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Tax holiday on REIT incomes?

November 13, 2006

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FACED with a burgeoning population and speedy urbanisation, Pakistan is suffering from an annual shortfall of 270,000 housing units. To make up for the backlog as well, the construction industry needs to produce 570,000 housing units every year against the actual supply of 300,000. Official data show that the country encountered a shortfall of over six million houses by the end of June last year.

The growing demand for houses has resulted in a real estate boom. For the last few years, real estate has been attracting investment with the prospect for greater pay-off.

The increasing share of the real estate in foreign direct investment (FDI) and rising domestic investment induced the Securities and Exchange Commission of Pakistan (SECP) to start working on the Real Estate Investment Trust (REIT) rules as early as in 2004 to regulate this so far largely informal sector.

But, bureaucratic red-tape, provincial taxation impediments, tenancy laws, high property taxes and legal complications in the implementation of the much-awaited (REIT) rules have halted any progress in this direction.

REITs are designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks. REIT is a security that sells like a stock. Its rules allow indirect investment in real estate that yield, in most of the cases, 90 per cent of its profit in the shape of dividends to shareholders.

The origins of REITs date back to at least the 1880s when trusts were not taxed at the corporate level if income was distributed to beneficiaries and thus investors could avoid double taxation on income.

Today, there are more than 200 publicly-traded REITs in the US, the combine assets which have crossed over $500billion and some two-thirds of them are traded on the stock exchange. REITs are successfully operating in the UK, Australia, Germany, Japan, Singapore and Hong Kong. Pakistan is following the model of Hong Kong by tailoring it to the local environment.

It was in December, 2005, when the SECP sent a draft of REIT rules to the finance ministry for approval. The ministry forwarded the draft to the law ministry, which did not agree with Rule 45 of the draft - which gave the SECP the powers to relax its requirements for REITs in case of any financial crisis or threat to the interests of the small investors - saying it was against the Companies Ordinance. The various perceptions of the finance ministry and the Commission over this issue delayed the process for more than 10 months.

The SECP had to redraft the rules and announce the amended draft on November 3, 2006 for feed back of the stakeholders. In the meantime, the finance ministry and the commission agreed to constitute a task force for removing hurdles in the way of implementation of REIT rules.

According to the revised draft, a REIT Management Company shall make an application to the SECP for grant of license for establishing a REIT scheme and carrying on the business of providing REIT management services. The license, issued to the company, shall be liable to cancellation if it does not start business within six months of getting the license. These companies should invest only in real estate, real estate related assets and non-real estate assets.

The draft says that REIT fund or REIT assets shall not be utilised directly or indirectly for investment in vacant land and mortgages. However, investment can be made in vacant land approved for development into housing schemes.

The dividend policy of the REIT scheme shall be clearly stated in its constitutive documents and the dividends shall only be paid in cash unless allowed by the SECP for paying it in any other form. The Commission shall monitor the general financial conditions of the REIT schemes and may at any time order special audit.

There is also the concept of the appointment of an independent property valuer, who shall neither be a connected person nor an associated company or undertaking of the REIT Management Company, the trustee or any significant holder or itself be a unit holder of the REIT Fund.

The property valuation methodology shall follow the best practices prevalent in the industry. The valuation report shall include all material details in relation to the basis of valuation and the assumption used and describe and explain the valuation methodology adopted.

“We are expecting a more regulated real estate market in Pakistan and believe me it would be beneficial for small investors and stock exchanges once the REIT rules are implemented,” said an SECP official. He said the system would strongly discourage the existing File System of property and Benami and overheating in the sector.

A spokesman for the Islamabad Stock Exchange (ISE) said that after the implementation of REITs, there would be less over-heating in the real estate sector and that a good number of people would start diverting their investments from real estate to stocks.

Over the last few years, he added, investments in stocks had seen a considerable decrease from time to time, as the real estate boom attracted investment in urban areas, especially in major cities like Karachi, Lahore and Islamabad.

“This would bring a sort of balance between investments in stocks and real estate,” the spokesman added.

Challenges: The stakeholders of REITs including the SECP, stock exchanges, mutual funds and property dealers have pointed out a number of issues that need to be addressed before introducing REITs.

They say that the rental yield of real estate in Pakistan (3.5 to 5 per cent) is the lowest in the world. Land records are not properly maintained which encourages multiple ownership.

There is no uniform tax system at federal and provincial level and that the cost of transaction in this sector is too high to be attractive. In order to make the investment environment conducive for REITs, the SECP has proposed a considerable reduction in tax on rental property, elimination of withholding tax and a decade of tax holiday on the income of REITs.

In Pakistan, land records are maintained by district administration for deciding ownership and boundaries of land or property mostly on paper, and in some instances, on cloth. They need preservation and updating from time to time.

Computerisation of these records is unavoidable before introducing the REITs. The Indian government has already started computerising land records and has successfully implemented it in the state of Karnataka. The process is tiresome, but will provide the much-needed one-window solution to all the land related issues.

Stakeholders are of the view that tenancy laws must be classified as Criminal Law and not Family Law to allow efficient execution for the property formed under REIT structure.

But, above all, the real challenge is the well-coordinated and sincere efforts on behalf of SECP and law and finance ministries to create enabling environment for REITs without wasting any further time on minor issues.