The UK was cautious in its approach to setting up a real estate investment trust (REIT) regime. There was a general feeling of scepticism and uneasiness among policymakers and Her Majesty's Revenue & Customs (HMRC) with any proposal for a tax-efficient regime in the real estate sector. However, those pushing for change put forward the macro-economic benefits (see box, Macro-economic benefits), and after extensive debate, REITs were introduced in the UK for accounting periods beginning on or after 1 January 2007.

Under this regime, where a company or group of companies elects REIT status, the REIT is exempt from tax on the income profits and capital gains of its property rental business. In addition, the distribution of these profits to the REIT's shareholders is generally treated as UK property income, rather than corporate dividends, allowing investors to broadly obtain the same returns as if they had invested in the property directly.

When the UK REIT regime was first introduced, nine UK listed companies elected to become REITs, and a significant number have since followed. By the end of August 2010, there were 21 UK REITs with a combined market capitalisation of roughly GB£18 billion (as at 1 September 2010, US$1 was about GB£0.65). Although the UK REIT regime is one of the least mature REIT markets, it is now one of the largest, by market capitalisation. However, not all the anticipated benefits have yet materialised.

Against this background, this chapter examines:

To become a REIT, a company or group of companies must satisfy a number of entry conditions relating to both the structure of the legal entity and the characteristics of its business.

On entry into the UK REIT regime, the base cost of assets held by UK-resident companies as part of their property rental business are generally reset to the market value at the time of entry. Any gain arising as a result of this re-adjustment is not subject to corporation tax. However, both UK and non-UK companies joining the regime are subject to an entry charge equal to 2% (or 2.19% if payable in instalments) of the gross market value of the properties involved in the property rental business, which will form their tax-exempt business going forward. As UK-resident companies are deemed to cease carrying on their property rental business on entry to the REIT regime (and a new ring-fenced property rental business begins), any losses accrued in the pre-REIT business cannot be carried forward. However, losses can be used by the residual business of the REIT outside the tax-exempt ring-fence.

Once within the REIT regime, the ring-fenced income profits and capital gains of the tax-exempt business are not subject to UK corporation tax, while the remaining residual business continues to be subject to normal corporation tax rules.

Distributions made in relation to profits of the tax-exempt business by a REIT company, or the principal company of a REIT group, are generally treated as UK property income in the hands of the shareholders for UK corporation tax and income tax purposes. These distributions are subject to withholding tax at 20%, subject to certain exemptions. The tax treatment of REIT distributions makes investment through a UK REIT particularly attractive to exempt bodies such as pension funds and charities, as it minimises the tax costs of indirect investment through a corporate vehicle by more closely mirroring the tax treatment of investing directly or through a tax-transparent vehicle.

Since the inception of the UK REIT regime, the economic climate and the real estate market have changed significantly. It is therefore unsurprising that there have been calls to adjust the REIT rules to ensure they remain appropriate and attractive to potential participants.

In recent years, UK REITs have increasingly been looking for new ways to raise capital as asset values across the UK commercial real estate market remain low and bank lending continues to be constrained. Changes introduced by the 2009 Finance Act, which enable REITs to issue convertible preference shares, have therefore provided an interesting additional means of attracting investment to the UK REIT sector. REITs have also sought methods to retain cash and welcomed proposals in the June 2010 Budget which will enable REITs to issue stock dividends to satisfy the 90% property income distribution requirement. However, at the date of publishing this chapter, there is some concern among industry participants that the flexibility of this proposed legislation may be hampered for certain technical reasons and because it does not permit REITs to distribute stock dividend as property income distributions (PIDs) in excess of the 90% minimum requirement.

Market participants have requested more significant changes, but these have not yet been accepted. One such change is for REITs to be listed on a junior market such as AIM. This would allow new entrants to establish themselves and grow in a less prescriptive regulatory regime before moving up to the Official List and its regulatory burdens and costs. Other significant recommendations for reform have been put forward to remove the perceived barriers to entry for REITs in the residential real estate market. These recommendations include:

For the UK REIT regime to remain effective, it must continue to develop as the economic environment and real estate market change.

When REITs were introduced, there was an expectation that the market was at the beginning of a new wave of corporate finance activity. At the market's peak commentators predicted new listings that would result in the listed real estate market reaching a market capitalisation of GB£100 billion between 2010 and 2012 with consolidation and specialisation to establish a market that more closely resembled the US REIT model. The reality has been very different.

The introduction of UK REITs in 2007 coincided with the beginning of a major downturn in the commercial real estate market. The UK REIT was designed and conceived during a UK property boom, and almost four years into the UK REIT regime, the UK REIT market continues to face challenges. However, as property prices begin to show signs of recovery, there should be a renewed interest in UK REITs as a tax-efficient investment structure. In particular, banks which own vast portfolios of the UK real estate may seek joint ventures with existing UK REITs to take advantage of their significant property know-how. In addition, changes to the way in which overseas dividends are taxed in the UK mean that it is now possible to repatriate the profits of an overseas property business without suffering additional UK tax leakage. This opens up exciting possibilities to use the UK REIT framework as an efficient means of structuring cross-border property portfolios.

The UK REIT regime is an improvement to the tax environment for UK real estate companies. When market conditions improve, the regime is expected to have a positive long-term impact on the UK listed real estate sector and it is hoped that the proposed benefits of the UK REIT regime will be fully realised.