South Africa: REITs investing offshore
The use of real estate investment trusts (REITs) is becoming increasingly popular in South Africa. However, care needs to be taken where a South African REIT holds various foreign property owning subsidiaries either directly or through a non-South African intermediary holding company (IHC).
The REIT regime in South Africa aims to create a 'flow though' vehicle for income tax purposes. A fundamental part of the regime relates to the ability of the REIT and its subsidiaries to deduct for income tax purposes, dividends declared and paid to their immediate shareholder/s. In order to be tax deductible, any such dividend must meet the criteria for a 'qualifying distribution' as defined.
A dividend will be deemed a qualifying distribution as long as 75% or more of the gross income of the REIT (or 'controlled company' paying the dividend) was attributable to 'rental income' in the preceding year of assessment. Rental income itself includes qualifying distributions derived from a controlled company.
A qualifying distribution, however, can only arise if a dividend is paid or is payable. Under the South African Income Tax Act, a dividend, as defined, can only be paid by a resident. Distributions made by non-residents are defined as 'foreign dividends'.
Consequently, a foreign dividend paid to a South African REIT by a subsidiary cannot constitute a qualifying distribution, with the result that the receipt of this amount in the hands of the REIT will not constitute rental income and will not help the REIT to meet the criteria required for its own distributions to be tax deductible.
This is severely prejudicial to shareholders in a REIT who invest on the basis of the tax flow through treatment. Until this issue in the law is resolved, South Africa REITs which expand offshore need to carefully monitor the extent to which the receipt of dividends from foreign subsidiaries (even if fully funded from income derived by those companies from immovable property) will dilute their own rental income. Oddly enough, a foreign dividend received by a REIT from a so-called 'property company' is included in rental income. (A property company is a company other than a subsidiary in which a REIT holds at least 20% of the equity, and at least 80% of the assets of which are attributable to immovable property.)
Treatment of a foreign dividend paid by a controlled company to a REIT
A foreign dividend declared by a foreign controlled company to a South African tax resident REIT may be fully or partially exempt under the provisions of Section 10B of the Act.
As long as the foreign company paying the dividend to the REIT cannot deduct that dividend from its own taxable income and the REIT holds at least 10% of the total equity shares and voting rights in that foreign company, the dividend from the foreign company will be fully tax exempt.
Where the 10% threshold is not met (or the dividend is deductible for the payer) a partial exemption is allowed for the foreign dividend, bringing the effective South African tax rate on the dividend to 20%.