SINGAPORE (Nov 26): On Oct 30 and 31, Manulife US Real Estate Investment Trust (MUST) fell sharply to a low of 69.5 US cents, but rebounded on Nov 1. Its decline followed a protracted fall by Keppel-KBS US REIT (KORE), from 73 US cents on Oct 16 to a low of 53 US cents on Nov 5. KORE has since stabilised at 57 US cents to 58 US cents, and MUST has stabilised at 77 US cents. KORE was listed at 88 US cents about a year ago, but has traded below this level for much of this year.
On Oct 30, KORE published a circular to unitholders for its 295-for-1,000 rights issue to raise US$93 million ($127.8 million). The rights circular highlighted a tax leakage, the fourth time that KORE had drawn attention to it this year, alarming analysts and fund managers. The tax issue, coupled with the announcement of an acquisition (on Sept 28) and a dilutive rights issue (on Oct 17), sent KORE’s unit price tumbling, and subsequently caused MUST’s unit price to fall as well.
To take a step back, non-resident aliens such as Asian investors face a dividend tax rate of 30% on dividends paid out by US companies. This rate can be lower, depending on the treaty between the alien’s home country and the US.
When the two US-based S-REITs were listed, their managers said the REITs had tax transparency and that unitholders would be able to receive their distributions per unit without having to pay withholding tax. Both REITs had a US parent that owned preferred shares in sub-REITs. In addition, the distributable income that flowed through from the US would also not attract US taxes because of certain tax shields such as interest deductions on various loans. Up till Dec 31 last year, MUST’s unitholders did not pay any withholding tax on DPU, and MUST’s net property income — less interest and other expenses — flowed all the way to unitholders.
The Trump changes
All this changed on Jan 1 this year because a new tax regulation was passed on Dec 22, 2017. In the new Inland Revenue Code (IRC), section 267A disallows the deduction of interest paid to a “hybrid entity”. From a US tax perspective, a hybrid entity is “fiscally transparent” for US tax purposes but not fiscally transparent for foreign tax purposes. It is usually created by an MNC subject to corporate income tax in one jurisdiction that qualifies for tax transparency treatment in another, resulting in significant tax savings. Fiscally transparent means that income (completely) flows through to investors or owners (with no withholding tax).
1. As at Jan 1, 2018. Details of the restructuring undertaken by MUST can be found in the Singapore Exchange announcement dated Jan 2 and titled ‘Redemption of Preferred Shares by US REITs and Proposed Establishment of Wholly-Owned Entities’
2. There are three wholly-owned shareholder loan SPVs, each of which has made equity investments in two wholly-owned Barbados entities that had formed a Barbados limited partnership
3. The Barbados limited partnerships have extended loans to the parent US REIT and the interest income on the loans is taxed in Barbados
4. Subject to 30% withholding tax
5. Principal repayments are not subject to US withholding taxes. Interest payments are not subject to US withholding taxes, assuming unitholders qualify for portfolio interest exemption and provide appropriate tax certifications, including an appropriate IRS Form W-8
6. Each sub holds an individual property
If the REITs had kept to the previous tax structure, where the Singapore REIT held a special-purpose vehicle (which is likely to be a hybrid entity), the interest expense on the shareholder loan would no longer act as a tax shield. Income flowing into the SPV or hybrid entity would be taxed as dividends at 30%.
Section 163(J) of the new IRC limited the amount of business interest expense that could be deducted in a given year to the sum of its 1) interest income, plus 2) 30% of its adjusted tax income plus 3) the taxpayer’s floor plan financing interest.
Protecting distributable income: MUST’s four pillars
Almost at once, the managers of MUST and KORE restructured the REITs so that the rental income could be “shielded” from the 30% tax as much as possible.
To get around Section 163(J), MUST restructured its sub-REITs in favour of the US parent REIT’s directly holding the physical property, Jag Obhan, chief financial officer of MUST’s manager, tells The Edge Singapore. He says: “For a non-real estate entity, there is a cap on interest expense deduction. We redeemed these preferred shares and [converted them to] non-REIT status, and the properties are held directly by the US parent REIT so that the US parent REIT would have real estate business. Therefore, we can continue to get the interest deduction for tax purposes.”
Obhan explains that four pillars hold MUST’s tax structure together to ensure that as much rental income flows through to unitholders as possible. The first pillar is the US REIT structure and the widely held rule. Income from the properties is collected and placed in a REIT. A regular corporate structure attracts income tax (of 21%). “To have tax transparency, we created a US private REIT [so] you can receive income without paying taxes, and pay it out without paying taxes,” he explains. To qualify as a REIT, the entity must derive most of its income from physical property, pay out at least 90% of taxable income and be widely held, with no fewer than five persons holding 50% of a company.
The second pillar is zero tax in Singapore for foreign-sourced income.
The third pillar is the US portfolio interest-exemption rule. Any income that leaves the US is automatically charged 30% withholding taxes. However, interest income on the shareholder loan that qualifies as “portfolio interest” is not subject to 30% withholding taxes, provided that the unitholder holds less than 10% of the units and has filed the respective W-8 US tax forms. In addition, the unitholder shall not be a foreign-controlled corporation to which the US parent REIT is a “related person”.
The fourth pillar is the distribution from the US to Singapore through a hybrid entity in a combination of dividends, interest payments and repayments on shareholder loans. Section 267A disqualified related-party tax deductions and distributions into a hybrid entity. In January this year, MUST restructured so that the US parent REIT had a shareholder loan from a Barbados limited partnership.
“We had implemented a Barbados structure, which addressed two issues. One, the entity in Barbados was treated as fiscally transparent in Barbados and the US; and, two, we pay some tax in Barbados,” Obhan says. The witholding tax rate in Barbados is 2.5%. “If you’re paying taxes somewhere, you are exempt from [being] a hybrid entity and you can keep on deducting the interest on the shareholder loan.”
Why Barbados? “We selected Barbados because Manulife already has a presence there and we like to go to tax regimes we have experience with. Whenever we select our tax regimes, there are three to four key criteria. First, it has to be politically stable; second, Manulife has to have experience or a presence there; third, it has to [comply with] the tax rules; and, four, we try to assess where there is the least tax leakage and whether it is beneficial to unitholders,” he says.
Distributable income as a waterfall
If the four pillars are somewhat complicated, think of the income from the US as a waterfall. Of the 100% of the waterfall, 20% is likely to be used for interest expense for the portfolio’s onshore mortgages for its properties. Of the remaining 80%, which is the residual distributable income, depreciation for the buildings is allowed, and about 50% of distributable income can be partially shielded from tax with this cost. Interest payment on the shareholder loan is likely to account for the remaining 50%.
MUST’s current tax structure meets the US Tax Act requirements. US tax authorities are expected to issue further tax regulations and clarifications, but the timing and impact of the new regulations are unknown.
If the current Barbados tax jurisdiction is not allowed, MUST has options to move to different tax jurisdictions to continue to deduct shareholder loan interest, including the option of paying Singapore corporate tax of 17%, putting 8.5% of distributions at risk. The Barbados structure puts just 1.25% of distributions at risk (2.5% of 50%).
“Our property loans were done in the US and we were not overreliant on the shareholder loan. In the worst-case scenario, where no shareholder loan interest deduction is allowed, the impact on distributable income will be about 15%,” Obhan says, referring to US withholding tax on dividends repatriated overseas.
At any rate, if Barbados is not an acceptable jurisdiction, Obhan reckons there are others in which Manulife has a presence. “We have different scenarios. We have knowledge about different jurisdictions. Barbados made sense to us because we have a big reinsurance business there. We have used different tax structures in different places. If tax regulations come out tomorrow, we’ve worked out various scenarios that make sense for us.”
KORE makes similar changes
On Jan 2, KORE’s manager announced that it had established a partnership in Barbados. The partnership became lender to KORE’s US parent REIT, that is, the Barbados entity provides the shareholder loan to KORE’s US parent REIT to shield the distributable income from 30% withholding tax (on dividends). More recently, in its rights issue circular, KORE’s manager had reiterated that the REIT was restructured because of the new tax regulations.
“In the KORE announcement on Jan 2, 2018, it was stated that one of the effects of the US Tax Act on KORE was that it impacts the deductibility of certain interest expenses for taxable years beginning after Dec 31, 2017,” a Keppel spokeswoman says. Keppel owns 50% of KORE’s manager and a 7% stake in the REIT. “To address such effects, the manager commenced a process of its own restructuring, and established directly and indirectly wholly-owned companies and a partnership in Barbados,” she adds.
One of the risks of the new US Tax Act is that the tax could be retroactively applied. “Legislative technical corrections, regulations or administrative guidance addressing the new provisions of the US Tax Act may be enacted or issued in the future, possibly with retroactive effect,” a KORE statement warns.
As with all other risk factors, the manager prefers to err on the side of caution and present the worst-possible outcome, the Keppel Corp spokeswoman says. The worst-case scenario could be “a 30% downside risk to distributable income, potentially on a retroactive basis. This scenario assumes that the manager takes no further action at all to mitigate downside risks”, she says. However, KORE’s manager has been actively looking into alternative structures to mitigate the downside risks and protect unitholders’ interests, the spokeswoman points out.
Another REIT with US property
The US accounts for 12.4 % of Ascott Residence Trust’s (Ascott REIT) assets, and contributes 11% to its gross profit. Interestingly, Ascott REIT appeared to be unaffected by the changes in US tax regulations. “Ascott REIT has no offshore shareholder loan structure for all its US investments. Therefore, the new Section 267A [which was introduced as part of the US tax reform in late 2017], has no impact on Ascott REIT,” says an Ascott REIT spokeswoman. Ascott REIT announced DPU of 1.82 cents for 3QFY2018, translating into a yield of 6.74%.
Since Ascendas-Singbridge acquired a US portfolio of campus-style properties, the market has been abuzz on an impending IPO of a fourth REIT by the company. Like CapitaLand and Mapletree Investments, Ascendas-Singbridge holds significant stakes in its three listed REITs and trusts: Ascendas REIT, Ascendas Hospitality Trust and Ascendas India Trust. Analysts have said that Ascendas-Singbridge is likely to opt for the widely held rule if it lists a US-focused S-REIT, that is, it will hold no more than 9.8% of the new REIT.
Both DBS Group Research and Deutsche Bank have maintained their “buy” calls on MUST. “We believe the current structure should be able to maintain most, if not all, of [MUST’s] tax transparency,” the Deutsche Bank report states. DBS says it is still awaiting clarification from tax authorities. It forecasts a DPU of 6.24 US cents for FY2019, up from an estimated 5.53 US cents for this year, translating into a forward DPU yield of 8.18%.