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Opinion

Real Estate Investment Trust scheme: A comprehensive package for development of real estates

  1. General
Pakistan, after the relevant amendment in the proposed Finance (Supplementary) Act, 2021 has...

1. General

Pakistan, after the relevant amendment in the proposed Finance (Supplementary) Act, 2021 has incorporated innovative, modern, simple, practical and tax effective laws for the development of real estates under Real Estate Investment Trust (REIT) scheme.

Corporate regulations for REIT are laid down in Real Estate Investment Trust Regulations, 2015 (Rules). These rules have been substantively amended through SRO 724(I)/2021 dated June 7, 2021.

In line with the international best practices and keeping in view the practical circumstances the concept of a Special Purpose Vehicle (SPV) under REIT scheme has been introduced in Pakistan through the aforementioned rules. Nevertheless these provisions were practically non-implementable unless the relevant considerations were simultaneously laid down in the tax laws.

Through the Finance (Supplementary) Act, 2021 tax measures on the REIT with SPV structure have been introduced. After the incorporation of these provisions the REIT regulations in Pakistan provide a comprehensive mechanism for real estate development under this regime.

After appropriate amendments as made in the relevant laws there is an ample possibility of bringing the property to their fair value without any tax incidence under REIT with SPV structure.

As REIT is a documented process therefore development of real estates under REIT, with only a low overall tax of 15%, entails an incentive for documentation in this sector for all parties.

The salient features of the corporate and tax regimes for REIT with SPV structure and the relevant provision of the rules and income tax law are stated here. For the sake of simplicity only Non-PPP REIT has been discussed.

It is expected that this internationally prevalent practice will accelerate organized and documented development in the real estate sector.

2. What is a REIT?

REIT is a corporate structure for developing real estate assets. In the corporate sense a REIT is established as a closed end trust fund. Under the prescribed rules a REIT is incorporated as a fund registered with Securities & Exchange Commission of Pakistan (SECP) read with relevant trust laws.

The units of such funds are held by unit holders in their individual capacity and a part is held by REIT Management Company (RMC).

REIT funds are used for the development of real estates. REITsare of two kinds:-

  • A Developmental REIT means a REIT scheme established for investment in one or more projects with the object of development, construction, refurbishment, rehabilitation, management and /or operation of such real estate for industrial, commercial residential purposes or a combination thereof.

  • A Rental REIT means a REIT scheme with the object of making investment in industrial, commercial or residential real estate with the purpose of generating rental income from it. Others are called Non PPP REIT.

3. PPP or Non-PPP REIT

In Pakistan REITs have been further classified into PPP and Non-PPP REITs. A PPP REIT is the one engaged in a Public Private Partnership project established under statutes operative in Pakistan for this purpose. Others are called Non-PPP REITs.

  1. Benefits for REIT with SPV scheme

Income tax laws in Pakistan provide special concessions for a REIT Scheme. Firstly, any person selling a property to a REIT Scheme is not liable to tax on the amount of gain arising on such sale. This exemption is valid until June 30, 2023. This is a very big concession for sellers of properties to REIT schemes. An acquisition of a property by a SPV under a REIT scheme is also eligible for this concession.

Secondly, income of REITs is not taxable if 90% of the profits are distributed. Same principle applies to SPV under a REIT scheme. Dividends from REITs are taxed at the normal rate applicable for dividends.

Resultantly, under the REIT structure the rental income of a Rental REIT is taxable effectively at the rate of 15% as against the rate applicable to companies of 29% percent or 25% for individuals.

5. Ownership of Property and need for SPV

A REIT is required to be the owner of the property under the REIT scheme.

This requirement entails transfer of property in the name of a REIT fund for every project to be undertaken. In order to overcome this difficulty and practical issues on transfers a concept of SPV has been introduced throughout the world.

Under an SPV structure the REIT can invest in the shares of a SPV mainly engaged in real estate and all the provisions relating to REIT become applicable on SPV as if the property of SPV is the property of REIT.

In Pakistan it is required that in order to operate a SPV structure under REIT the REIT must have seventy five (75) percent shareholding in SPV and SPV’s assets and business should be up to eighty (80) percent in real estate

Now after the relevant amendment in the rules REIT Assets means:

(i) in the case of a Non-PPP REIT Scheme, all Real Estate and other assets moveable or immoveable of the REIT Scheme, which include investment in SPV acquired in the name of the Trustee of a REIT scheme; and

(ii) in the case of a PPP REIT Scheme means interest in or right over moveable and/or immoveable assets acquired and/or developed in the name of or by a PPP REIT Scheme;

6. Why SPV under REIT?

A SPV structure under REIT is essential inter alia for the following reasons:

  • Transfer of properties: Since REIT requires property in the name of REIT therefore unless a SPV structure is placed every REIT is required to get the property transferred in the name of REIT which is expensive and not practically possible in every case;

  • Determination of Value after development: The owners of the SPV property are always not ready to transfer the property on account of non-determination of the real value of the property as would be after development. Under the SPV structure they continue to be the owners in effective partnership with the REIT owners and can realize the fair value of property as and when developed under the REIT structure;

  • Diversification and sharing of risks: SPV structure allow the REIT to diversify and share the risk with the original owners of the property being developed;

The aforesaid three fundamental considerations entails the need for SPV under the REIT which has been fully incorporated in the new corporate and tax legislation.

Ownership Illustration

7. Minimum holding by RMC

Under the law all REITS are required to be managed by a company incorporated under Companies Act, 2017. They are called REIT Management Companies RMCs.

Every Non-PPP REIT RMC is required to hold 25% of the units of the REIT fund. Such funds can also be held through Strategic Investor (as defined under the rules). Each Strategic Investor should hold not less than 5% of the units.

8. Listing of REIT

A Non-PPP REIT is required to be listed on stock exchange within a maximum period of three (3) years from the date of Financial Close.

A PPP REIT is to be listed on the stock exchange no later than the first anniversary of the Commercial Operation.

9. Investments in SPV by REIT

A Non-PPP REIT Scheme may make an investment in property by way of direct ownership or through a shareholding in a SPV

Investment through shareholding in a Special Purpose Vehicle may be undertaken subject to fulfilment of the following:

(i) the SPV is controlled by the Non-PPP REIT Scheme, provided that, the Non-PPP REIT Scheme, shall invest not less than seventy-five per cent of the total issued share capital of the SPV, with the Special Resolution of the Unit Holders;

(ii) eighty per cent (80%) of all assets of the SPV are used/engaged for the purposes of holding, developing, refurbishing, rehabilitating, managing and/or operating Real Estate and any other activity incidental thereto;

(iii) once a Non-PPP REIT Scheme has invested in a Special Vehicle in terms of this regulation the SPV shall only acquire any additional Real Estate;

(iv) no shareholder of the SPV shall exercise any rights that prevents the Non-PPP REIT Scheme or the RMC from complying with the provisions of these Regulations and an agreement is entered into with such shareholders to that effect prior to investment in the SPV:

Provided that the shareholders’ agreement shall provide for an appropriate mechanism for resolution of disputes between the Non-PPP REIT Scheme and the other shareholders in the SPV:

Provided further that the provisions of these Regulations shall prevail in case of inconsistencies between such agreement(s) and the obligations cast upon a Non-PPP REIT Scheme or the RMC under these Regulations.

(v) the RMC, in consultation with the Trustee, shall appoint at least such number of nominees on the board of directors of such SPVs, as applicable, which are in proportion to the shareholding or holding interest of the Non-PPP REIT Scheme in the SPV;

(vi) the SPV has been engaged by the RMC for the purposes of REIT Management Services in connection with the holding, developing, refurbishment, rehabilitation, management and/or operation of Real Estate held by the SPV, by execution of a SECP approved SPV Management Services Agreement; and

(vii) both the REIT Scheme and the SPV shall appoint the same accountant and auditor and adopt the same accounting principles and policies.

10. Procedural requirements-investment in REIT

Following procedural aspects are also required to be complied with in relation to investment in SPV:

(i) a report made by an auditor shall be prepared on:

(a) the profit and loss of the SPV in respect of each of the two financial years (or such shorter period as applicable if the SPV has been in operation for less than two years) immediately preceding the transaction; and

(b) the assets and liabilities of the special purpose vehicle as at the last date (which cannot be more than six (6) months old from the date of the report) to the accounts of the SPV. were made up. The report required under shall indicate how the profits and losses of the SPV would, in respect of the shares to be acquired, have concerned the scheme, if the Non-PPP REIT Scheme had at all material times held the shares to be acquired.

(ii) A Valuation Report in respect of the SPV interest in Real Estate shall be prepared, and such report shall comply with the requirements set out in these Regulations.

11. SPV Management Service Agreement

All REITs shall enter into a SECP approved SPV Management Services Agreement.

Broad guidelines for this agreement are laid down in the rules as under:

a) the duties, rights and obligations of the parties;

b) the management and governance of the SPV;

c) periodic reporting requirements, accounting period and audit of SPV;

d) valuation of real estate

e) appropriate dispute resolution mechanism;

f) procedure for change of RMC or SPV;

g) policies for borrowing and issuance of shares;

h) dividend policy;

i) the circumstances under which the contract can be revoked:

j) The contract shall, initially or on renewal, be valid for a period not exceeding the life of Non-PPP REIT Scheme and shall not be renewed or modified unless such renewal or modification has been authorized by the Unit Holders of the Non-PPP REIT Scheme in a general meeting and consent of the Trustee is granted on the same.

k) The contract shall, inter-alia provides, for the consequential penalty or damages to be borne by the contracting parties in case of violations of any provisions or breach of contract.

12. Tax on REIT, SPV and Unitholders

The Finance (Supplementary) Act, 2021 has introduced a practical, reasonable and market oriented system for REIT taxation.

It is reiterated that the SPV system though introduced in the SECP regulations was non operative as relevant amendments were not made in the income tax law. The changes are:

  1. Income of a REIT SPV has been exempted from tax if 90 % of the profit is distributed. This means that SPV will neither be taxable on its income nor the dividends from SPV to REIT will be taxable. This means that for REIT SPV is effectively a pass through entity:

  2. Transfer of shares of a SPV to REIThas been exempted from tax. This means that there will be no tax in the hands of shareholders of SPV when they sell the shares of SPV to REIT. In the absence of this exemption huge tax liability may arise on account of different between the cost of shares of SPV (which is generally historical) and the fair value of such shares which is determined on the basis of fair value of underlying properties ; and

  3. Dividends received by REIT from SPV have been exempted from tax, however the dividend received by non REIT shareholders of SPV will be taxed at the rate of 35%.

Income Illustration

Comprehensive Illustration

The tax status has been illustrated in Table A to these notes.

Copyright Business Recorder, 2021

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