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RE Fundraising guide: Fund structuring

David Ryland and Steven Cowins of SJ Berwin examine the legal perspective behind structuring a fund.

Real estate funds vary greatly in size and complexity from a relatively standard English limited partnership (ELP) model investing in UK property to fund structures involving many jurisdictions with the potential to invest in real estate globally. Many real estate funds may also have the power to invest in real estate indirectly to a greater or lesser extent, for example, through real estate loans, bonds or shares in the real estate sector or investments in other indirect vehicles holding real estate.

The structures chosen to form a real estate fund vary accordingly to the style of the fund and the location of its assets and investors and managers and by the related legal, tax and regulatory concerns.

Essentially investors seek an established and reliable legal framework for the fund, which minimises tax liabilities and complies with the regulatory regime in which the real estate fund and its manager are based.

The aims and/or characteristics of a real estate fund are generally as follows:

1) A tax-efficient structure: a key aim is to try and create a structure where the investors in the fund are no worse off than if they had invested in the real estate directly and the manager receives its incentivisation in a tax-efficient manner.

This means trying to ensure the structure is tax-transparent, and seeking to minimise withholding taxes while at the same time not creating a structure which is unwieldy or expensive to set up and operate.

2) Ensuring the investors have limited liability: investors will want certainty as to the quantum for which they could become liable by investing in the fund.

3) Regulatory environment: this gives investors sufficient comfort to invest in the fund but is workable for the manager in terms of requirements relating to fund promotion or operation or capital-reserve requirements.

4) A flexible contractual framework where investors and the manager can agree terms, not prescribed by law, to meet both of their needs.

This chapter discusses these aims and characteristics in further detail including an overview of the issues facing certain fund structures and identifying some typical fund structures. Although it cannot offer advice as to which fund structure is more suitable in any given circumstances as these are often unique, it should give the reader an idea of the main issues and drivers in structuring a real estate fund.

This chapter is primarily concerned with institutional or club-like funds for sophisticated investors but also includes a separate section relating to retail funds and real estate investment trusts (REITs) which are important players in the real estate fund market.

Tax efficiency

The main tax objectives which can influence the choice of fund structures include:

a) eliminating taxes on gains at the fund level;

b) allowing properties and interests in the fund to be bought and sold without paying transfer tax;

c) reducing as far as possible the amount of tax on income paid on rental income at fund level; and

d) reducing or eliminating withholding taxes on the repatriation of profits.

Another tax factor which can influence the choice of structure is the need to submit tax returns in jurisdictions other than the one in which the investor is resident and the detail required to be produced by the fund to allow investors to submit tax returns.

Eliminating taxes on gains at the fund level

Clearly if tax is suffered on gains at both the fund and the investor level this can significantly decrease the attractiveness of an investment especially if the investor is exempt from tax itself.

This means when an unquoted fund vehicle for investing in UK property will often be either a taxtransparent vehicle such as a limited partnership (so that tax is paid directly by the investor), an offshore unit trust or an offshore company. Any nonresident investor (including for this purpose an offshore company or offshore trust) is exempt from UK tax on chargeable gains on the disposal of investment properties.

If an offshore company is used then frequently the fund will be a holding company which is not subject to tax in either the UK or its country of incorporation, and the exit will be by way of a sale of the shares in other special purpose vehicle (SPV) companies each holding a single property.

In the case of overseas properties this is normally achieved by using corporate structures. The fund structure will usually be a corporate holding company (frequently based in Luxembourg) or a partnership holding such a company. The holding company will hold individual properties within corporate SPVs and individual disposals are usually made by selling the shares in the SPVs. The holding company will benefit from appropriate tax exemptions and double- tax treaties to minimise tax on any gains or will distribute profits in a manner which is tax-deductible under local law; for example a Luxembourg holding company may pay out profits by way of profit-participating loans, preferred equity certificates and/or convertible preferred-equity certificates.

In relation to the retail funds, authorised unit trusts (AUTs) and property authorised investment funds
(PAIFs) are exempt from UK tax on gains.

Where the fund vehicle is a unit trust or a limited partnership there is no UK tax payable at the entity level and investors are usually treated as though they had invested directed in the real estate. The use of these tax-transparent vehicles, such as limited partnerships and unit trusts as the main fund vehicle, is a common method of avoiding double taxation. This is, however, not the case in certain European jurisdictions which require the unit trust or limited partnership to have certain characteristics if they are to treat them as tax-transparent.

This partial chapter is one of 11 in The Definitive Guide to Real Estate Fundraising: Leading insight and know-how for real estate fund managers, investors and professional advisers, a new book from PEI Media.