TAXATION OF REAL ESTATE INVESTMENT TRUST SCHEMES (REITS) AND OTHER COLLECTIVE INVESTMENT SCHEMES (CIS)

Introduction

The Securities and Exchange Commission ((herein referred to as “SEC”) SEC), Nigeria is the apex regulatory institution of the Nigerian capital market supervised by the Federal Ministry of Finance.

The Commission has evolved over time having started with the establishment of the Capital Issues Committee in 1962 by the government as an essential arm of the Central Bank of Nigeria. This was purely an ad-hoc, non-statutory committee, which later metamorphosed into SEC in 1979, following a comprehensive review of the Nigerian financial system, with the promulgation of SEC Decree No. 71 of 1979. Successive reviews of this earlier enactment led to the introduction of a new legislation, the Investments and Securities Act (ISA) No 45 of 1999.   The ISA No. 45 of 1999 was repealed with the promulgation of the ISA No. 25 of 2007, which gives the Commission its current power.

Real Estate Investment Trust (REITs) in developed capital markets have been in existence in their present format since the 1960s, however, were actually originally introduced in the 1800s. Corporate tax exemption was a critical element in the development of the REIT industry. REITs are typically exempt from corporate tax as long as 90% of net income is distributed to shareholders. REITs are commonly structured as close ended trusts due to the illiquid nature of property.

Securities and Exchange Commission (SEC) can play a strong role in the further development of the real estate sector. The introduction of REITs is viable given the demand for real estate, and the need for additional financial instruments. As a result, it is recommended the Securities and Exchange Commission introduce REIT regulations and work with the Federal Government to give fiscal incentives. Housing should be given extra incentives to help the government meet their 2020 Vision goals.

The capital markets can help mobilize and allocate resources, as there is a strong demand and cultural bias towards property investments. Retirement Benefit Schemes as well as many individuals are already investing in property but many are very limited in their ability to do so in that they cannot afford direct investments that are not liquid. With the introduction of REITs it is felt property developers would come to the capital markets to raise funds. It is also likely that through a higher level of participation through the capital markets, bank financing would be forced to become more competitive thus helping to further reduce development costs.

Nigeria’s current range of Collective Investment Vehicles (CIVs)

This examines the current tax treatment of the existing range of CIVs to identify issues in achieving the desired outcomes established by the terms of reference.

Currently, there are a range of vehicles in Nigeria that could potentially meet the definition of a CIV. These include:

·         Unit Trusts

·         Venture Capital Funds

·         Open-ended Investment Companies

·         Real Estate Investment Schemes

·         Specialized Funds

v  UNIT TRUST

A Unit Trust Scheme is a Fund into which small sums of monies from individual investors are collected to form a “pool” for the purpose of investing in stocks, shares and money market instrument by professional fund managers on behalf of the contributors called unit holders [subscribers]. By investing in a unit trust scheme, the unit holders enjoy the benefits of diversification and professional management of their fund at low cost.

The total fund of a unit trust scheme is divided into units of exactly equal monetary value e.g.  If one unit is N1.00, any person investing N100 will get 100 units. Unit Trust Funds are invested in highly-rated securities on behalf of the unit holders by the management company.

There are two types of Unit Trust Schemes, viz;

·         Open-Ended

This is a Fund that continuously creates issues and redeems units after the initial public offering. The price is based on the Net Asset Value (NAV), which is total asset of the fund minus liabilities as at date of purchase or redemption.

·         Closed-Ended

In a Closed–Ended Fund, there is no additional issue of new units or redemption of units. The Fund is usually listed and traded on the Stock Exchange and its price will be determined by the market forces of supply and demand. A unit holder who wants to redeem his unit will therefore have to go through his Stockbroker.
 

v  Trust Deed

A Trust Deed is the agreement between the Fund Manager and the Trustee. It governs the management of a Unit Trust Scheme by laying down rights, responsibilities, investment objectives, policies, outlets and all other relevant information of the Fund.
   
Key Parties to Unit Trust Scheme

·         Fund manager

·         Trustee

·         Custodian

·         Registrar

Benefits of Unit Trust Schemes

·         Deepening of the Nigeria capital market

·         Bringing capital market activities to the grassroots

·         Helps to pool funds from various investors for investment purposes

·         Encourages small private enterprises to take advantage of capital market funds for long-term investment purposes, which is necessary for the expansion of their businesses and subsequently the economy

·         Profit/income, capital appreciation e.t.c.

·         Avails retail investors with professional Management for their Funds

v  Venture Capital

It is early stage financing of new and young companies seeking to grow rapidly. It is defined as a profit seeking venture by an entrepreneur, whose primary objective is to provide fund not otherwise available to new and growing business venture for the purpose of making profit in the long term.

For a Venture Capital Fund to exist there must be the presence of the following:-

·         Risk-Takers, who are prepared to invest in Venture Capital Fund and wait for long term gains rather than short term profits (Venture Capitalist).

·         There must be a Venture Capital Company to collect the money from the risk-takers and offer them shares in return with a promise of high return in future.

·         There must be a viable business venture whether new or young into which the Venture Capital Company could invest part of its equity.

·         There must be an entrepreneur with a good business under taking yearning for expansion capital.

The process for a Venture Capital activity involves:

·         Fund raising

·         Real flow/investment

·         Monitoring/value enhancement

·         Exit stage.

Sources of Venture Capital Fund

·         Institutional investors: - these are made up of pension fund, insurance companies, and professionally managed, charitable foundations/endowment fund of universities.

·         Wealthy individuals who are members of a business community, aggressive risk takers who possess the acumen to select good ventures with strong potentials.

·         Corporate organizations that are set up to fund new business ventures that lack the capacity to attract funding from banks because they lack collateral and impressive track record.

Benefits of Venture Capital Financing

·         It assists in providing seed capital to start-up companies with a view to helping the entrepreneur attain on-going concern status before being able to attract bank financing.

·         It provides risk capital to an existing company as support in a period of rapid growth or, to facilitate the introduction of a new product into the market.

·          It contributes to the GNP/GDP of the economy through output expansion.

·         It creates employment.

·         It enables companies involved to obtain tax rebates.

·         It helps in transforming technology.

·         It increases activities on the stock exchange through purchase of shares from existing shareholders, thereby stimulating capital market growth.

·         Provides capital with which to fund mergers and takeovers.

Problems associated with Venture Capital in Nigeria

·         Inadequate funding.

·         Problem associated with identifying suitable new domestic technologies and investment outlets.

·         Lack of defined framework.

·         Competition from other attractive investment alternatives.

·         Lack of qualified and experienced management.

·         Lack of technical capabilities.

·         Infrastructural problems in the areas of transport, good roads, power (electricity generation), health, telecommunication, etc.

v  Real Estate Investment Trust Scheme (REITS)

REITS is a Collective Investment Scheme which directly invests (acquire, hold and manage) in income generating real estate (and real estate related) assets using pooled funds from subscriptions of its participant investors/ unit holders

(1) DESIGN OF A NEW CORPORATE CIV REGIME

The previous paragraphs considered whether changes can be made to the existing CIV regimes. This paragraph considers the desirability of a wider range of CIVs, in particular a new corporate CIV regime, and the design issues that would need to be addressed should such a change be implemented.

The terms of reference ask whether a broader range of tax flow-through CIVs (such as corporate CIVs) should be permitted. In making our recommendations, we considered:

·         the nature and extent of, and the reasons for, any impediments to investment into Nigeria by foreign investors through CIVs;

·         the benefits of extending tax flow-through treatment for CIVs, including the degree to which a non-trust CIV would enhance industry’s ability to attract foreign funds under management in Nigeria; and

·         Whether there are critical design features that would improve certainty and simplicity and enable better harmonisation, consistency and coherence across the various CIV regimes, including by rationalisation of the regimes where possible.

1.   Design of a new CIV regime

Internationally, most countries seek to promote neutrality, that is, the outcome from investing in the CIV aims to replicate, as far as possible, the outcomes that would arise as if the investor had directly acquired the underlying investment. However, the mechanism by which this outcome is achieved can vary from country to country.

Which model is ultimately adopted will depend heavily on the tax framework of the respective country, taking into consideration issues such as the country’s treatment of capital (as opposed to income) gains, the tax treatment of companies, the tax treatment of other entities, the regulatory environment for different kind of entities including CIVs and how the country taxes non-residents.

Details of the main CIVs used in the UK (authorised investment funds, authorised unit trusts, open ended investment companies and real estate investment trusts), Ireland (collective investment funds, variable capital investment companies, common contractual funds, investment limited partnerships and qualifying investor funds) and in the US (real estate investment trusts, regulated investment companies, limited partnerships and entities using the check-the-box rules).

Drawing on international analysis, it is understood that a typical structure of a CIV comprises:

·         the investment fund (comprising the financial assets purchased with the funds provided by investors, together with available cash reserves);

·         the management company (the entity that collects the money from investors, invests in accordance with the objectives and policies of the fund, calculates the net asset value per unit of the fund and issues and redeems units, shares or other interests as requested by the investors);

·         the fund manager (engaged by the management company to advise and manage the portfolio of investments);

·         the custodian, trustee or depositary (entrusted with the assets of the fund and with the exercise of any rights in respect of the entrusted assets, including overseeing that the issuance and redemption of units etc are carried out, and the value of units etc calculated, in accordance with the law and fund rules); and

·         the investors, who provide the money for investments in the fund and in consideration receive one or more securities (such as units in a unit trust) that entitle them to the income or gains generated by the fund, net of expenses.

Open-ended funds refer to CIVs in which the units (or shares etc) can be redeemed upon an investor’s request at a value corresponding to the net asset value of the unit. Most open-ended funds continually offer new units to investors. They are open in the sense that through the issuance and redemption of units, the number of units may change on a daily basis. Only open-ended CIVs can qualify as Undertakings for Collective Investments in Transferable Securities (UCITS) under the EU Directives.

By contrast, closed-ended funds have a fixed capital and are not obliged to redeem units etc upon an investor’s request. Their units, shares or other interests are typically traded on a stock exchange and their total value does not necessarily correspond to the net asset value of the fund, instead being determined by ordinary stock market forces. Australia’s LICs are examples of closed-ended funds.

Some closed ended funds are not traded on a stock exchange. These may be designed for a specific set of investments that require patient capital. In these cases the fund’s assets are sold after a pre-determined period and the proceeds distributed to investors.

CIVs can also operate through a variety of legal structures offered within a jurisdiction. These include a corporation, trust, partnership, co-ownership of property or contractual arrangements.

Depending on the jurisdiction, different legal structures will be governed by differing levels of regulation. For example, partnerships in Nigeria are taxable by state laws, whereas corporations are taxable by federal law. Some jurisdictions may also have overarching regulation which governs the operation of CIVs which may be dependent or independent of the legal form the vehicle may take.

For example, the UCITS Directive imposes regulations across CIVs operating in the EU. Common basic rules are set for such things as the structure of investment funds, management companies, investment policies, information disclosures, and authorisation and supervision requirements. These rules will apply despite the legal form of the investment fund, giving a consistency of protection and assurance to investors.

In the case of UCITS, some governance remains subject to the particular laws of each EU member state. This includes marketing and advertising rules. It is important to note that taxation of UCITS is governed by the particular tax laws of each member state, and is not part of the overarching EU UCITS regime.

Broadly, there are four generic models for taxation of CIVs that are utilised throughout the world. These are set out below.

In principle, the taxation models discussed could apply to CIVs regardless of their legal form. However, the appropriateness of a particular taxation model for the purposes of enhancing Nigeria’s status as a regional financial centre will depend on a number of factors, including the existing tax and other legal frameworks which apply to each legal structure in Nigeria, the complexity of the tax rules which would need to be created and the compliance burden placed on CIVs and investors.

Flow-through model

In its purest form, this model treats the CIV as fully transparent and allocates all the different items of income and losses to the investors. Investors are treated as if they earned the income directly and are taxed accordingly, even if the CIV does not distribute the income.

The CIV is disregarded for tax purposes, that is, tax effects occur at the level of the investor and the CIV is merely a conduit by which the individual derives the income or loss, comparable to the way in which partnership income is treated in many countries.

The Common Contractual Fund (CCF) in Ireland is an example of a transparent CIV. The CCF is exempt from Irish tax, and income and gains arising or accruing to the CCF are treated as arising or accruing to the unit holders. Each investor receives an annual breakdown of income on investments by type and source.

The exemption model

The CIV may be recognised as a taxable entity, but be wholly exempt from tax on any item of income or capital gain if it meets certain conditions.

Variable Capital Investment Companies (VCICs) domiciled in Ireland that are established in accordance with the conditions established in the UCITS Directive can be described as an example of an exempt CIV. No tax is imposed at the fund level and non-resident investors are exempt from withholding tax on distributions.

The distribution model

The CIV is subject to tax at normal rates, but usually the tax is nil or close to nil because of the way the tax base is constructed (usually featuring a deduction for distributions, often again subject to criteria specifically designed for CIVs).

Under this model the CIV is taxed on any undistributed income and investors are taxed on any income distributed to them. Countries that follow this model generally require funds to distribute a substantial portion of their income each year.

US REITs and mutual funds or regulated investment companies are examples of CIVs whose taxation regime is structured under a distribution model. US REITs are treated as corporations for tax purposes but receive deductions for dividend distributions of current year income and capital gains. US REITs must annually distribute at least 90 per cent of their ordinary taxable income.

A distribution model could also be implemented under a ‘deemed distribution’ approach, whereby CIVs are not required to actually make the required minimum distributions to access the deduction, and investors are taxed as if they had received the distributions and reinvested the corresponding amounts.

The integration model

The CIV is recognized for tax purposes and subject to tax at normal rates, with full integration of the tax on the CIV and tax on the investor in the CIV by way of an exemption for the investor or through the provision of full imputation credits.

Nigeria’s corporate taxation regime, with franking credits attached to any Nigerian source dividend received by resident investors and withholding tax exemption for any fully franked dividends paid to bank holding companies, has elements of a partial integration model, although it is not a model specifically designed for CIVs.

Any recommendations on appropriate CIV vehicles should provide investors, particularly those at the retail level, with high levels of consumer protection and assurance (such as those afforded by existing corporation law or other regulations).

2.    PRINCIPLES FOR TAXATION TREATMENT OF COLLECTIVE INVESTMENT VEHICLES (CIVs) AND INVESTORS IN CIVs

The following could be taken as guiding policy principles for the taxation treatment of CIVs and their investors.

Policy principle 1: The tax treatment of a CIV should be determined by the nature of its investment activities rather than the legal nature of the entity through which the funds are pooled

Managed funds can be seen as providing a service of managing the domestic and foreign savings of a number of individual investors and investing them across a range of domestic and offshore equities, property and bonds.

In overseas jurisdictions, managed funds can be established as companies, trusts, partnerships, jointly held property or contractual arrangements. In most jurisdictions, to be taxed as a CIV the entity must be subject to and meet established regulatory requirements related to investor protection such as investment guidelines and disclosing and reporting obligations. In many instances, the CIV must be registered under a relevant authority.

Entity taxation arrangements in Nigeria are often driven by the legal form of the entity used rather than the nature of the entity’s activities.

Policy principle 2: Tax outcomes for investors in a CIV should be broadly consistent with the tax outcomes of direct investment — achieving tax neutrality

A neutral tax regime is one that does not influence investors’ choices between investing directly or through a CIV in the same underlying investments. The ability of a tax regime to achieve neutrality between direct and indirect investment outcomes varies depending on the legal form in which CIVs are established, the characteristics of the prevailing income tax regime, the different jurisdictions involved in the chain of taxing a CIV investment (as a general rule, the more taxing jurisdictions, the more difficulty in achieving full neutrality) and the range of investors.

Transparent tax treatment or flow-through taxation is one way of achieving consistent outcomes between direct and indirect investment.8 Tax flow-through broadly enables a CIV to be ‘looked through’ for tax purposes so that income and gains from an underlying investment of the CIV would flow-through the CIV to be taxed in the hands of the investor, with the amounts retaining all of their tax characteristics. In practice, tax jurisdictions may offer partial flow-through vehicles where some tax characteristics may not pass through to the investor.

Aside from using tax flow-through, there are other methods of achieving tax neutral outcomes between direct and indirect investment. An example is an ‘integration model’ where a CIV is subject to tax, but where the investor receives tax credits to offset the tax already paid by the CIV.  A decision on which model or models to implement would depend on a number of factors including the feasibility of each model, whether the model aligns with existing tax rules to a particular legal structure, the complexity in the tax rules and other laws which would need to be implemented, the level of compliance burden imposed on the CIV, and other costs and benefits of the model.

It is not necessary that the same form of taxation be used for the different types of legal entities. What is important is that the tax outcomes for investors in a particular type of CIV are broadly similar to the tax outcome that the investors would obtain through direct investments in the underlying assets of the CIV.

The following represent the key tax attributes that arise for investors undertaking a direct investment, and will be critical to achieving tax neutrality in the design of a broader CIV regime in Nigeria.

Resident investors

Under an investment made directly, a resident investor broadly:

·          remains subject to tax on their income;

·         is able to offset tax payable by the franking credits attached to dividends from Nigerian resident companies;

·         retains the right to access the CGT discount in relation to the disposal of a CGT asset, where the relevant conditions have been satisfied;

·         is able to offset capital losses against capital gains made on the disposal of investments held on capital account;

·         is able to offset revenue losses made on the investments, such as those that may arise from funding costs or share trading, against assessable income; and

·         receives a credit for any foreign tax paid on foreign income, broadly up to the lesser of the foreign tax paid and the investor’s marginal rate of tax.

Non-resident investors

Under an investment made directly, a non-resident investor broadly:

·          is subject to a final withholding tax on Nigerian sourced dividend, interest and royalty income applicable on a gross basis;

·         is not subject to Nigerian tax on any capital gains derived from the disposal of assets, except for the disposal of taxable Nigerian real property assets or assets used by a permanent establishment of the non-resident in Nigeria; and

·          is not subject to Australian tax on any foreign source income.

Nigeria has a special regime of 7.5 per cent final withholding tax rate applicable on a gross basis for fund payments to foreign residents in a double tax treaty country or 10 per cent for residents in other countries. This regime, particularly relevant to property trusts, provides a more favorable tax outcome than direct investments by non-residents and is consistent with the emerging international norm based on the different character of investments in Real Estate Investment Trusts (REITS) compared to direct investments in land.

The tax neutrality objective does not operate in the same way for non-residents as for residents. The foreign resident’s ultimate tax outcome depends on the tax treatment in their country of residence. The main objective for Nigeria is to set out tax rules that aim to provide similar tax outcomes whether the foreign residents invest directly into Nigeria or through a CIV. The objective is to collect an appropriate amount of revenue on a source basis without discouraging or creating tax impediments to mobile foreign investment in Nigeria.

Policy principle 3: Any recommendations should seek to enhance Nigeria’s status as a leading regional financial centre while maintaining the integrity of the tax system and revenue neutral or near revenue neutral outcomes

This principle highlights the need to consider an appropriate balance between the objectives of enhancing Nigeria’s status as a leading regional financial centre and protecting (or not adversely affecting) the revenue. With respect to investments by non-residents in Nigerian CIVs the objective is to ensure the tax regimes do not constitute a barrier to investments in Nigeria while at the same time ensuring that Nigeria collects source taxes on a timely basis. With respect to investments by residents, the objective is to ensure that the integrity of the tax system is preserved, with the income of residents being taxed on an appropriate and timely basis.

Preventing accumulation of income

Tax flow-through models require that the fund investor is considered to have earned the income in the same tax year in which the CIV earned the income, that is, with no (or limited) accumulation of income at the CIV level. Where no or little tax is levied at the CIV level, accumulation of income in the CIV could result in the income earned by the CIV not being subject to any tax until it is ultimately distributed to investors.

Accumulation of income could be prevented through a ‘deemed-distribution’ approach, where investors are taxed as if the corporate CIV income is distributed to investors in the year of income, regardless of the actual distribution made by the CIV (in the case of non-resident investors, this would apply to any Nigerian source income of the CIV).

Such an approach crystallises a tax obligation to investors who may not be funded from distributions made. However, if this possibility is disclosed to investors, who choose to invest or maintain their investment, it is an option that can be considered.

Creating CIVs for non-residents

Another possibility to address the issues raised by policy principle 3 is to create specific CIVs for non-resident investors which are limited in use to such investors. This would allow providing a tax regime for the CIVs that is consistent with the tax regime and concessions applicable to investments made directly by non-residents.

However, experience suggests that it is preferable to make regimes available for both resident and non-resident investors. Otherwise, domestic capital could round-trip to a foreign entity which then invests back into Nigeria to obtain advantages available to non-residents. Apart from the potential problem of round-tripping, the creation of CIVs limited in use to non-residents could lead to the creation of mirror funds for resident investors that are willing to invest in similar investment opportunities as those available for non-residents. This could add uncertainty and regulatory or tax compliance costs, and detract from the objective of establishing Nigeria as a leading regional financial centre.

3.    The significance of tax treaties and foreign tax on CIVs

International issues of relevance to the taxation treatment of CIVs often arise under tax treaties and the impact of foreign tax laws. Nigeria needs to take account of these issues in designing its domestic tax and regulatory laws for CIVs.

Tax treaties as a whole cannot be changed in the short to medium term due in part to the need to negotiate them on a bilateral basis.

Because of the numerous tax treaties with different rules and the various foreign countries concerned, it is not possible to discuss all the issues that may arise nor deal with them in detail. Accordingly, some of the benefits and detriments of transparent or flow-through CIVs compared to those of non-transparent corporate CIVs are outlined in this section in general terms only.

In designing options for CIVs in Nigeria  it is necessary to identify which countries’ laws are of greatest relevance and what particular issues cause the greatest impediment to cross-border investment into Nigerian CIVs.

4  Conclusion

Unless the CIS investment is in a company granted a tax holiday, dividends paid to the CIS would suffer withholding tax. Distributions by a CIS to unit holder are treated as a dividend for tax purposes. The fund manager will deduct tax from the profit before paying the balance to unit holders. Distribution to unit holders will not suffer further tax in the hands of the unit holders.

REITS will usually invest directly in real property. REITS income is usually from rents from properties, interest from mortgages or dividends. The REITS manager will subject the income from rents and interests to normal income tax. The fund manager is also obliged to deduct tax from payment from distributions due to unit holders. REITS will charge Value Added Tax on commercial letting and sales of property.

Disposal of investment property that results in a gain will be subject to capital gains tax, unless the investment property is shares/stock.

Nigerian tax provisions regarding CIS and REITS are not at par with a number of developed countries. It would be helpful to investors and tax practitioners alike if CITA is redrafted to address collective investment schemes in general, rather than just Unit Trust because a unit trust is just a type of CIS. Also, it would be helpful if specific tax provisions are introduced to address REITS as a standalone.

Olatunji Abdulrazaq is Director, Tax & Advisory Services at Nolands Nigeria Professional Services.

Email: olatunjia@nolands.ng, oabdulrazaq11@gmail.com