March 30, 2007
I. Introduction/Status of German REIT Legislation
On March 30, 2007, the German Public REIT Introduction Act ("G-REIT Act") was passed by all German legislative bodies and becomes effective retroactively as of January 1, 2007. The G-REIT Act provides a tradable real estate investment instrument which meets international standards. However, legislative obstacles still exist and these may have an effect on the success of the German REIT ("G-REIT") as an alternative investment vehicle. After a lively political discussion, the German parliament decided not to allow G-REITs to acquire residential property located in Germany (constructed before January 1, 2007) whereas this limitation does not apply to Private Equity Funds and foreign REITs. According to some experts, the exclusion of German residential properties from G-REIT compliant properties may reduce the total volume of G-REITs by a third. In addition, the German parliament did not address the question of how a G-REIT’s prior-taxed foreign income will be handled. Thus, as opposed to a direct investment in foreign real estate, where a G-REIT is not used, the G-REIT Act will lead to double taxation of real estate income in the state where the property is located and also at shareholder level, upon the profit distribution by the G-REIT. By contrast, the favorable exit tax regime for a transfer of real estate to a G-REIT is now applicable to real estate which has been part of the transferor’s fixed assets for at least five years, instead of ten years as was provided for in the draft G-REIT Act of November 2, 2006.
II. Criteria for Obtaining REIT Status
Only German stock corporations (Aktiengesellschaft) having their registered office and place of management in Germany can qualify as a German REIT ("G-REIT"). The G-REIT can be formed as a new entity or by way of a reorganization (e.g. spin off) with a minimum share capital of EUR 15 million. Its objective is to acquire, hold, manage and dispose of real estate, except residential real estate in Germany which was built before January 1, 2007. However, a G-REIT is entitled to invest in residential real estate located abroad. G-REITs can also hold interests in domestic or foreign real estate holding partnerships. An investment in real estate corporations is limited to 100 % investments in foreign corporations, which exclusively hold real estate located abroad. An indirect real estate investment via domestic corporations is excluded. Moreover, a G-REIT can provide services which are linked to the management, maintenance and development of real estate through a subsidiary, whose assets may not exceed 20% of the G-REIT´s net asset value.
The G-REIT must be listed on a stock exchange in the European Union or the European Economic Area. At the time of IPO, at least 25% and thereafter 15% of its shares have to be held by investors who own less than 3% of the G-REIT shares. In addition, no shareholder may hold more than 10% of the G-REIT shares.
At least 75% of a G-REIT’s net asset value must be real estate. In addition, at least 75% of its gross revenue must be rental income from the lease or sale of real estate, whereby the G-REIT may not sell more than 50% of the fair value of its real estate portfolio within a period of five years. The G-REIT is allowed to leverage its real estate investments, if the borrowings do not exceed 60% of the G-REITS’s net asset value. In order to benefit from the tax exemption, the G-REIT has to distribute at least 90% of its distributable profits to shareholders.
III. Taxation at the G-REIT Level
G-REITs fulfilling the aforementioned requirements are fully exempt from German corporate income tax (including the solidarity surcharge thereon) and German trade tax. The tax exemption does not apply to the income of the G-REIT service companies.
Where certain requirements are not met, this does not necessarily result in a denial of the tax exemption. The G-REIT Act provides for different sanctions depending on the type of violation. However, if the G-REIT conducts real estate trading or does not meet the free float or leverage requirement for three successive business years, the G-REIT loses its tax exempt status.
IV. Taxation of G-REIT Investors
The dividend distributions made by the G-REIT are fully taxable, for both domestic and foreign investors. There is no tax relief as is applicable for distributions made by regular corporations. The dividend distributions are subject to a 25% withholding tax. Domestic shareholders can credit the withholding tax against their income tax liability. For foreign shareholders, the withholding tax may be reduced under an applicable tax treaty. Since no investor may directly hold 10% or more of the shares in a G-REIT, the European Parent-Subsidiary Directive (withholding tax of 0%) is not applicable to foreign corporate investors.
In the case of a domestic or foreign corporate investor, capital gains are fully taxable; there is no 95% tax exemption as is applicable for a sale of shares in a regular corporation. A private investor is subject to German taxation on its capital gain if it has held at least 1% of the G-REIT shares at any time during the five years prior to the disposal or if it has not held the G-REIT shares for more than one year. However, capital gains are usually tax exempt in Germany if the private or corporate investor is treaty protected.
V. Exit Tax upon Formation of G-REITS
Where the transfer of real estate to G-REITs results in a realization of hidden reserves, only half of such capital gain is subject to German income tax and German trade tax, provided that the real estate belongs to the fixed assets of the transferor for at least five years (exit tax). The tax privilege applies to individuals as well as corporations which dispose of real estate and is limited to transactions made between January 1, 2007 and December 31, 2009. It does not apply to a transfer of real estate in connection with the sale or termination of a business. Only half of the expenses incurred in connection with this type of tax privileged transfer can be deducted. This does not apply when the transfer leads to a capital loss. Such a loss can be deducted from the total.
The exit tax regime, but not the tax exemption at the G-REIT level, is applicable to corporations that pursue the formation of a G-REIT, but do not yet fulfill all requirements, i.e. the listing requirement ("Pre-REIT"). The Pre-REIT rules are applicable if the corporation is registered with the Federal Tax Office (Bundeszentralamt für Steuern) as Pre-REIT and fulfills certain requirements, i.e. 75% of the G-REIT’s net asset value has to be real estate and 75% of its gross proceeds needs to be real estate income.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or Hans Martin Schmid (+49 89 18933-189, [email protected]) or Christian Schmidt (+49 89 18933-189, [email protected]) in the firm’s Munich office.
© 2007 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.