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How Do Managers and Shareholders Respond to Taxation? An Analysis of the Introduction of the UK Real Estate Investment Trust Legislation


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Complexity is a recurring criticism of tax systems. Using the introduction of Real Estate Investment Trusts (REITs) in the United Kingdom, we examine how managers and shareholders respond to this new regulatory regime, during which there was a lack of certainty over the form of the legislation.

This new regime provided existing quoted companies with material taxable profits from property investment activities, to elect to enter the REIT regime on the payment of a conversion charge. The charge was based on the gross carrying value of property investment assets as valued for financial reporting purposes. Once within the REIT regime, companies’ taxable profits from property investment activities would be exempted from company-level (corporation) tax. The nature and magnitude (2%) of the conversion charge was only disclosed in March 2006 when the government announced its intention to legislate for the REIT regime. Leading up to that announcement in 2006, a series of government consultations had taken place over several years during which the government repeatedly pledged that any legislation would be “tax neutral”.

The markets clearly took another view on the relative costs and benefits of the new regime including the conversion charge. On the afternoon of the announcement in March 2006, the market value of the property sector increased by £3.4 billion, with two companies in particular experiencing large increases in market values of £1.1 billion and £700 million respectively. These price increases were highly speculative because no potential REIT had committed to converting to REIT status at that stage and only did so when the legislation was published in full several months later. We use hindsight to categorise, at March 2006, potential REITs into those companies subsequently converting to REIT status and those companies retaining their existing basis of taxation.

While only taxable profits from property investment activities would be exempted, potential REITs were not restricted to existing quoted property investment companies. Potential REITs could be carrying on other trades or be newly established. In order to objectively identify potential REITs for research purposes, we used the 40 members of the FT-SE Real Estate Holdings and Development (FT-SE) industry classification as a sample. While the sample size is small and this is reflected in the statistical tests, the REIT setting has the advantage of revealing a clearly identifiable tax-related decision. Other potential settings in which to observe decision making and taxation, for example, capital structure, capital intensity and so on, often involving conflating finance or operating decisions with tax considerations.

The main features of the REIT legislation can be linked to identifiable company characteristics. Firstly, following conversion any unrealised gains on investment property can be realised free of taxation. Hence, any existing provision for deferred tax on these gains could be written back to distributable reserves for the purposes of financial reporting. Gains accruing post-conversion are also tax free. Non-tax costs of conversion which need to be weighed against the benefit of tax-free realisation can also be identified. The primary non-tax cost arises from the requirement to have a minimum pay out rate of 90%. A high pay out rate imposes a cost on managers by reducing their control over internal funds and increasing reliance on debt as a source of finance along with associated increased external scrutiny.

Managers’ tax decisions appear not to be constrained by investors

Drawing on data from the financial reports of the 40 companies comprising the FT-SE Real Estate Holdings and Development industry category, we first examine managers’ decision making by using logistic regression to model the option to convert to a REIT or to retain the existing tax status. Our results indicate the managers’ decisions were consistent with the trade-off between the opportunity to realise gains free of tax against the requirement to pay a conversion charge. However, managers facing potentially higher agency costs were less likely to convert to REIT status, indicative of managers’ willingness to trade off investors’ welfare for the benefit of their own welfare. This finding is consistent with long-established agency theory, which posits that managers will prioritise their self-interest in the absence of appropriate incentives. However, its presence in this setting is surprising given the decision to convert or not is publically observable. This suggests that managers’ decisions in the field of taxation, at least, are not fully constrained by investors.

Managers appeared to anticipate the introduction of the legislation, and had taken pre-emptive action. Converting companies had lower asset disposals in the year preceding conversion. A feature of the introduction of REITs was greater prior consultation between the government and interested parties. Pre-emptive action prior to the legislation, while almost inevitable, may be facilitated by more extensive government consultation in the process of formulating tax strategy and legislation. This is an aspect worthy of further examination.

Turning to shareholders, we focused on the abnormal or unexpected share returns at the time of the March 2006 announcement. Our results indicate these abnormal returns on the date of the announcement can be explained to a significant extent by company characteristics relevant to the legislation. However, a number of factors hypothesised to be relevant were not significant, for example levels of debt finance used and dividend pay-out. Compared with the modelling of managers’ decisions discussed above, a smaller number of variables were used for modelling shareholder returns. This is consistent with managers’ applying a high level of sophistication in assessing the impact of the legislation.

More significantly, while shareholders judged the March 2006 as being potentially beneficial to the FT-SE sector as a whole, there was limited evidence of shareholders’ ability to identify those companies that would subsequently convert from those that did not. Across the various announcements occurring during the consultation process prior to March 2006, no statistically significant abnormal returns arose on any of the individual announcements or in aggregate across all these consultation announcements. While on the day of March 2006 announcement there was a significant difference between the companies subsequently converting and the non-converting companies, both groups reported statistically significant mean abnormal returns. Moreover, when measured over three days, the mean cumulative abnormal returns of the two groups did not differ significantly.

How investors can hold managers accountable?

This apparent lack of shareholder sophistication in dealing with taxation has implications for both asset pricing (market efficiency) and corporate governance. Investors can only monitor managers’ actions, and intervene where necessary, if they have sufficient expertise and access to information. Legislative changes in the UK have attempted to increase shareholder scrutiny through, for example, the requirement of large companies to publish their tax strategy annually. While these disclosures can be utilised by any external stakeholder, sufficient shareholder sophistication and interest is critical if direct influence is to be brought on managers. Observing managers acting in their own interest is not a new finding. Instead of relying on well-used financial incentives (for example, options, bonuses and so forth). In the field of a taxation, at least, it may be necessary to require managers to provide fuller explanations of their actions. Doing so will allow shareholders and other interested parties to judge if managers are responding appropriately to tax-based policy initiatives.

Research-wise, there is the need to update our findings using a suitable tax change where tax and non-tax effects can be clearly identified, and outcomes are publicly observable. Frustratingly, such events are rare.

The post How Do Managers and Shareholders Respond to Taxation? An Analysis of the Introduction of the UK Real Estate Investment Trust Legislation appeared first on Austaxpolicy: The Tax and Transfer Policy Blog.


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