| Author: |
Glen Lonie and Matìj Èaòo |
| Publication: |
Czech business weekly |
| Date: |
3.4.2006 |
Global real estate investment is currently at a record high. The "wall of money" looking to invest in real estate has resulted in rapid development of the real estate markets across the CEE region and the former Soviet states. The Czech Republic is no exception in this respect. This supply-demand imbalance has had a number of impacts.
First, commercial real estate markets in the Czech Republic are generally seller's markets. Competition among investors for properties is high, resulting in significant reductions in returns for investors. This situation has meant that yields the relationship between a property's annual rental to its capital value have rapidly converged to levels approaching those of Western Europe. As a consequence, investors are looking eastwards, where higher returns may be achieved.
Second, given the difficulty of sourcing properties, investors are looking at a wider range of property types and classes and at moving away from Prague to regional centers. To meet demand, there's a great deal of development in all types of property office, retail, industrial and logistics, hotel, residential and tourism.
Third, rather than only buying standing properties, investors are also looking to get involved in projects at an earlier stage by participating in their development or by committing to forward purchases of new properties, both to secure investment opportunities and to maximize returns.
Taxes, acquisition issues
Since real estate investment is very much a cash-flow focused business, the fundamental objectives are to reduce or avoid the following:
- taxes on the acquisition of property;
- tax leakage on ongoing repatriations of dividends and interest;
- taxes on operating profits;
- and taxes on capital gains on exit.
The first question is usually whether to buy the property itself, or the company that owns it, that is, through a so-called asset deal or share deal. A basic comparison between the implications of these two types of transaction is included in the table below. Given the current seller's market and the fact that share deals are generally more tax-beneficial to a seller, it's common for transactions to occur as share deals. As this means that a buyer is taking on the history of the company, comprehensive legal, tax and financial due diligence is advisable to make sure that any risks are identified prior to the purchase. The major disadvantage to a buyer of a share deal relates to the difference between the market price paid for the shares and the historical cost of the property, which is usually the basis for depreciation. Further, if the buyer is required to sell through an asset deal in the future, the capital gain on the difference between the market value and the historical tax book value will be taxable. Although buyers may seek to achieve a discount in order to be compensated for this disadvantage, in a seller's market, such discounts are the exception rather than the rule.
| |
Asset deal |
Share deal |
| Transfer tax |
Tax due |
No tax due |
| VAT |
If VAT due, timing of recovery and possible corrections
for VAT-exempt use need to be considered |
No VAT |
| Capital gains |
Tax due immediately |
Value of deferred tax liability relevant for future exit |
| Depreciation |
Step-up achieved to market value |
No step-up |
Cash repatriation
The key structuring objectives as regards repatriation of cash to investors are to mitigate withholding taxes on payments of interest and dividends. If interest or dividends are being repatriated cross-border, it is also necessary to consider how to reduce or avoid withholding tax. For the Czech Republic, being an EU member state, this is often done under the terms of the Interest Royalties Directive or the Parent Subsidiary Directive. Alternatively, this is managed by the selection of a holding country that has concluded a suitably beneficial double taxation agreement with the Czech Republic . Given the large capital values of real estate properties, depreciation charges are correspondingly large. As such, in structuring real estate projects, it's important to make sure that an investment doesn't suffer so-called trapped cash, where the amount of depreciation is effectively locked into the company, restricting the repatriation of available cash.
Minimizing tax
Investors need to weigh the effects of factors ranging from depreciation to foreign exchange rates in order to minimize tax impact.
Tax depreciation. Buildings generally have a long economic life, whereas other assets generally have shorter depreciation periods. In certain cases, therefore, it may be worthwhile to consider separating fixtures and fittings from buildings to accelerate tax depreciation.
Financing. In funding projects, it's common for investors to seek to structure their equity in such a way that a minimum amount is covered by registered capital and a maximum amount by related-party or "subordinated debt", allowing for maximum repatriation of available funds in the form of interest. The main consideration is the "purpose test." In very simple terms, this means that it needs to be established whether the interest is incurred to generate taxable income. However, a number of other considerations will also be relevant, such as the thin capitalization rules, transfer pricing provisions, and the general question of whether the interest will need to be capitalized or expensed. Assuming these matters are properly addressed, the interest is tax deductible to the property company reducing tax on profits.
Foreign exchange differences. Project finance is often provided in the same currency as the currency of the rent, which is often the euro. In the Czech Republic, where the local currency must be used for accounting and tax purposes, this will mean that foreign exchange differences (realized or unrealized) have to be recognized in the books. In case of an appreciation of the Czech crown, this may imply that significant unrealized foreign exchange gains appear, such gains being fully taxable as they arise. It is, therefore, generally important to address this issue in time, for example through hedging arrangements.
Exit considerations
When structuring real estate investments, it's important to ask the last question first: After a successful investment, how will the money be taken out? Given the difficulties that investors now face in finding opportunities to invest in real estate, a key exit issue is flexibility. Accordingly, structures need to be considered that not only provide for sales, but also allow partial exit through the creation of joint ventures, the possibility of refinancing, and other possible means for investors to exit, such as an IPO, to ensure maximum tax efficiency.
For a sale, the preferred option for most investors is a share deal, where the owner of the property company is located in a country with a double taxation treaty allowing allocation of the taxation rights in respect of a gain on a sale of shares to that country. Ideally, that country then has a so-called "participation exemption," whereby capital gains from the disposal of shares are not taxed.
In the above, we have outlined various tax aspects that may play a role in real estate investments. Getting them wrong can seriously impact a project's performance, whereas addressing them properly, and in time, will contribute to optimizing the return on an investment.
