European corporations considering spinning off real estate portfolios must be taking envious glances at their US counterparts.
Last week, the Internal Revenue Service - the US tax authority - issued a ruling that revoked a 28-year-old rule, possibly paving the way for corporations to sell off property and gain tax advantages at the same time. Bob Willens, a tax and accounting analyst with Lehman Brothers, termed the implications of the ruling "limitless". "There are pretty vast benefits to be gained from this," he said. "Once real estate is removed from a company's balance sheet, its return on equity and return on assets are vastly enhanced." The point apparent to a growing number of European corporations is that real estate is a low-yielding asset. Capital deployed in bricks and mortar cannot be used to generate returns on the sale of fast food or ladies' lingerie, for example. Whether or not US companies with large real estate portfolios, such as retailers McDonald's and WalMart, find it to their advantage to take such a step, the move poses questions for European companies that have already shown signs of going down that rout e. For while the UK does not offer real estate investors tax-advantaged vehicles, others do, such as Germany and the Netherlands. But it is not clear that a spin-off is automatically acceptable to the IRS, no matter what advice investment bankers offer. The genesis of the ruling lies in the 1960 act creating REITs (Real Estate Investment Trusts). Originally they were intended as passive vehicles enabling retail investors to invest in property and obtain the same tax advantages as those wealthy enough to buy property outright. A 1973 IRS ruling clarified this point. Richard Passales, from the office of the IRS' associate chief counsel, says originally REITs could not even perform simple maintenance on their properties themselves; all work had to be contracted out to third parties. The 1973 ruling clarified that REITs could not engage in "substantial management and operational activities", and these, according to a spokesman for the National Association of Real Estate Investment Trusts (NAREIT) involved activities as simple as providing a lifeguard at the swimming pool of an apartment development or landscaping work. However in 1986, as REITs began to recognise the greater cost of outsourcing management, the law was changed to allow them to engage in activities related to their own management; although fees earned, for example, through third-party management, remained subject to tax.
The law was hardly used until 1992, when a US REIT, Kimco, devised a structure to allow its management and ownership to sit in a single vehicle; it was then that REITs began to grow into the operating businesses that many are today. Yet the 1973 ruling lay on the books. But last summer, Georgia-Pacific Corp announced the planned sale of its Timber Group subsidiary with a REIT, Plum Creek; a merger that needed IRS clarification because of the 1973 ruling. The IRS ruling this week is understood to have been issued in response to the Timber Group/Plum Creek plans. NAREIT, for its part, says the ruling is welcome, although it is far from clear that companies will use the ruling to spin off their property assets. For one thing, the depreciation on property shields profits against tax. But for the industry, the implications are significant.
