AIFs: Property authorised investment funds (Property AIFs): tax treatment of Property AIFs and distributions: calculation of the net income for the tax-exempt business
Definition of net income of the Property AIF (regulation 69Z SI 2006/964)
The net income /expense before taxation is defined as the amount shown inthe statement of total return. This is computed under GAAP in accordance with the currentStatement of Recommended Practice issued by the Investment Management Association.
Calculation of net income for the tax-exempt Property Investment Business (regulation69Z SI 2006/964)
This will be that part of the net income of the Property AIF that arises from thetax-exempt Property Investment Business. That part of the income that arises from theproperty rental business (CTM48813) should be calculated in thesame way as for the taxable profit of a Schedule A business but with certain exceptions:
- any overseas rental income and expenses are included in the calculation,
- the requirement in Schedule A rules (section 15(1) Income and Corporation Taxes Act (ICTA) 1988) to disregard loan relationship and derivative contract credits and debits does not apply, in as far as the loan relationship or derivative contract is entered for the purposes of the tax-exempt business and, in the case of a derivative contract, is used as a hedging instrument (see below) or is an embedded derivative contract, and
- any capital allowance that the tax exempt business could claim if it were taxable should be treated in the calculation as claimed in full. This is so that the distributable income of the tax exempt business is calculated in the same way as the profits of a taxable chargeable property business are arrived at, and is achieved by operating what is effectively a shadow capital allowances regime. To illustrate the point for the first two accounting periods of a tax exempt business, see the capital allowances example below.
A derivative contract is hedging instrument in relation to a Property AIF (in this casethe deemed company which carries on the tax-exempt business) if or in so far as it isacquired as a hedge of risk in relation to an asset or the income of the business. Forexample, the Property AIF may have a USA property portfolio yielding a dollar rentalstream and the Property AIF wants to ensure its income in sterling does not decline, soenters into a dollar/sterling swap.
An embedded derivative contract is one that has a host contract with a derivative embeddedinto it and takes the meaning provided in the derivative contracts legislation inparagraph 2(3) Schedule 26 FA 2002. More information on these definitions can be found atin the Corporate Finance Manual at CFM16100.
An example of an embedded derivative entered into for the purposes of the tax-exemptbusiness is where a lease contains a provision that the rent is adjusted upwards everyyear at five times the increase in the retail price index. The index-linking term is aderivative embedded in a host contract (the lease), and because the inflation adjustmentis leveraged, the Property AIF may have to recognise the derivative separately in itsaccounts. Provided the lease itself is within the ring-fence, the embedded derivative willalso be part of the tax- exempt business.
Where a property rental asset is hedged by a loan relationship with an embedded derivative(for example a Property Index Certificate (PIC) issued by the company owning theproperty), movements in the value of the PIC are within regulation 69Z1(3) SI 2006/964 (asit relates to the tax-exempt business).
Although shares in property companies or units in property unit trusts may appear to beproperty-related, these assets are normally outside the ring-fence and it thereforefollows that debits and credits arising on derivatives where these are the underlyingsubject matter are excluded for the purposes of calculating the profits of the tax-exemptbusiness. This does not apply to those shares in property companies that are UK-REITs ortheir foreign equivalents as these are specifically brought within the property investmentbusiness in the legislation. See CTM48815.
A contract that is not a derivative contract for the purposes of Schedule 26 FA 2002 byvirtue of paragraph 4(2)(b) of that schedule is also excluded from being taken intoaccount for the calculation of net income of the tax-exempt business (regulation 69Z1(6)SI 2006/964).
Capital Allowances - Example
Accounting Period (A/P) ended 31/03/2008
Assume this is the final full 12 month accounting period of property rental businessA. Its taxable profits, before capital allowances, are £125,000 and it has acapital allowances pool with a written down value (wdv) brought forward of £32,000. Itschargeable profits are therefore as follows:
|Net profits, adjusted for tax||£125,000|
|less capital allowances |
|wdv £32,000 x 25%||(£8,000)|
|Profits chargeable to corporation tax||£117,000|
|(wdv carried forward: £32,000 less £8,000||£24,000)|
The open-ended investment company then converts to a Property AIF at, say, 30 September2008 and so the Property Rental Business has a six-month AP ended 30/09/2008. Assumingtaxable profits, before capital allowances of, say, £70,000 the position is as follows:
A/P 01/04/2008 to 30/09/2008
|Net profits, adjusted for tax||£70,000|
|less capital allowances |
|wdv £24,000 x 25% x 6/12 (short A/P)||(£3,000)|
|Profits chargeable to corporation tax||£67,000|
The value of the capital allowances pool is now £21,000 (£24,000 less £3,000), and thisis the value at which the pool is transferred when the deemed transfer of the propertyrental business takes place. The effect of this is that there is no further allowance orcharge on the taxable Property Rental Business, and the tax exempt business bases itscalculation of shadow capital allowances on the deemed sale / acquisitionprice. This will work as follows for the tax exempt business first accounting periodto, for example, 31 March 2009:
A/P 01/10/2008 to 31/03/2009
|Net profits (calculated as for a taxable property rental business)||£72,000|
|less capital allowances |
|wdv £21,000 x 25% x 6/12 (short A/P)||(£2,625)|
|Income of the tax exempt business||£69,375|
|(shadow wdv carried forward: £21,000 less £2,625||£18,375)|