Capital Gains Tax – Reits, recoupments and assessed losses

capital gains tax 2Author: Louis van Manen (Grant Thornton)

The Taxation Laws Amendment Bill of 2013 (TLAB) contains a proposed amendment to the newly introduced Real Estate Investment Trust (REIT) legislation which should be welcomed by such trusts. While it is generally assumed that the tax burden associated with income and capital gains of REITs is effectively shifted to shareholder level under the REIT legislation, it will not always be the case under the current legislation. Despite enjoying exemption from Capital Gains Tax (CGT) on most immovable property related asset disposals, REITs are not specifically exempt from the recoupment of past wear and tear allowances deducted on immovable property. This is reflected in the resultant deferred tax liabilities being maintained by reporting REITs.

This obstacle is then made insurmountable by the qualifying distribution deduction formula as it is currently contained in section 25BB(2) of the Income Tax Act No 58 of 1962 (the Act), which effectively requires REITs to utilise any assessed losses before the deduction of qualifying distributions. This is achieved by limiting the deduction of qualifying distributions to the taxable income of a REIT, which is by definition determined after deduction of any assessed loss. Without the ability to maintain or create assessed losses, REITs cannot shield themselves from the tax implications resulting from the recoupments of past wear and tear deductions.

Although the TLAB does not propose the introduction of a recoupment exemption for REITs, it does address the matter to an extent by proposing an amendment to the qualifying distribution deduction mechanism by limiting the deduction to taxable income before deducting any assessed loss of the REIT. The assessed loss deduction will consequently move below the qualifying distribution deduction in a REITs tax calculation, whereas it currently sits above it. By preventing the erosion of assessed losses resulting from qualifying distribution deductions REITs will be able to maintain assessed losses until they can be utilised against taxable recoupments.
As section 25BB(4) prohibits the deduction of immovable property related allowances in terms of sections 11(g), 13, 13bis, 13ter, 13quat, 13quin or 13sex, REITs abilities to create assessed losses are severely hamstrung. The TLAB unfortunately does not alter this position. Section 25BB does not however, prevent REITs from deducting section 11(e) wear and tear allowances on qualifying assets owned and used by REITs. SARS’s Interpretation Note 47 lists such assets and write-off periods acceptable to SARS which include assets typically owned by REITs as part of their property investments. Such assets include air-conditioners, communication systems, carports, lift installations, demountable partitions, fire detection systems, fitted carpets, generators, advertising boards, escalators, security systems and shop fittings. These assets often account for fair portions of property development, acquisition or improvement costs and should not be ignored.

Although such allowances will ultimately also need to be recouped under section 8(4)(a) of the Act when the relevant assets are disposed of (typically when a property is disposed of), the allowances may create assessed losses which could shield REITs from tax costs on earlier recoupments for a period of time.

It should also be borne in mind that despite the fact that most REITs will distribute their net income to shareholders or linked unit holders, which distributions will qualify as tax deductions under s 25BB, they will still often be liable for tax resulting from differences between the calculation of net income for accounting purposes and the calculation of taxable income. Such differences will typically stem from leasing commissions, tenant installation costs, bonus provisions, leave pay provisions and bad and doubtful debts which could lead to tax liabilities in some years and assessed losses in others. For this reason REITs should take extra care when estimating taxable income for provisional tax purposes to they are not exposed to provisional tax underestimation penalties which can become very expensive and arduous to contest. Maintaining an assessed loss could act as a safeguard against such unwelcome surprises.
REITs, along with all taxpayers, are however cautioned that SARS currently levies understatement penalties under section 222 of the Tax Administration Act No 29 of 2011 regardless of whether or not taxpayers were in assessed loss positions when understatements occur. In light hereof the preparation of accurate provisional tax estimation calculations and annual tax computations must remain an important item on any REITs agenda. REITs seeking to deduct section 11(e) allowances should ensure they are able to substantiate such allowances by keeping accurate records of the assets and deduction calculations. Identifying and valuing qualifying assets on existing properties will require the professional analysis of each property as a whole.

This article first appeared on the Jan/Feb edition of Tax Talk.