“The best investment on earth is earth.”
This quote promoting real estate
investments above all others is
often attributed to the 20th-century
real estate investor Louis Glickman.
The second-best investment for
a real estate business, however,
may well be a good tax advisor
to consider and mitigate the
numerous taxes associated with
real estate investments. This article
serves as a high-level roadmap,
setting out different types of
taxes that should be taken into
consideration when setting up and
growing a real estate business.
The owner of real estate would
generally be qualified by tax
authorities as the (principal)
taxpayer, although users of the
real estate (eg, tenant or usufruct
holder) may also be qualified
as such. The development of a
tax-efficient property ownership
structure ensures that significant
value is preserved in that
investment’s lifetime. The most
notable levies in this respect are
corporate income tax (CIT) and
capital gains tax (CGT).
Local CIT may be levied on the
profits generated with the real
estate, generally the operating
earnings minus the deductible
expenses. Important aspects to
consider include the CIT rate(s),
depreciation rules as well as
potential deduction restrictions.
In most countries, CGT is levied on
the capital gains (profits) made on
the sale of an asset that increased
in value, such as real estate or a
shareholding in a local (real estate)
subsidiary. As a general rule of
thumb, capital gains derived
from real estate are taxed in the
country where the asset is located
(known as the situs principle).
Many jurisdictions have (domestic)
rules which also subject the sale of
shares in a real estate subsidiary
to CGT. In order to prevent double
taxation, tax treaties are routinely
concluded between jurisdictions
to solidify this principle and to
allocate taxing rights. A tax treaty
may dictate that only one of the
countries may levy CGT. Some tax
treaties for example stipulate that
a jurisdiction is not allowed to levy
tax on the sale of shares in a real
estate (rich) company, established
in that jurisdiction. Spearheaded
by the Organisation for Economic
Co-operation and Development
(OECD) with its anti-Base erosion
and profit shifting (BEPS) project,
the international community is
in an ongoing process to avoid
exploitation of gaps and mismatches
between jurisdictions, including with
respect to the (improper) use of the
tax treaties. In some cases, this also
concerns CGT on the alienation of
real estate rich company’s shares.
While technically not a tax topic,
bilateral investment treaties can
also be important for international
investors. In broad terms, the
nationalization or expropriation of
investments is typically prohibited
under the BITs, unless such
measures are taken in the public
interest and the host state pays
prompt, adequate and effective
compensation to the investor. As
such, particular attention should
be paid to these treaties when
envisaging investing in certain
high-risk source countries.
Funding and treasury
In addition to the ownership
structure, the financing structure
can be equally important. Payments
of dividend and interest may
be subject to withholding taxes
(WHT). As with the CGT, tax treaties
may provide mitigation of WHT
by allocating taxing rights to the
investor and/or source country.
Returns from your target
investment may also impacted by
interest expenses deduction rules.
Deduction of interest expenses may
be restricted to a certain percentage
by means of the “thin capitalization
rule” (or “thin cap rule” for short).
Such a thin cap rule may for
example result in interest on debt
in excess of four times the equity to
be non-deductible. The restriction of
deductions would result in a higher
CIT taxable base.
Deductibility of interest expenses
can also be (further) restricted by
formal transfer pricing rules and/or
the general at arm’s length principle.
This principle requires related
parties to conclude transactions
on an independent basis, ideally
resulting in fair market prices. Some
jurisdictions have formal transfer
pricing rules in place, which may
require detailed reports to be kept
substantiating that transactions with
related parties are in line with the at
arm’s length principle.
Local tax planning
Different tax aspects and incentives
of the target source country
should be closely reviewed.
The acquisition of real estate
(entities) may be subject to real
estate (transfer) tax and/or stamp
duties. Some jurisdictions apply
different real estate (transfer) tax
rates depending on the type of
real estate (eg, a lower tax rate
for residential real estate).
The acquisition of real estate may
also be subject to value added tax
(VAT) which may, or may not, be
recoverable. In certain jurisdictions,
a special VAT exception applies in
case the acquired real estate is
considered to be (part of) a business
(the “transfer of going concern”), in
which case the transaction would
normally not be liable to VAT.
Some countries may provide
tax credits, capital allowances
(similar to a tax credit) or certain
environmentally driven depreciations/
incentives. Depending on the target
jurisdictions, all three categories
might be considered and could result
in a lower domestic CIT basis.
Intellectual property planning
Certain types of real estate, such as
hotels and restaurants, require a
particular brand or formula in order to operate. For tax purposes, such as a brand or formula is typically referred to as intellectual property (IP)It is not uncommon to assign IP rights to a designated
special purpose vehicle which sole purpose would be to
license the IP to the real estate operator/owner. IP rights
may provide for tax efficient structuring possibilities.
Countries may have transfer pricing and/or at arm’s
length rules in place requiring licensing fees paid by
group entities to reflect the fair market value. In order
to ensure an appropriate allocation of the returns from
the exploitation of IP, and also the costs related to the
IP, it is a globally acknowledged principle to look at the
functions of the entities involved, the assets used and
the risks assumed in the “development, enhancement,
maintenance, protection and exploitation” (DEMPE)
functions of the IP. IP, being a relatively easy transferred
asset across borders, is one of the OECD’s main focus
areas. The OECD introduced the DEMPE functions for
IP as part of its BEPS project.
Sustainability and growth
Once the ownership, financing and/or IP structure is
in place, it is important that the day-to-day operations
are optimally managed, also from a tax perspective.
Taking into account liquidity requirements and internal
fund flows, certain arrangements can be designed to
achieve full tax efficiency in cash management. This is
particularly important for the avoidance of any trapped
cash, local expense deduction restriction rules and WHT.
VAT exposure is often hidden in organizations, but can
have a major impact on the cash flow, particularly when
unrecoverable. It is not uncommon for countries to have
long-term revision rules for, among others, real estate.
Such revision rules may require taxpayers to keep
track of the use of the real estate and, under particular
circumstances, repay previously recovered VAT.
Furthermore, some countries may have special
incentive schemes for sustainable energy production,
environmental investment rebates or arbitrary (or
accelerated) depreciation of environmental investments.
Compliance and reporting
Operating real estate often triggers registration and
filing obligations on both a national level (eg, CIT and
VAT) and on a local level (eg, municipality tax). These
various obligations may involve time-consuming and
complex exercises, in particular for real estate investors
active in multiple jurisdictions. Tax reporting policies
and/or models should therefore be set up and ongoing
compliance should be monitored.
Acquisitions and exits
Assets and businesses may be acquired by means
of an asset deal and/or share deal. The chosen route
generally depends on a mix of commercial, legal and tax
considerations. In any scenario, due diligence should be
conducted to determine historic tax risks and liabilities.
Such risks and liabilities, and the integration of newly
acquired assets and businesses in existing structures,
need appropriate attention.
Based on the location of the target asset and/or the
target entity, analysis should be undertaken to determine
the most tax efficient acquisition structure, also taking
into consideration a potential future exit. A proper exit
from an investment should always ensure that tax does
not wipe out significant returns on investment.
From the acquisition up to the sale of real estate,
a myriad of taxes may be applicable to “earth’s best
investment.” All real estate transactions should
therefore be carefully examined and planned, including
from a tax perspective to ensure tax efficiency