SINGAPORE (Nov 1): Deutsche Bank is maintaining Manulife US REIT (MUST) at “buy” saying valuations are attractive after the REIT fell as much as 7.9% during the week on concerns over sustainability of its US tax structure.
Deutsche says the key worries revolve around the tax deductibility of interest income related to shareholder loans and upcoming IRS revisions.
In a Thursday report, lead analyst Man Chien-Fie believes MUST’s current structure “should be able to maintain most if not all of its tax transparency and while it is expected that there will be regulations and clarifications to the existing law, the research house does not anticipate a major revision”.
Recall that Manulife US REIT was restructured as a Singapore-Barbados-US-based entity in January in order to manage the tax leakage from revisions to the US tax code in December 2017 when the IRS issued “Section 163(J)” which limited the amount of business interest expense that could be deducted in a tax year.
However, an exemption was granted to the real estate sector, hence the first phase of Manulife US REIT's restructuring which eliminated the sub-REIT structure in favour of direct holdings by the parent US REIT.
The IRS at the same time also issued “Section 267A”, which disqualified related-party tax deductions for interest or royalties paid for hybrid entities if 1) The amount is not included in the income of the related party under the local tax laws of the country of which the related party is a resident for tax purposes or where the related party is otherwise subject to tax; or 2) The related party is allowed a deduction with respect to the payment under local tax law.
Hence, the second phase of Manulife US REIT's restructuring which uses a Barbados-based structure.
Under this structure, Manulife US REIT is not considered a hybrid security under US tax laws as the interest income from shareholder loans is taxed in Barbados, and does not claim deductions, says Deutsche.
As for the upcoming tax rulings, Man says they are more likely to clarify which tax deductions are allowed under Section 163(J) but disallowed under Section 267A.
“Currently, the Manulife US REIT is structured such that the Barbados-US is a non-hybrid structure and, as the structure currently stands, we do not believe that there is scope in the current tax law to eliminate the shareholder loan deduction,” says Man.
Manulife US REIT’s management has indicated that revisions to certain accounting treatments for buildings as well as accelerated depreciation schedules could serve to increase the depreciation tax shield and reduce the impact of the tax changes.
Management has also highlighted that there could also be alternative structures that could also help to shield income.
In a worst case scenario where new regulations eliminate the shareholder loan tax shield, Deutsche estimates that there could potentially be an 8.5% impact on DPUs given 17% income tax on 50% of onshore income.
As at 11.04, units in MUST are trading at 72 US cents or 0.8 times book value.