets as REITs. Furthermore, they are expecting significant tax losses from the introduction of REITs and fear that the market for the existing open-ended real estate investment schemes could be endangered.
Not all of these objections are legitimate. Foreign investors as well as private equity funds will buy German residential property irrespective of whether German REITs are introduced. Furthermore, German tenants of residential property are wellprotected against inappropriate rent increases by the law. Additionally, one should expect that German REITs would focus primarily on investments in the commercial property market.
Tax losses should also not be expected from companies joining the REIT regime. The introduction of these vehicles would in fact have the opposite effect if the entry tax on hidden reserves is moderate.
The Initiative Finanzplatz Deutschland estimates that $150 billion of property assets could be floated by 2010.
Finally, one cannot assume that the market for open ended real estate funds will be damaged. Certainly, a portion of the investments in property assets will move to REITs, but the two structures differ significantly in their characteristics. REITs provide the advantage that investors can sell their investment over the stock exchange whereas open-ended investment schemes have to redeem the investment units from their investors. Accordingly the investment schemes have to provide liquidity for that redemption and are sometimes forced to sell property simply for this reason. Yet despite these differences, both structures should be able to find their place in the market.
DEATH AND TAXES
It should be possible to clear up the illegitimate objections against the introduction of the German REITs, particularly since the lawmakers in favor of the structure still have the continued support of the German finance minister. However, the tax issues involved are the critical area of discussion and need to be solved. Whether this new regime will be attractive for investors depends almost entirely on the tax structure of the investment vehicle. Looking to the well established REIT markets in foreign countries, one concept is clearly predominant: REIT profits will only be taxed at the level of the individual investor, not at the level of the REIT itself. Implementing this concept in Germany will not be a problem if the investor is tax resident in Germany. But how can Germany introduce a REIT without a loss of tax revenue if the investor is a foreign entity?
A withholding tax on distributed REIT profits would be an appropriate method. The withholding tax levied by the REIT will be credited against the personal income or corporate income tax due from the REIT investor. The distributions of profits by a listed German company generally qualify as dividends, which are taxed at a lower rate. Therefore, profit distributions from REITs must be re-classified from regular dividend income to real estate income in order to ensure the full taxation on the level of the REIT investors.
For investors who are tax resident of Germany, this should be straightforward. However, the enforcement of this arrangement is affected if non-resident investors can utilize double tax agreements in order to reduce German withholding tax. The double tax agreements generally provide a reduction of withholding tax on dividends to 15 percent; furthermore, treaty protected nonresident corporate investors can often reduce German withholding tax to 5 percent or even to zero if they hold more 10 percent or of a company, in this case the German REIT.
Because of this treaty framework there are fears that non-resident investors would structure their participations in German REITs such that Germany loses withholding tax. This is what happened to the French exchequer when the government introduced the French REIT (SIIC) several years ago— non-resident investors were able to reduce French withholding tax by the utilization of the French double tax agreements. The best option to avoid such tax leakage would be the amendment of all German double tax agreements and the adoption of a provision that is already implemented in the double tax agreement between Germany and the US: The country where the REIT is located keeps all rights to tax distributions of REIT profits without any limitation of the withholding tax. However, since the amendment of double tax agreements is a time-consuming and tedious procedure, this concept is currently impracticable.
In general, German double tax agreements do not limit the right of Germany to tax income and capital gains deriving from real estate located in the German territory. Given that background, two alternative models are currently being discussed for the German REIT: the segregation model, favored by the Initiative Finanzplatz Deutschland, and the so-called single company model. Both structures are designed to reclassify the distributed REIT profits as real estate income rather than dividends. The segregation model provides a separate trust asset pool, which holds all the properties in the REIT and is legally owned and administered by the REIT company. The participation in the REIT comprises the shares in the REIT as well as the units of the trust asset pool; both securities can only be owned and transferred jointly. Since distributions are only made from the trust asset pool, they cannot be qualified as dividends as defined by the double tax agreements. In the single company model, the REIT would consist only of the listed company. A legally binding claim for the distribution of REIT profits, or the implementation of a so-called right of use, shall prevent the classification of REIT profits as dividends. In both models, the distribution of REIT profits would qualify as real estate income, meaning that the German government has the unlimited right to impose withholding tax.
Not long ago the political discussion regarding REITs in Germany was only positive. Since April of this year, however, some parliamentary members of the SPD have begun to mount opposition.
It is still uncertain which model will be picked up in the draft legislation. The government's proposal could be a surprise in that neither model will be recommended. The implementation of the segregation model is rather complicated and would require a lot of explanation, particularly for international investors who are used to straightforward REIT regimes with a single company. Yet it is still unclear whether the modified single company model will actually solve the withholding tax issues connected with Germany's double tax agreements. Since the plans of the UK government have been introduced, which call for a single company model, it seems reasonable that Germany will adopt a similar construct.
The issue of taxing foreign investors would be solved then, as it is in the UK proposal, by preventing any one investor from owning 10 percent or more of the REIT. Nevertheless, pursuant to the UK model, failure to comply with this requirement will not mean that the REIT status is lost. Instead, the REIT itself will be taxed on the proportion of its income payable to the relevant shareholder.
However, there are still concerns. A 10 percent threshold could prevent property companies from converting to REIT status since it may be difficult to place shares in the capital markets without allowing some investors to hold bigger stakes. And some companies could have legitimate reasons to hold a larger portion. Divergent from the proposed UK model, the German REIT regime could allow a company to hold more than 10 percent through indirect participation as long as each group company holds directly less than 10 percent.
In addition to the tax issue surrounding foreign investors, the introduction of a German REIT will only be successful if property-owning companies are not taxed too heavily when they convert to REIT status. All foreign REIT concepts provide that the hidden reserves, i.e. the difference between the higher market value and the underlying book value, must be taxed. France is providing a reduced corporation income tax on hidden reserves at a rate of 16.5 percent. The UK will probably introduce a conversion charge equal to 2 percent of the market value of the investment properties at the date the company joins the REIT regime. For the German REIT, the IFD has proposed that hidden reserves shall be taxed at half the regular rate of German corporate income and trade tax. Accordingly the conversion tax rate would be in the range of 18 percent to 20 percent.
Another hurdle for the successful introduction of the German REIT is the German real estate transfer tax. If a company wants to prepare its properties for the conversion to a REIT, they will have to transfer such properties to a separate company. Such a transfer would trigger a German real estate transfer tax of 3.5 percent on the value of the property. In order to provide the proper incentives, the German government should seriously consider abolishing this transfer tax if the company in question is planning to become a REIT.
It is the hope of the German property market that REITs will be introduced by 2007. The German government supports this project and it should be possible to clear up concerns among members of parliament. As in France and the UK, the key issue will be finding a competitive REIT regime with the right balance between encouraging tax-efficient property investment and limiting loss of tax revenue. Comments on the UK's proposal suggest that the UK government has got this broadly right and it seems reasonable that Germany will adopt the 10 percent threshold for REIT ownership. The market is eagerly waiting for the initial draft legislation. Its presentation to the public is expected within the next couple of weeks.
Dr. Michael Kreft is a partner at SJ Berwin LLP in the firm's Munich office.