Tuesday 28 March 2017

Finance Bill fuels debate on commercial real estate

1 Sir John Rogerson's Quay, which is currently being developed by Hibernia REIT
1 Sir John Rogerson's Quay, which is currently being developed by Hibernia REIT

Donal Buckley

Government efforts to close the tax loophole enjoyed by some property tax investors could either create a property tax bubble or add the brakes to an already slowing market. The only certainty seems to be that the Finance Bill changes will generate lots of work for tax consultants trying to unravel how their clients could be affected.

Stephen Donnelly TD believes that the new tax regime in the Irish Real Estate Funds (IREFs) contained in the Finance Bill currently going through the Oireachtas will serve to inflate prices, especially in the office sector.

Other commentators within the property sector, however, say that even before the new tax regime was announced that the commercial property market was already showing signs of cooling. Furthermore, some argue that the new tax regime is likely to deter some investors and this will further slow the pace of growth and could affect the prices that such investors are willing to pay.

The key aspect of the Finance Bill is that certain funds with 25pc or more of the market value of their assets related to Irish land will automatically become IREFs and payments from these funds will be subject to a 20pc withholding tax.

Mr Donnelly says the Finance Bill proposals would make almost all real estate investment tax-free for institutional investors. Furthermore, IREF grants full CGT exemption, once property is held for five years and grants full withholding tax exemption for a majority of investment classes.

The Government, on the other hand, sees the changes in the Finance Bill as being designed to foster long-term investment vehicles rather than those who flip properties in the short term for capital profit.

A spokesperson for the Department of Finance points out that: "Although a gain may be exempt where the property is held for more than five years, tax will still be payable on the rental income that is being generated. This will, in the longer term, lead to a more sustainable, secure, property market for both investors and property tenants whilst generating regular and reliable tax revenues for the Exchequer, from the taxation of the rental profits.

"Where an investor has influence or control over the IREF, they will not be eligible for the capital gains tax exemption. The proposal has been drafted in a balanced way to ensure that the Irish tax base is protected where Irish property transactions are taking place within collective investment vehicles whilst not damaging the commercial property market in the long term. This proposal is not a tax incentive for people investing in commercial property and will not create a commercial property bubble as claimed. Under the proposal, payments from the IREF made to non-resident investors will be subject to a 20pc withholding tax."

Mr Donnelly says, however, that he has been advised that a recent Government amendment to the Bill will apply the IREF withholding tax to capital gains in a limited number of cases, such as US investors investing through the Caymans. This is based on the finance minister's final amendment that excludes 'personal portfolio' from the CGT exemption.

Mr Donnelly adds that: "In most cases [e.g., a fund based in Luxembourg owning an investment undertaking], even if the withholding tax is applied, it will not accrue to the Irish exchequer. Furthermore, the tax expert I spoke with confirmed that virtually no withholding tax will actually be paid on trading profits, as trading profits are brought close to zero using a propco to extract the trading profits via rent.

"There are still differences of opinion between the Government and also between some very senior experts … The IREF section may result in one part of one tax being applied to some investors, but the sector, in aggregate, remains largely tax-free."

Ronan MacNioclais, tax partner with consultants PwC agrees with Mr Donnelly that the Finance Bill is not exactly clear on which types of investors are affected, and in what ways.

However, unlike Mr Donnelly, Mr MacNioclais believes that many property investors will pay tax.

He says: "Firstly, even many large US pension funds will suffer the 20pc IREF tax. However, other funds which have many investors, such as Irish pension funds, may not be subject to this witholding tax. Then even though REITs do not pay corporation tax, they are obliged to pay dividends from rental income with the REIT deducting withholding tax. Typically those dividends are taxable at the marginal rates in the hands of the shareholders as well. Certain large international investors who own a large percentage of a REIT can claim a refund of part of the withholding tax, but there are very few such investors.

"Small Irish companies will pay 25pc tax on rental income from commercial property and 33pc tax on capital gains. Individual Irish or international investors are also subject to income tax and CGT on returns from property," he adds.

Mr MacNioclais' concern is that the changes will impact the property market.

"Not alone is there a new 20pc IREF tax but there is also the uncertainty that it creates for investors. They must factor this in when calculating what price they might bid for Irish properties.

"Not alone will they factor in the tax, but they will factor in an extra percentage for the risk that the Government may introduce other tax changes in the future."

Commenting on the Finance Bill changes in Hibernia's interim report, CEO Kevin Nowlan suggested that the uncertainty created by the changes may benefit his company.

"The proposed changes do not affect the Irish REITs directly, but any impact on capital values as a result of the uncertainty or the changes themselves will likely be felt by all market participants including the REITs. In the event that certain investors exit the market as a result of these changes, Hibernia is well-placed to move quickly in acquiring any assets which enhance the current portfolio," he said.

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