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Get into gearing

Our panel compare offshore bonds with their onshore counterparts and discuss how introducing Reits could affect the market

What are the advantages for UK residents of using offshore property funds rather than onshore funds? Has this been the main driver behind the growth in the number of offshore property funds being established?

Ilott: For UK residents, offshore property funds are attractive because individual property transactions within the fund are not caught by the 4 per cent stamp duty charge suffered by onshore funds. They can also invest up to 100 per cent of their assets in real bricks and mortar while a UK authorised unit trust operating under the collective investment scheme rules has to provide 20 per cent liquidity, which effectively restricts real bricks and mortar exposure to a maximum of 80 per cent. Another advantage is being able to distribute income on a gross basis and, for some funds, invest within an Isa. For offshore funds with distributor status, the capital gains tax treatment is the same as for onshore funds.

Burns: The key advantage of using an offshore property fund is that gains made by the fund on the sale of an investment property are not taxed in the hands of the investor at the time of realisation but are rolled up within the fund, thereby allowing the fund to invest the gross sale proceeds in further assets. As tax is paid by the UK investor only at the time at which they sell or otherwise dispose of their units in the offshore fund, this roll-up effect should allow for better returns on the original investment. The delaying of the tax liability on the realisation of profits has been the main driver behind the growth in number of offshore property funds being established. Certain private unit trusts have been established offshore as a way to avoid or delay the impact of stamp duty land tax on property transactions. This has been a major driving force for the establishment of private unit trusts over the past two years, in particular.

Frepp: In the absence of a real estate investment trust structure in the UK, offshore funds have been seen as a tax-efficient investment structure for UK residents to invest in the UK commercial property market. There are several reasons why offshore property funds have been established over the past few years. Flexibility, choice and access to highly professional and experienced commercial fund managers are among the main drivers of the expansion of this sector over the past few years.

How might the UK Government change the tax rules affecting offshore property funds and how would this affect their attractiveness? Will this detrimentally affect the number of funds being established in offshore jurisdictions, such as the Channel Islands?

Ilott: It is difficult to say. One thing the Government could do is to make it more attractive for property companies to remain established in the UK. Currently, one of the main drivers behind property funds being established offshore, rather than onshore, is the level of tax paid by onshore property companies. If the Government fails to introduce a Reit structure, quoted companies could delist and simply move their assets offshore, which would result in even greater leakage of tax revenue for the Treasury.

Burns: There is much speculation in the property and tax press that the UK Government will change the stamp duty land tax rules, reducing the effectiveness of private unit trusts for the avoidance of this tax.

Frepp: Until the Government makes a formal announcement about its intention to introduce Reits in the UK and their tax structure, then it is impossible to comment on how this would affect the offshore fund sector. Investors look to offshore funds for a variety of reasons, including tax suitability, and funds are domiciled in different jurisdictions, such as Jersey, Guernsey and Dublin, where the regime suits the type of investment fund structure.

When Reits are finally introduced in the UK, how will this affect the tax advantages of offshore funds for UK-resident investors?

Ilott: Assuming the costs of converting to Reits are justified, quoted property companies are likely to spin off some of their operations into Reits. The tax advantage for them will be that the company itself will have no tax liability on its ring-fenced property letting business. From an investor’s point of view, any tax payable will be their own responsibility, so the tax issue is transparent. To a degree, offshore pooled property funds open to UK investors already share similar characteristics to Reits, for example, M&G property fund. From a tax perspective, the introduction of Reits is therefore likely to deflect the interest of some property fund investors away from offshore funds. But offshore funds often have more innovative and flexible structures that will still appeal.Burns: If the investment rules are drawn widely enough and the costs of the Reits structure are within acceptable limits, then UK-resident investors may look to Reits as an indirect property investment vehicle rather than offshore funds. However, Investec’s view is that the Reits structure is unlikely to permit the fund to borrow on its asset base (gearing) to the extent permitted in offshore funds and in most cases this is likely to have a detrimental impact on the returns under the Reits structure. Our view is that Reits will be attractive to retail investors who will tend to be UK-resident taxpayers. Non-residents of the UK, including non-domiciled UK residents, are less likely to find the Reits structure as attractive as the offshore option.

Frepp: It is impossible to comment until such time as the Government makes a formal announcement about its intention to introduce Reits in the UK and their tax structure. The issue of how to tax an onshore structure is one that the Treasury is continuing to consider and, at this stage, there is no clear indication what the outcome will be. However, we think that the Government is still considering the following key aspects of the Reits structure – levels of rental income distribution as dividends, levels of gearing, management structure, the conversion tax to be applied to existing property companies which wish to convert to a Reits structure and levels of withholding tax on dividends for non-UK investors.

What are the advantages of offshore property funds other than tax and how might they be affected by the introduction of Reits in the UK?

Ilott: has been one feature that has set some offshore funds apart from those available onshore. Onshore, gearing is restricted to 10 per cent. Gearing is attractive when returns from the underlying properties exceed the costs of borrowing but it can also exaggerate losses on the downside. A very high level of gearing and, therefore, risk is something to be aware of in some offshore property vehicles. Being able to be 100 per cent invested in real bricks and mortar is also a potential benefit from the point of view of being able to properly diversify clients’ assets away from equities. In onshore unit trusts, there is a requirement to have at least 20 per cent liquidity, which often means holding property shares, the returns from which might more closely resemble broader equity markets.

Burns: There are a number of other advantages of owning offshore property funds. First, investors are offered a wider spread of risk through investing in the fund rather than investing directly into property. Not only is the risk of negative capital growth mitigatedby having a spread of properties but also the risk of a single tenant or group of tenants defaulting on rental is reduced by being exposed to a wide range of tenants. A second advantage of the offshore property fund is that the cost of indirect investment into the funds tends to be lower than the alternative direct investment into UK property. This means that the overall return to shareholders is enhanced. Another reason for indirect investment is the ability, in the case of most open-ended property funds, to exit the fund at relatively short notice. The alternative of direct investment can often be slow and would depend on the disposal of the underlying property.

Frepp: Offshore property funds in a market with or without Reits simply offer investors a greater choice. There is a growing variety of commercial property funds that suit particular investors’ needs and these will continue to be of value with or without Reits. The primary reason for using these products is to meet an investor’s end aims and the underlying investments should be the primary focus.

What does a UK-resident investor need to consider before deciding whether to invest in an offshore property fund rather than an onshore fund?

Ilott: The tax treatment is certainly a big issue for Sipp investors and people who want to use their Isa wrapper because this favours offshore funds. As far as investment scope is concerned, many of the more esoteric property structures are found offshore and this is where you also find real bricks and mortar exposure of up to 100 per cent, rather than the maximum 80 per cent onshore. But some of the distinctions in terms of scope of investment have now been removed with the arrival of the non-Ucits retail scheme rules now permitted under the FSA’s new collective investment scheme sourcebook regulations. Onshore property funds that adopt Nurs regulations will not only be eligible as Isa investments with effect from next year but they are already able to invest 100 per cent of their assets in real bricks and mortar. Some investors might also want to avoid the higher level of gearing in offshore vehicles although this is fund-specific rather than something that affects all offshore funds.

Burns: The UK-resident investor needs to consider their personal tax position before investing in an offshore property fund to be entirely sure that they are maximising their tax position by investing offshore. Offshore property funds are generally not regulated by the FSA in the UK and any investor should ensure that the offshore fund they are selecting is well constituted and regulated in a suitable jurisdiction such as Guernsey.

Frepp: Investors should get their own professional advice when considering any investment. Aside from any tax issue, the decision to invest in an offshore fund is no different from a decision to invest in an onshore fund. Investors should consider the following among other things, when deciding to invest in any onshore or offshore fund – manager ability and performance track record, fees and total expense ratios, gearing and risk as well as the sectors and regions the fund is invested in and tenant credit quality.

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