by: Tam Ging Wien
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At the close of the trading day on 30-Oct-2018 (Tue), Keppel-KBS US REIT (Keppel-KBS REIT) lodged the Offer Information Statement (OIS) for its 295-for-1,000 rights issue which was used to acquire the Westpark Portfolio. Contained within the document was a risk factor where the REIT could be subjected to a 30% US withholding tax should certain interpretations of the modified Internal Revenue Code (IRC) Section 267A be found to be unfavourable.
Immediately the next day, analyst from J.P. Morgan released a short note entitled Singapore REITs: New US tax rule could see 30% downside risk to SG-listed US REIT income. In the note, analyst highlighted the tax risk factor of Keppel-KBS could also impact Manulife US REIT’s (Manulife REIT).
The markets reacted negatively to the announcements – share prices of both Keppel-KBS REIT and Manulife REIT fell following this news release.
On the same day, J.P. Morgan released a second short note after it had a tele-conference call with the management of Manulife REIT with regards to the tax risk entitled Feedback from Manulife US REIT Teleconference.
This goes to show that tax regulations and changes are a risk that investors need to bear in mind when investing in tax jurisdictions that they are unfamiliar with and could impact their investment returns.
If any readers are interested in the analysis and context of Keppel-KBS REIT’s rights issue and acquisition of Westpark portfolio, ProButterfly had previously done a write-up entitled Is the Keppel-KBS REIT Acquisition and Rights Issue Truly Beneficial to Unitholders?
While we ourselves are no tax experts, we will try to the best our knowledge and ability to explain the potential impact of the tax rule on both Keppel-KBS REIT and Manulife REIT.
US President – Donald Trump in order to fulfil his campaign promise to cut taxes to boost job creation and the economy – signed into law on 22-Dec-2017 the “Tax Cuts and Jobs Act of 2017” (TCJA) that amended the Internal Revenue Code (IRC) of 1986. The TCJA comes into effect from 01-Jan-2018.
Key elements of the TCJA include:
Specifically, for both Keppel-KBS REIT and Manulife REIT that derive their income from the US, the TCJA’s anti-hybrid rule impacts them directly.
Since, we are not tax experts, and since this article is not about specifically US taxation laws, we will not try to elaborate the various terminologies such as hybrid entities, disqualified related parties or hybrid transaction. Instead readers who are interested to delve deeper may refer to this article by Rödl & Partner entitled Limits on Deductions for Interest or Royalties Paid to Hybrids. Instead we will focus on what investors need to know and how it may potentially impact them.
What investors need to be aware of is that both REITs had to modify their holding structure and introduce a Barbados partnership to insulate the REIT unitholders against US withholding taxes. This new entity can be clearly seen in the before and after REIT structure.
In the past, both REITs used a Singapore based special purpose vehicle (SPV) to provide loans to the US Parent REIT entity to invest in real estate assets. In return, the US Parent REIT pays interest to these SPVs. These SPVs convert the interest into income which can be used to pay part of the distributable income to unitholders.
An entity is deemed to be a hybrid entity, if an entity is:
The TCJA disqualifies hybrid entity transactions from tax exemption and a withholding tax of 30% will be levied upon them.
In order to sheld unitholders against this withholding tax, a new Barbados partnership is introduced which are subjected to Barbados tax laws. Barbados was chosen as the preferred jurisdiction to incorporate as its tax rate is sufficiently low – between 0.25% to 2.50%. Since the Barbados partnership pays tax (a very low tax rate!), it is technically not treated as a hybrid entity and therefore shielding unitholders from the 30% US withholding tax.
It definitely makes corporate sense for both REITs to pay a small 0.25% to 2.50% tax to protect unitholders from an enormous 30% tax rate!
We also understand that from the management of both REITs that when cash is repatriated back to Singapore from Barbados, there are also no withholding taxes payable.
From the perspective of the US Parent REIT, the interest it pays to the Barbados partnership can be expensed, hence shielding its income from the 30% withholding taxes.
As the US Parent REIT are holding company the physical real estate assets, the depreciation of these assets can be used to further reduce taxable income and therefore resulting in lower tax payable.
Using a combination of these 2 methods, both REITs will be able to minimize tax leakages and pay out a large part of its cash flow as dividends directly to its parent REIT in Singapore.
In simple words, this whole strategy of using a Barbados partnership to insulate unitholders from taxes is untested. While it has been used numerous times by different organisations, the US tax authorities have not provided any firm rulings or guidance that such a structure is deemed not to be a hybrid entity.
Among the concerns that the US tax authorities may have which may completely nullify this Barbados partnership are:
Therefore, the ultimate risk lies in how the US tax authorities choose to interpret the entire setup of both REITs using the Barbados partnership.
Will they rule for or against the REITs? There is simply no easy way for investors to predict this outcome.
The best-case scenario is that US tax authorities will recognise the Barbados partnership structure of the REIT as a non-hybrid entity. Both REITs pay low taxes to Barbados and at the same time, the management minimizes the taxes paid by the US Parent REIT through interest expenses and depreciation. This way, unitholders of both REITs will continue to enjoy the high payout on both REITs.
However, should the US tax authorities interpret the law against the REITs’ favour both REITs could potentially be facing up to 30% US withholding tax of the income that flows through Barbados partnership and intercompany loan SPVs.
We understand from Keppel-KBS REIT’s management that the REIT relies primarily on interest expense as a tax shield. With all things being equal, Keppel-KBS REIT could see its income available for distribution reduced by almost 30%.
As announced in the proposed acquisition of the Westpark Portfolio, based on the rights issue scenario, Keppel-KBS REIT’s pro forma DPU is estimated to be 3.64c from listing date till 30-Jun-2018. On an annualised basis, this works out to be approximately 5.65c.
At the current price at the time of writing of 57.5c, the REIT yields 9.83%. A 30% hit on the DPU would result in a payout of only 3.96c reducing the yield to 6.88% at current prices.
Manulife REIT’s management has provided a guidance half of the income are shielded through interest expenses while the other half are via depreciation. If the interest expense shield is lost due to unfavourable interpretation, then that half will be subjected to 30% tax. As a result, only 15% of its income will be impacted.
We will illustrate this with a simple, let’s say the income to be distributed by the parent REIT is $100. 50% of the income will be shielded from tax via depreciation of its assets leaving $50 to be passed through via dividends. The remaining $50 will be taxed at 30% before being passed to the Barbados partnership leaving only $35. As a result, of the total $100 in income, only $85 had made it through to Singapore resulting in a 15% loss of income to be distributed to unitholders.
Manulife REIT declared 4.04c dividends for 9-months YTD 2018. Taking the assumption that the DPU for Q4-2018 will be the same as Q3-2018 of 1.51c, the estimated total DPU for 2018 would be 5.55c.
Therefore, a 15% pro-forma impact would mean DPU could reduce to 4.716c.
Based on the 21-Dec-2018 closing price of 73c, in a worse case, the impact would be a fall from 7.60% to 6.46%.
In our personal opinion, unlikely.
As its stands today, we understand the Barbados partnership structure is very widely used by many major funds in order to shield their payouts from US withholding tax. The structure is also likely to have been reviewed and advised by numerous legal and tax consultants, many of which are likely to raise objections should the US tax authority interpret the law against such a structure.
Strengthening the case for the use of the Barbados partnership structure, just November 2018, the Barbados Prime Minister Mia Amor Mottley announced several tax changes to the country’s tax regime in order to keep Barbados’ tax regime globally competitive. This is likely a response ahead of any tax clarifications to come out of the US. It would certainly be in Barbados’ favour to prevent these SPVs for relocating elsewhere and losing tax income.
On the 20-Dec-2018, the United States Department of the Treasury released proposed regulations under Section 267A. As the document is long and complex to understand, for those interested, we suggest looking through the overviews by EY and PWC. Very swiftly, both Keppel-KBS REIT and Manulife US REIT followed up with an announcement that "no changes to the REIT structure is expected as a results of US tax regulations" and "will not have any material impact on the consolidated net tangible assets or distributions per unit" - alleviating months of investor uncertainty.
Its worth noting that both Keppel-KBS REIT and Manulife US REIT where still careful to caution that the document is still in "proposed form" and the "final regulations to be promulgated by 22 June 2019":
At the prices that both Keppel-KBS REIT and Manulife REIT is trading at, we think that the risk of this impact could be partially or fully priced in by the market by now.
Should the news break that US tax authorities have interpreted the law against the Barbados partnership structure, we think that both REITs are likely to be hit with a sell down of their unit prices.
Under this scenario, both REITs have contingencies in place and are likely to exercise one or a combination of these options:
We are on the view that the US tax authorities are unlikely to interpret the law against a widely used Barbados partnership structure. The markets have likely already partially or fully priced in the negative impact of this tax risk.
Investors should still remain aware of this risk factor and risk-manage their portfolio allocation and exposure to these 2 REITs accordingly.
From here, investors planning to investing in either of these 2 REITs should consider the long term growth potential of both REITs in terms of growing their DPUs and NAVs per unit.
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