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INTERNATIONAL TAX NEWSLETTER
01/07

ITALY’S NEW REAL ESTATE INVESTMENT COMPANIES

Italy’s 2007 Budget Law (Law n. 296 of December 27, 2006) includes provisions[1] that create a new special tax vehicle – the real estate investment company, or REIC - for investment in the real estate market. The new regime is elective and available only for publicly traded companies.

A company that elects for REIC status is not subject to corporate income tax or regional tax on production activities (IRAP), and only one tax applies to shareholders on the distribution of dividends. For foreign investors resident in treaty countries, the shareholder tax can be reduced or eliminated by treaty.

Unlike the existing real estate investment fund (REIF), which is designed primarily for passive investors in the retail market who purchase shares of the fund as portfolio investment the new REIC allows active investors to exercise control over real estate operation and strategic management decisions and is conceived for corporate strategic investors interested in participating in the active management of real estate and derive profits there-from.

The new provisions establish the requirements to elect for REIC status, the tax consequences of the election and the tax treatment of REIC and its shareholders.

The election is available for Italian resident publicly traded companies. To elect for REIC status, a company must satisfy specific ownership, business activity and dividend distribution requirements. The election allows a step up in basis for appreciated assets owned by the company that elects for REIC, and the gain deemed realized upon election is taxed at a reduced flat tax rate (20 per cent).

At taxpayer’s option, net gain or loss on company’s appreciated assets deemed realized upon election for REIC may be subject to general tax rules (net loss is carried forward and net gain is taxed either in the year in which it is deemed realized or pro rata over five years). Gains realized upon contribution of real estate property to a REIC are subject to a similar tax treatment (20 per cent substituted tax or ordinary taxation at taxpayer’s election).

In addition to eliminating all corporate level taxes (corporate income tax and IRAP), dividends under the REIC regime are subject to a 20 per cent withholding tax. The tax rate is reduced to 15 per cent for dividends distributed out of earnings derived from rental of homes or apartments used for residential purposes.

The government will issue regulations within April 30, 2007 to implement the new provisions, and companies will be able to exercise the election for taxable years beginning on or after June 30, 2007.

Requirements for the Election

REIC is not a new type of entity but a special tax regime based on fiscal transparency (no corporate level tax, shareholder tax only). Only publicly traded joint stock companies (SPA) resident in Italy for tax purposes can elect REIC status.

The election can be extended to non-publicly-traded subsidiaries of REICs when one or more REICs own at least 95 per cent of the voting power and profit share of a subsidiary, and the subsidiary otherwise satisfies the other requirements for the REIC election.

To be able to elect as REIC, a company must satisfy the following requirements:

- No shareholder can own, directly or indirectly, more than 51 per cent of the company’s voting power[2] or profit share, and least 35 per cent of the company’s stock is owned by shareholders who do not directly or indirectly own more than 1 per cent of the voting power or profit share (ownership requirement);

- The company must carry out the real estate rental business as its primary business activity (business activity requirement);

- The company must currently distribute at least 85 per cent of its income coming from real estate rental business (dividend distribution requirement).

Real estate rental activity is considered the company’s primary business activity if at least 80 per cent of the company’s total assets are rental real estate (asset test)[3], and at least 80 per cent of the company’s revenue for each taxable year is real estate rental income (revenue test)[4].

For the purposes of the asset and the revenue tests a look through rule applies for to stock owned in, dividends distributed by, or gains realized through the disposition of, other REICS.

Consequently, in accordance with the look through rule, stock owned in another REIC and dividends distributed by or gains realized through the disposition of stock held in other REIC - to the extent that they come from real estate rental income of the distributing or sold REIC - qualify for the election under the asset and revenue test.

Income subject to the dividend distribution requirement includes qualifying real estate rental income received from other REICs.

Individual and Joint Group Election

The election must be exercised within the end of the immediately preceding taxable year and is irrevocable. If any of the requirements for the election is not met for two consecutive taxable years, the election is retroactively terminated from the beginning of the second tax year in which the requirements are not met. However, if the dividend distribution requirement is not met for any tax year, the election terminates from the beginning of that tax year.

If the election is terminated, general rules apply for computing taxable income in the relevant taxable year.

Under the join group election rule, REIC election can be extended to non-publicly traded subsidiaries that are at least 95 per cent owned (by voting power and profit share) by a REIC, individually or jointly with other REICs, and otherwise satisfy all other requirements for REIC treatment.

Basis Step-Up and Tax Treatment of Deemed Gains

As a result of REIC election, all unrealized, built-in gains or losses in the company’s rental real estate are deemed realized and the tax basis of the assets is stepped up or down at fair market value.

The net gain deemed realized is subject to tax at the flat rate of 20 per cent, which applies in lieu of ordinary corporate income tax and regional tax on production activities. The tax can be paid in five equal installments. In this case, interest is charged at the official discount rate (currently 3.5 per cent) plus 1 per cent.

The new tax basis applies beginning from the fourth tax year following the tax year immediately preceding the one for which the election is made for purposes of the asset test of the business activity requirement used to determine eligibility for REIC.

In the case of an anticipated sale of the assets, the gain or loss is computed with reference to the original adjusted tax basis of the assets as it existed before the election, adjusted for depreciation, and the pro rata portion of the substituted tax is granted as a credit against taxes due on the gain realized on the sale.

At taxpayer’s option, instead of the application of the substituted 20 per cent flat rate tax, the net gain that is deemed realized upon the election can be taxed according to the general rules.

In that case, the net gain is either included in the taxable income for the tax year immediately preceding the one for which the election is made, for its full amount, or is pro rated over five years (the year in which it is deemed to be realized and the four subsequent years).

The portion of the gain that is pro rated to tax years following the REIC election does not qualify for the purposes of the revenue test of business activity requirement used to determine eligibility for REIC treatment.

Tax Treatment of Contribution of Property to REIC

Gains realized upon contribution of appreciated real estate to a REIC are taxed according to the general rules (namely, they are included in income of their full amount in the tax year of the contribution, or are apportioned pro rata over that year and four subsequent tax years at taxpayer’s election, for assets held for more than three years).

At taxpayer’s election, the gain can be subject to the substituted 20 per cent flat rate tax as described above. However, the application of the substituted tax requires that the REIC held the contributed asset for at least three years.

The contribution is subject to VAT, if applicable, and registration, cadastral and mortgage taxes are charged at the fixed amount of EUR 168. VAT does not apply if the contribution concerns a group or real estate assets that constituted a business or line or business in the hands of the contributing company.

Tax Treatment of a REIC

The real estate rental income of a REIC is exempt from corporate income tax. Exempt income includes dividends distributed by other REICs out of their exempt real estate rental income. A REIC’s production value is exempt from IRAP in the same proportion as its exempt income. Consequently, if a REIC carries out only a qualifying rental activity and earns only exempt rental income, it is totally exempt from corporate level tax.
A REIC must keep separate books of accounting for the computation of its exempt income and taxable income deriving from non-qualifying rental activities.

Stock owned by a REIC does not qualify for the general participation exemption rules for the purposes of the exemption of gains. Therefore, gains realized through the sale of stock owned by a REIC are fully taxable.

Although the statute is not clear, it would seem reasonable to conclude that gains realized on disposition of stock owned in other REICs are exempt, to the extent that they are allocable to exempt income of the sold REIC.

The statute does not rule out the application of participation exemption provisions for exemption of dividends. Therefore, dividends received by a REIC, other than dividends from other REIC distributed out of REIC exempt income (which are totally exempt as clarified above), should be partially exempt from tax (95 per cent exemption) like dividends received by corporate shareholders of ordinary companies.

Items of income or loss accrued in prior years and whose tax recognition has been deferred to subsequent years must be allocated to REIC’s exempt or taxable income. The tax administration will issue rules establishing the criteria for the allocation of previous years’ deferred income or deductions.

Net operating losses carried over from previous years can be used to offset gains recognized upon the election for REIC (and subject to the substituted 20 per cent tax or ordinary corporate income taxes as clarified above) or REIC’s taxable income from non-qualifying activity.

Tax Treatment of Shareholders

Dividends distributed by a REIC out of its exempt earnings and profits are subject to 20 per cent withholding tax, which is reduced to 15 per cent for dividends distributed out of the earnings and profits allocable to the rental of homes or apartments used as private residences.

No withholding tax applies on dividends distributed to another REIC or by non-publicly traded subsidiaries that have been consolidated with their REIC’s parent under the group election.

Dividends distributed out of taxable earnings and profits (or earnings and profits from prior years) are subject to the general rules.

At the domestic level, the withholding tax is a final tax for individual portfolio shareholders[5] and is treated as an anticipation of the tax due on the shareholder’s taxable income in all other cases.

The new provisions do not contain any special rule about the tax treatment of REIC’s dividends in the hands of the shareholders. Therefore, dividends should continue to be subject to the ordinary rules (that is, 95 per cent of the dividend would be exempt from tax for REIC’s corporate shareholders, and 60 per cent of the dividend would be exempt from tax for REIC’s individual shareholders who own qualifying shareholdings[6] or hold the stock in the conduct of a trade or business).

Cross Border Aspects

Foreign companies that are not resident in Italy for tax purposes (that is, with their legal seat, place of management and principal place of business outside Italy) do not qualify for the REIC election.

However, according to a similar interpretation adopted for domestic tax consolidation, if a foreign company is domesticated and establishes its tax residency in Italy, while maintaining its foreign charter (which Italy allows), and has legal features similar to those of Italian companies (primarily, limited liability, centralized management and free transferability of shares), it should be eligible to elect for REIC status.

The 20 or 15 per cent withholding tax generally is a final tax for foreign shareholders, unless they are engaged in a trade or business through a permanent establishment in Italy to which dividends are effectively connected. The statute does not provide any exemption for such the withholding tax[7].

The withholding tax can be reduced by treaty, for foreign shareholders who are resident in a treaty country (and satisfy all other requirements for the application of the treaty benefits).

The application of the EU parent-subsidiary directive, which would exempt from withholding tax the dividends distributed to a EU parent company, may be problematic, however. A REIC satisfies all the requirements of the directive, but for the fact that it is exempt from corporate income tax in Italy. Hopefully, this issue will be clarified by the tax administration when it adopts the rules that will implement the new REIC provisions.

Capital gains from the sale of REIC stock are subject to the general rules. Consequently, they are exempt from Italian source-based tax for foreign portfolio investors and taxable (on a net basis with duty to report the income by filing income tax return in Italy) for foreign non-portfolio shareholders holding qualified shareholdings in a REIC[8].

However, for shareholders resident in treaty countries, the tax on capital gains would be eliminated altogether in accordance with the treaty. Indeed, most of Italian tax treaties do not contain provisions that preserve source state taxation for gains from sale of stock of real estate holding companies.

Conclusion

The new REIC regime appears to be very favorable for foreign investors interested in investing in real estate in Italy. It allows for the complete elimination of corporate level tax, and the distributed profits are subject to withholding tax at a reduced rate, which can be reduced further under tax treaties. Further, gains from sale of REIC stock would be generally exempt from tax under treaty.

The REIC regime is complementary to the existing REIF regime and fills a gap in the Italian tax system, by placing Italy in line with other jurisdictions within and outside the European Union that had already adopted similar rules.

It is crucial that the tax administration adopt clear rules to properly implement the new regime and provide the necessary guidance to avoid uncertainties and allow reliable and predictable results according to the general ratio of the new regime.


[1] Article 1, paragraphs 119 to 141 of Law n. 296 of December 27, 2006.
[2] Voting power is measured by the total number of share entitled to vote at the ordinary meeting of shareholder, which elects company’s directors.
[3] The statute does not specify whether the assets are to be measured by book value or tax basis.
[4] Reference is to revenue as appearing from the company’s financial income statement.
[5] Portfolio shareholders are shareholders who own less than 2 per cent of voting power or 20 per cent of stock (by value).
[6] Qualifying shareholding means stock representing more than 2 per cent of voting rights or more than 20 per cent of value.
[7] This is a major difference with the rules on real estate investment fund, which exempt foreign investors from Italian source-based tax on the fund’s income (fund’s distributions or gains from sale of fund’s shares).
[8] Under tax code section 67(1)(c), qualified shareholding is defined as shareholding representing more than 2 per cent of voting right or 5 per cent of stock (by value).

INTERNATIONAL TAX NEWSLETTER

01/07

ITALY’S NEW REAL ESTATE INVESTMENT COMPANIES

 

Italy’s 2007 Budget Law (Law n. 296 of December 27, 2006) includes provisions[1] that create a new special tax vehicle – the real estate investment company, or REIC - for investment in the real estate market. The new regime is elective and available only for publicly traded companies.

A company that elects for REIC status is not subject to corporate income tax or regional tax on production activities (IRAP), and only one tax applies to shareholders on the distribution of dividends. For foreign investors resident in treaty countries, the shareholder tax can be reduced or eliminated by treaty.

Unlike the existing real estate investment fund (REIF), which is designed primarily for passive investors in the retail market who purchase shares of the fund as portfolio investment the new REIC allows active investors to exercise control over real estate operation and strategic management decisions and is conceived for corporate strategic investors interested in participating in the active management of real estate and derive profits there-from.

The new provisions establish the requirements to elect for REIC status, the tax consequences of the election and the tax treatment of REIC and its shareholders.

The election is available for Italian resident publicly traded companies. To elect for REIC status, a company must satisfy specific ownership, business activity and dividend distribution requirements. The election allows a step up in basis for appreciated assets owned by the company that elects for REIC, and the gain deemed realized upon election is taxed at a reduced flat tax rate (20 per cent).

At taxpayer’s option, net gain or loss on company’s appreciated assets deemed realized upon election for REIC may be subject to general tax rules (net loss is carried forward and net gain is taxed either in the year in which it is deemed realized or pro rata over five years). Gains realized upon contribution of real estate property to a REIC are subject to a similar tax treatment (20 per cent substituted tax or ordinary taxation at taxpayer’s election).

In addition to eliminating all corporate level taxes (corporate income tax and IRAP), dividends under the REIC regime are subject to a 20 per cent withholding tax. The tax rate is reduced to 15 per cent for dividends distributed out of earnings derived from rental of homes or apartments used for residential purposes.

The government will issue regulations within April 30, 2007 to implement the new provisions, and companies will be able to exercise the election for taxable years beginning on or after June 30, 2007.

Requirements for the Election


REIC is not a new type of entity but a special tax regime based on fiscal transparency (no corporate level tax, shareholder tax only). Only publicly traded joint stock companies (SPA) resident in Italy for tax purposes can elect REIC status.

The election can be extended to non-publicly-traded subsidiaries of REICs when one or more REICs own at least 95 per cent of the voting power and profit share of a subsidiary, and the subsidiary otherwise satisfies the other requirements for the REIC election.

To be able to elect as REIC, a company must satisfy the following requirements:

- No shareholder can own, directly or indirectly, more than 51 per cent of the company’s voting power[2] or profit share, and least 35 per cent of the company’s stock is owned by shareholders who do not directly or indirectly own more than 1 per cent of the voting power or profit share (ownership requirement);

- The company must carry out the real estate rental business as its primary business activity (business activity requirement);

- The company must currently distribute at least 85 per cent of its income coming from real estate rental business (dividend distribution requirement).

Real estate rental activity is considered the company’s primary business activity if at least 80 per cent of the company’s total assets are rental real estate (asset test)[3], and at least 80 per cent of the company’s revenue for each taxable year is real estate rental income (revenue test)[4].

For the purposes of the asset and the revenue tests a look through rule applies for to stock owned in, dividends distributed by, or gains realized through the disposition of, other REICS.

Consequently, in accordance with the look through rule, stock owned in another REIC and dividends distributed by or gains realized through the disposition of stock held in other REIC - to the extent that they come from real estate rental income of the distributing or sold REIC - qualify for the election under the asset and revenue test.

Income subject to the dividend distribution requirement includes qualifying real estate rental income received from other REICs.

Individual and Joint Group Election


The election must be exercised within the end of the immediately preceding taxable year and is irrevocable. If any of the requirements for the election is not met for two consecutive taxable years, the election is retroactively terminated from the beginning of the second tax year in which the requirements are not met. However, if the dividend distribution requirement is not met for any tax year, the election terminates from the beginning of that tax year.

If the election is terminated, general rules apply for computing taxable income in the relevant taxable year.

Under the join group election rule, REIC election can be extended to non-publicly traded subsidiaries that are at least 95 per cent owned (by voting power and profit share) by a REIC, individually or jointly with other REICs, and otherwise satisfy all other requirements for REIC treatment.

Basis Step-Up and Tax Treatment of Deemed Gains


As a result of REIC election, all unrealized, built-in gains or losses in the company’s rental real estate are deemed realized and the tax basis of the assets is stepped up or down at fair market value.

The net gain deemed realized is subject to tax at the flat rate of 20 per cent, which applies in lieu of ordinary corporate income tax and regional tax on production activities. The tax can be paid in five equal installments. In this case, interest is charged at the official discount rate (currently 3.5 per cent) plus 1 per cent.

The new tax basis applies beginning from the fourth tax year following the tax year immediately preceding the one for which the election is made for purposes of the asset test of the business activity requirement used to determine eligibility for REIC.

In the case of an anticipated sale of the assets, the gain or loss is computed with reference to the original adjusted tax basis of the assets as it existed before the election, adjusted for depreciation, and the pro rata portion of the substituted tax is granted as a credit against taxes due on the gain realized on the sale.

At taxpayer’s option, instead of the application of the substituted 20 per cent flat rate tax, the net gain that is deemed realized upon the election can be taxed according to the general rules.

In that case, the net gain is either included in the taxable income for the tax year immediately preceding the one for which the election is made, for its full amount, or is pro rated over five years (the year in which it is deemed to be realized and the four subsequent years).

The portion of the gain that is pro rated to tax years following the REIC election does not qualify for the purposes of the revenue test of business activity requirement used to determine eligibility for REIC treatment.

Tax Treatment of Contribution of Property to REIC


Gains realized upon contribution of appreciated real estate to a REIC are taxed according to the general rules (namely, they are included in income of their full amount in the tax year of the contribution, or are apportioned pro rata over that year and four subsequent tax years at taxpayer’s election, for assets held for more than three years).

At taxpayer’s election, the gain can be subject to the substituted 20 per cent flat rate tax as described above. However, the application of the substituted tax requires that the REIC held the contributed asset for at least three years.

The contribution is subject to VAT, if applicable, and registration, cadastral and mortgage taxes are charged at the fixed amount of EUR 168. VAT does not apply if the contribution concerns a group or real estate assets that constituted a business or line or business in the hands of the contributing company.

Tax Treatment of a REIC


The real estate rental income of a REIC is exempt from corporate income tax. Exempt income includes dividends distributed by other REICs out of their exempt real estate rental income. A REIC’s production value is exempt from IRAP in the same proportion as its exempt income. Consequently, if a REIC carries out only a qualifying rental activity and earns only exempt rental income, it is totally exempt from corporate level tax.
A REIC must keep separate books of accounting for the computation of its exempt income and taxable income deriving from non-qualifying rental activities.

Stock owned by a REIC does not qualify for the general participation exemption rules for the purposes of the exemption of gains. Therefore, gains realized through the sale of stock owned by a REIC are fully taxable.

Although the statute is not clear, it would seem reasonable to conclude that gains realized on disposition of stock owned in other REICs are exempt, to the extent that they are allocable to exempt income of the sold REIC.

The statute does not rule out the application of participation exemption provisions for exemption of dividends. Therefore, dividends received by a REIC, other than dividends from other REIC distributed out of REIC exempt income (which are totally exempt as clarified above), should be partially exempt from tax (95 per cent exemption) like dividends received by corporate shareholders of ordinary companies.

Items of income or loss accrued in prior years and whose tax recognition has been deferred to subsequent years must be allocated to REIC’s exempt or taxable income. The tax administration will issue rules establishing the criteria for the allocation of previous years’ deferred income or deductions.

Net operating losses carried over from previous years can be used to offset gains recognized upon the election for REIC (and subject to the substituted 20 per cent tax or ordinary corporate income taxes as clarified above) or REIC’s taxable income from non-qualifying activity.

Tax Treatment of Shareholders


Dividends distributed by a REIC out of its exempt earnings and profits are subject to 20 per cent withholding tax, which is reduced to 15 per cent for dividends distributed out of the earnings and profits allocable to the rental of homes or apartments used as private residences.

No withholding tax applies on dividends distributed to another REIC or by non-publicly traded subsidiaries that have been consolidated with their REIC’s parent under the group election.

Dividends distributed out of taxable earnings and profits (or earnings and profits from prior years) are subject to the general rules.

At the domestic level, the withholding tax is a final tax for individual portfolio shareholders[5] and is treated as an anticipation of the tax due on the shareholder’s taxable income in all other cases.

The new provisions do not contain any special rule about the tax treatment of REIC’s dividends in the hands of the shareholders. Therefore, dividends should continue to be subject to the ordinary rules (that is, 95 per cent of the dividend would be exempt from tax for REIC’s corporate shareholders, and 60 per cent of the dividend would be exempt from tax for REIC’s individual shareholders who own qualifying shareholdings[6] or hold the stock in the conduct of a trade or business).

Cross Border Aspects


Foreign companies that are not resident in Italy for tax purposes (that is, with their legal seat, place of management and principal place of business outside Italy) do not qualify for the REIC election.

However, according to a similar interpretation adopted for domestic tax consolidation, if a foreign company is domesticated and establishes its tax residency in Italy, while maintaining its foreign charter (which Italy allows), and has legal features similar to those of Italian companies (primarily, limited liability, centralized management and free transferability of shares), it should be eligible to elect for REIC status.

The 20 or 15 per cent withholding tax generally is a final tax for foreign shareholders, unless they are engaged in a trade or business through a permanent establishment in Italy to which dividends are effectively connected. The statute does not provide any exemption for such the withholding tax[7].

The withholding tax can be reduced by treaty, for foreign shareholders who are resident in a treaty country (and satisfy all other requirements for the application of the treaty benefits).

The application of the EU parent-subsidiary directive, which would exempt from withholding tax the dividends distributed to a EU parent company, may be problematic, however. A REIC satisfies all the requirements of the directive, but for the fact that it is exempt from corporate income tax in Italy. Hopefully, this issue will be clarified by the tax administration when it adopts the rules that will implement the new REIC provisions.

Capital gains from the sale of REIC stock are subject to the general rules. Consequently, they are exempt from Italian source-based tax for foreign portfolio investors and taxable (on a net basis with duty to report the income by filing income tax return in Italy) for foreign non-portfolio shareholders holding qualified shareholdings in a REIC[8].

However, for shareholders resident in treaty countries, the tax on capital gains would be eliminated altogether in accordance with the treaty. Indeed, most of Italian tax treaties do not contain provisions that preserve source state taxation for gains from sale of stock of real estate holding companies.

Conclusion


The new REIC regime appears to be very favorable for foreign investors interested in investing in real estate in Italy. It allows for the complete elimination of corporate level tax, and the distributed profits are subject to withholding tax at a reduced rate, which can be reduced further under tax treaties. Further, gains from sale of REIC stock would be generally exempt from tax under treaty.

The REIC regime is complementary to the existing REIF regime and fills a gap in the Italian tax system, by placing Italy in line with other jurisdictions within and outside the European Union that had already adopted similar rules.

It is crucial that the tax administration adopt clear rules to properly implement the new regime and provide the necessary guidance to avoid uncertainties and allow reliable and predictable results according to the general ratio of the new regime.


[1] Article 1, paragraphs 119 to 141 of Law n. 296 of December 27, 2006.
[2] Voting power is measured by the total number of share entitled to vote at the ordinary meeting of shareholder, which elects company’s directors.
[3] The statute does not specify whether the assets are to be measured by book value or tax basis.
[4] Reference is to revenue as appearing from the company’s financial income statement.
[5] Portfolio shareholders are shareholders who own less than 2 per cent of voting power or 20 per cent of stock (by value).
[6] Qualifying shareholding means stock representing more than 2 per cent of voting rights or more than 20 per cent of value.
[7] This is a major difference with the rules on real estate investment fund, which exempt foreign investors from Italian source-based tax on the fund’s income (fund’s distributions or gains from sale of fund’s shares).
[8] Under tax code section 67(1)(c), qualified shareholding is defined as shareholding representing more than 2 per cent of voting right or 5 per cent of stock (by value).