By Ben Strauss, director in Cliffe Dekker Hofmeyr’s tax department.
Put simply, a REIT may deduct for income tax purposes distributions made to its shareholders. As a REIT by its nature distributes most of its net income to its investors, the REIT itself usually pays little or no income tax; instead, the shareholder pays income tax on the distributions received from the REIT.
The distribution, however, is only deductible by the REIT if it falls within the definition of ‘qualifying distribution’ in s25BB(1) of the Income Tax Act, No 58 of 1962 (Act). Notably, to fall under the definition the REIT must meet one of the following requirements (among others):
(a) at least 75% of the gross income of the company during its first year of assessment that the company qualifies as a REIT (or a controlled company in relation to the REIT) must consist of rental income; or
(b) in any other case, at least 75% of the gross income of a REIT or a controlled company in the preceding year of assessment must have consisted of rental income.
The term ‘rental income’ is defined in s25BB(1) of the Act.
(Note that the provisions in paragraph (a) above were amended recently with effect from 1 April 2013, the date that the new REIT taxation regime was introduced. Before the change, the provision stated that “at least 75% of the gross income received by or accrued to a REIT or a controlled company until the date of the declaration of that dividend consists of rental income where a REIT or a controlled company is incorporated, formed or established during that year of assessment”.)
The term ‘qualifying distribution’ was the subject matter of a recent ruling of the South African Revenue Service (SARS), Binding Private Ruling: BPR 218 dated 1 February 2016.
The facts of the ruling were these: The first financial year and first year of assessment of a newly incorporated local company (NewCo) ended on 30 June 2015. NewCo listed on the JSE shortly after 30 June 2015 after concluding an amalgamation transaction with a portfolio created as a collective investment scheme in property (CISP).
As from its listing, NewCo started trading as a corporate REIT.
The CISP, under the regulatory requirements pertaining to its industry, converted its business to a corporate structure which was housed in NewCo. The conversion became effective on 1 July 2015. It consisted of the transfer of the assets and liabilities of the CISP to NewCo in exchange for the CISP receiving shares or linked units in NewCo, on the basis that those shares or linked units were issued on behalf of the CISP to the unit holders. The CISP was thereafter voluntarily wound up. The conversion constituted an ‘amalgamation transaction’ under s44 of the Act.
Notably, NewCo conducted no business activities and earned no income before the conversion.
NewCo would make distributions for its year of assessment ending 30 June 2016, being its first year of earning rental income and its first year to be assessed as a REIT.
The distribution in respect of its 2016 year of assessment (to be determined with reference to its financial results for the financial year ending 30 June 2016) will only be made after 30 June 2016, once its financial results have been finalised, unless an interim distribution is made during the course of the 2016 year of assessment, in accordance with the manner in which REITs ordinarily make distributions.
SARS ruled that the provision in paragraph (a) cited above did not apply as the distribution would only be made after 30 June 2016. Instead, in establishing whether 75% of the gross income of NewCo consists of ‘rental income’, in order for it to make a ‘qualifying distribution’ for its year of assessment ending 30 June 2016 – that is, its first year of assessment as a REIT – the applicable year of assessment to consider will be the year of assessment in which NewCo was incorporated, which ended on 30 June 2015. Accordingly, one must have regard to paragraph (b) cited above.
However, on the facts of the ruling, NewCo had no ‘rental income’ in its year of assessment ending on 30 June 2015. Accordingly, NewCo would not have been making a ‘qualifying distribution’ in its 2016 year of assessment.
However, SARS nevertheless ruled that NewCo will comply with the provisions of paragraph (b) and that NewCo would be making a ‘qualifying distribution’ in respect of the 2016 year of assessment (provided that all the other requirements of the definition are met).
The ruling shows that newly formed REITs must take great care at the time of their formation and listing to ensure that the distributions they make after their formation do in fact constitute ‘qualifying distributions’.