First published in the Business Daily on July 28, 2019.
The introduction of Real Estate Investment Trusts (REITs) in 2015 was hailed as a game changer in the property market. But contrary to expectations, REITs have failed to gather traction.
So far, there has been only one REIT, the Stanlib Fahari I-REIT which was the first and the only REIT listed at the Nairobi Securities Exchange (NSE). Fusion Capital’s attempt to develop what would have been second REIT in the market failed because they could not raise the minimum investment required by the Capital Market Authority to qualify for listing.
In an attempt to salvage the situation, the government through the Finance Bill 2019 proposes to amend section 20 of the Income Tax Act (“the Act”) to exempt REITs’ investee companies from income tax. This amendment is likely to give a big boost to the REIT industry as it will ease the structuring of how REITs hold their real estate investments.
In its current form, Section 20 of the Act only exempt REITs from income tax without extending the exemption to subsidiaries and investee companies which are wholly-owned by REITs. Consequently, if a REIT invests in a company (investee), the income of that company would be first subjected to corporation tax at the rate of 30 percent on the net profit before distribution to the REIT. Since the investee company is wholly owned by the REIT, as the law requires, the effect is subjecting income due to a REIT to 30 percent corporation tax, hence negating the essence of the tax exemption to income of the REIT.
This has been a setback to investors who would be interested in investing in REITs in order to enjoy the generous tax incentives, since the effect has been that income distributable to REIT unit holders would have suffered a 30 percent corporation tax before distribution to the REIT. This goes against the spirit and purpose of a REIT as a tax efficient vehicle of choice.
The proposed amendment will remove this hurdle by making the investee companies tax transparent vehicles. Tax transparency is where income passes through an entity without being taxed at the entity level and instead taxed upon distribution to the ultimate beneficiaries or owners. With the new proposal, income received by an investee company which is wholly owned by a REIT will not be taxed at the investee level; it will pass through to the REIT where it will further be exempt before distribution to the unit holders.
The distribution of the profits to the unit holders or the shareholders by the REIT would be subject to withholding tax (“WHT”) at the rate of 5 percent for resident and 10 percent for non-resident. This is as per the KRA’s interpretation of Section 20 of the Act which provides that “…a REIT; … registered by the Commissioner, shall be exempt from income tax except for the payment of withholding tax on interest income and dividends as a resident person as specified in the Third Schedule to the extent that its unit holders or shareholders are not exempt persons under the First Schedule”.
However, KRA’s interpretation of Section 20 can be disputed on the basis that the income of a REIT would not be subject to WHT on distribution to unit holders since the distribution is neither interest income nor dividends. The unit holders are not creditors and have not advanced any loan to the REIT and as such they cannot receive any income in the form of interest.
It is also not a distribution of dividends within the meaning of dividends as provided for under Section 2 of the ITA, "any distribution by a company to its shareholders with respect to their equity interest in the company…”. A REIT is a Trust and not a company within the definition of a company under the Companies Act which is the interpretation adopted in the tax law, hence incapable of distributing dividends.
If my interpretation was adopted, the amendment would exempt the entire income chain of a REIT from income tax and the unit holders would effectively receive 100 percent tax-free income from their investment in a REIT. This would encourage more investors into the market.
Nonetheless, the amendment will also encourage REITS to acquire properties for development by acquiring all the shares of companies holding properties instead of acquiring the properties themselves, which is often a faster and more cost-effective route than actual transfer of title.. Acquiring all the shares of property companies would give REITs full control of the property without having to transfer them into their names.
Acquisition of the company rather than the land is considerably much simpler, faster, and a cost-effective process. Transfer of property by way of acquiring the shares of the holding company is also more tax efficient. Stamp duty on transfer of shares into the REIT is lower (1 percent) compared to the stamp duty on transfer of property into a REIT which is 2 percent or 4 percent for property in municipalities.
This amendment will encourage REITs to add more properties into their portfolio by just acquiring landholding companies, hence removing some of the hurdles they currently face. This will make REITs one of the most tax efficient vehicles in Kenya and we should expect more entrants into the REITS market as a result.