Introduction
A Real Estate Investment Trust (REIT) is a regulated investment vehicle that enables the issuer to pool investors’ funds for the purpose of investing in real estate. In exchange, the investors receive units in the trust, and as beneficiaries of the trust, share in the profits or income from the real estate assets owned by the trust. REITs generally qualify for special tax treatment, providing a conduit for earnings to be taxed at the investor level and not at the entity level. This article mainly appreciates the general structure of REITs in Kenya and delves into the tax regime that governs REITs. The article seeks to demonstrate that, given the growing popularity of REITs as viable investment options, there is a compelling need for robust and dynamic tax legislation governing REITs to ensure that they are tax efficient, liquid and transparent investment vehicles.
Types of REITs
REITs can either be classified as D-REITs (Development REITs) or I-REITs (Income REITs).
- Development Real Estate Investment Trust (D-REIT): This is a type of REIT where investors pool resources together with the aim of acquiring, constructing, and developing real estate. Once a development has been completed, a D-REIT may be converted to an I-REIT.
- Income Real Estate Investment Trusts (I-REIT): this is a type of REIT that may acquire already developed property or even develop the property for purposes of generating rental income. They will usually hold and manage the properties over a period of time.
Both D-REITs and I-REITs may be listed by the Nairobi Securities Exchange (NSE) and subsequently delisted. This article will primarily focus on listed REITs. A listed REIT’s units are traded on the NSE like any other company shares, offering investors a liquid stake in real estate. These listed REITs are governed primarily by the Capital Markets (Real Estate Investment Trusts) (Collective Investment Schemes) Regulations, 2013 (REIT Regulations), the Capital Markets (Securities) (Public Offers, Listing and Disclosures) Regulations, 2002 and the Nairobi Securities Exchange Limited Listing Rules. They are structured as unincorporated trusts rather than companies.
When these listed REITs are offered, the REIT offers can be restricted or unrestricted. Restricted offers refer to issues or offers made to professional investors while unrestricted offers are open to the public. The D-REIT offers are restricted, while I-REIT offers/issue can either be restricted or unrestricted. Restricted I-REITs can either be structured as open-ended funds or a close-ended funds and may be converted from one form to another. Depending on the nature and structure of the REIT, its units can be traded on the Unrestricted Main Investment Market Segment (UMIMS), the Unquoted Securities Platform (USP) or the Restricted Board on the NSE.
The tax regime governing REITs in Kenya
The biggest advantage attached to listed REITs is that they enjoy highly favourable tax benefits in the form of exemptions. Normally, tax exemptions come in many forms, but one thing they all have in common is they either reduce or eliminate the obligation to pay tax. Through these exemptions, governments extend an olive branch to businesses and provide tax holidays to stimulate growth towards a particular industry.
In the case of REITs in Kenya, various exemptions have been implemented towards REITs as one of the tax neutrality measures with the aim of promoting the effective rollout of new capital markets products and services. The exemptions are major incentives designed to encourage the growth of REITs funds which allow the public to invest in the property market without requiring large cash investments.
As such REITs present themselves as the most efficient vehicles to invest in income-earning property as well as tax-efficient vehicles.
To understand the exemptions and how and who they apply to, it is important to first understand the parties involved in the entire process.
- Promoter– This is a party involved in setting up a real estate investment trust scheme. The promoter is regarded as the initial issuer of REIT securities and is involved in making submissions to the regulatory authorities to seek relevant approvals.
- REIT Manager (REIT): This is a company that has been incorporated in Kenya and has been issued a license by the Capital Markets Authority (“the Authority”) to provide real estate management and fund management services for a REIT scheme on behalf of investors.
- Trustee: The Trustee’s main role is to act on behalf of the investors/beneficiaries of the REIT, by assessing the feasibility of the investment proposal put forward by the REIT Manager and ensuring that the assets of the scheme are invested in accordance with the Trust Deed and the Regulations.
- Project/Property Manager: The role of the project manager is to oversee the planning and delivery of the construction projects in the REITs while the property manager assists the REIT Manager in the management of the real estate acquired by the REIT.
- Unit Holders – These are Investors who as a result of their capital contribution acquire REIT units and are the beneficiaries of the Trust.
REITs, as highlighted above, are required to invest in real estate, which they may acquire either directly or indirectly. Regulations 65 and 76 restrict the Trustee of an I-REIT and D-REIT respectively to inter alia invest:
i. directly in eligible real estate
ii. invest in Eligible Real Estate assets through investment in an Investee Company incorporated in Kenya which directly owns the Eligible Real Estate, and which is wholly beneficially owned and controlled by the Trustee in its capacity as the Trustee of the I-REIT; or
iii. invest in a wholly owned and controlled company which conducts Real Estate related activities.
Depending on the transaction structure, the tax implications may vary as will be demonstrated in the subsequent paragraphs of this article.
A. Exemption from Income Tax Act.
Section 20 (1) (c)and (d) of the Income Tax Act (ITA), provides that REITs and REIT investee companies, upon registration with the Commissioner of Domestic Taxes are exempted from the 30% income tax rate. Additionally, the distribution of income to unitholders of the REIT is exempt from tax.
However, the above income tax exemption does not extend to withholding tax on interest income and dividends earned by unit holders who are not exempted under the first schedule of the ITA. The rates for this withholding tax are specified under paragraph 5 of the third schedule of the Income Tax Act.
It has been and still is the practice that REITs duly established pursuant to the REIT Regulations and approved by the Capital Markets Authority (CMA) automatically qualified for exemption from income tax as the CMA authorization was transmitted to KRA. However, following the enactment of the Tax Laws (Amendment) Act, 2020 on 25th April 2020, the draft Income Tax (Real Estate Investment Trusts) Rules, 2020 (the draft Rules) propose the mandatory registration of a REIT or a REIT-controlled entity with the Commissioner of Domestic Taxes.
Pursuant to section 3 of the draft Rules, for a REIT or a REIT-controlled entity to qualify for tax exemption in the manner contemplated under section 20 of the ITA, the REIT has to apply to the Commissioner for registration of the REIT or its REIT-controlled entity. The Commissioner is required to render a decision within 30 days of the application and inform the applicant of the approval or rejection. However, given that a REIT is structured as an unincorporated common law trust and not a body corporate, it may be useful to get some guidance and clarity from the Kenya Revenue Authority on the practical application of the proposal as the draft Rules are yet to be enacted.
It is worth highlighting that, Rule 5 of the draft rules expressly states that where a REIT or REIT-controlled entity fails to satisfy the requirements of the REIT Regulations or the Income Tax Act for purposes of maintaining its exemption status, the exemption granted to the REIT or REIT controlled entity shall cease to apply and all the applicable taxes in accordance with the Income Tax Act shall fall due, and shall be payable from the date of such failure.
B. Capital Gains Tax exemptions.
The gain accrued by a Promoter or an investor on transfer of property into the REIT is subject to CGT at the newly adjusted rate of 15% from the initial rate of 5%. However, the transfer of property from life insurance companies into the REIT is exempt from CGT as provided in Section 19 (6B) of ITA.
Where there is an indirect transfer of property into the REIT to wit the Promoter transfers the initial properties into a special purpose vehicle i.e. an investee company which forms part of the Promoter group, and the shares in the investee company are subsequently transferred to the REIT, the transfer of the properties to the investee company will be CGT exempt as it would be considered a restructure given that the transfer does not involve the transfer of property to a third party.
The exemption is anchored on Paragraph 13 of the Eighth Schedule to the ITA which states that “Gains arising from transfer of property that is necessitated by a transaction involving the incorporation, recapitalization, acquisition, amalgamation, separation, dissolution or similar restructuring of a corporate entity, where such transfer is an internal restructuring within a group which does not involve transfer of property to a third party, is not subject to capital gains tax”.
However, CGT will accrue on gains made at the point of transferring the shares in the investee company to the REIT Trustee.
Payments for redemption of units or sale of shares received by unit holders or shareholders in a REIT are also exempt from tax (capital gains) pursuant to section 20 (2) of the ITA.
Further, upon disposal of the properties by the REIT either directly or through an SPV the gain made by the REIT will not be subject to CGT.
Where the unit holder decides to sell off its stake in the REIT, normally as a registered taxpayer they are required to pay Capital Gains Tax (CGT) at the recently adjusted rate of 15% due to the amendment of Section 34(1)(j) of the Income Act through the Finance Act 2022. A capital gain is simply the excess of the transfer value over the adjusted cost of the unit that has been transferred with the difference being subjected to a 15% tax.
However, by the mere fact that they have transferred an asset under the REITs regime in Kenya, the CGT does not affect the said transactions. This is because the listed REITS are an example of listed marketable securities that were excluded from the application of CGT under the Finance Act 2015.
C. Exemption from VAT Act.
The Finance Act 2021 reintroduced the exemption from VAT of all the transfer of assets and other transactions related to the transfer of assets into real estate investment trusts and asset-backed securities. Initially, this exemption had been revoked vide the Tax Laws Amendment Act No. 2 of 2020.
Pursuant to Paragraph 33 of Part II of the First Schedule to the VAT Act the stipulates that “The transfer of assets and other transactions related to the transfer of assets into real estate investment trusts and asset backed securities is exempt from VAT.”
In view of the above exemption, an outright transfer of property from the Promoter/investors would be VAT exempt. Where there is an indirect transfer of property to the REIT, the transfer of the initial assets into the investee company will be subject to VAT, however, the transfer of shares in the SPV to the REIT trustee will be exempt from VAT.
D. Exemption from Stamp Duty
The transfer of property by the Promotor/investor into the REIT for consideration of REIT securities is exempt from VAT. Additionally, once the properties in a D-REIT are stabilized, the subsequent transfer of the stabilized properties from the D-REIT to the I-REIT is exempt from stamp duty.
This is in line with section 96A of the Stamp Duty Act which provides:
(1) “This section only applies to real estate investment trusts authorized under the Capital Markets Act (CAP 485.A), in respect of which it is shown to the collector: –
a) That the effect is to convey or transfer a beneficial interest in property from one trustee to another trustee or to an additional trustee; or
b) That the effect thereof is to convey or transfer a beneficial interest in property from a person or persons for the transfer of units in the real estate investment trust.
(2) No stamp duty shall be chargeable on an instrument relating to the matters referred to in subsection (1).
It bears noting however, that the above exemption was applicable to instruments executed before the 31st December 2022. Therefore, all transfers effected from 1st January 2023 will attract stamp duty.
Main Challenge to the REITs Tax regime
While tax burden has been largely offloaded to REITs through the above exemptions, there remains a legal gap as to the rules and regulations that govern the REITS and REITs controlled entities exemption under Section 20(1)(d) of the Income Tax Act.
As of 22nd January 2023, the Kenya Revenue Authority has not published the regulations that will formally exempt the REIT-controlled entities from income tax. This is despite the fact that the Cabinet Secretary to the National Treasury and Planning exercising powers conferred by Section 130 of the Income Tax Act made the draft Income Tax (Real Estate Investment Trusts) Rules, 2020 and subjected the said draft to the public for comments.
As such REIT controlled entities have been operating with the belief that KRA will not demand taxes from them courtesy of Section 20(1)(d) of the Income Tax Act. This is a dangerous position to be in given that the tax authority has embarked on aggressive tax collection to try and hit the estimated three trillion (Kshs. 3T) for the 2022-2023 financial year.
Its trite law in tax legislations that they should ensure the right of certainty and predictability in economic activities as reaffirmed by Justice Odunga in the Minimum Tax case. Therefore, the regulations ought to be passed to avoid investors and REITs being on pins and needles during this period. Additionally, by taking care of the uncertainty aspect in the tax structure, more investors will be pulled towards REITs and raise the number from the current three. Currently other capital markets products such as financial derivates are subject to tax courtesy of the Finance Act, 2022 which amended the Income Tax Act to tax gains accruing to a non-resident from financial derivatives at a rate of 15%.
Additionally, it is our proposal that the definition of a REIT controlled entity under the draft rules is amended to include Limited Liability Partnerships. Borrowing from best practice, India, whose REIT market has attained significant maturity since its launch authorizes a REIT to invest in real estate assets either directly or through a holding company or a special purpose vehicle which can either be a company or an LLP.
Conclusion
Despite the legal gap on Income Tax regulations, REITs present themselves as the most efficient vehicles to invest in income-earning-property courtesy of their tax efficiency.
Further, REITs do present themselves as the best option to provide financing solution to accelerate affordable housing supply in the Country. Recently, the Government of Kenya committed to deliver a series of ambitious social programs to promote long-term economic development for Kenyan citizens through its Big Four agenda, and key among them is affordable housing. The housing pillar in the Big Four agenda will facilitate the development of 500,000 low-cost homes, together with the supporting infrastructure, using innovative funding mechanisms and technologies. With the annual housing demand in Kenya standing at 250,000 units and an estimated supply of 50,000 units and expected growth in the deficit attributable to high population growth and rising urbanization rates, there is an opportunity for.
With the tax incentives provided above, REITs continue to provide investors dividend-based income, competitive market performance, transparency, liquidity, inflation protection and portfolio diversification.
This article was published in the 10th Edition of the REITS Association of Kenya newsletter, April 2023