IFM04320 - AIFs: Property authorised investment funds (PAIFs): tax treatment of PAIFs and distributions: calculation of the net income for the tax-exempt business

Definition of ‘net income’ of the PAIF (regulation 69Z SI 2006/964)

’The net income /expense before taxation’ is defined as the amount shown in the statement of total return. This is computed under GAAP in accordance with the current Statement of Recommended Practice issued by the Investment 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 PAIF that arises from the tax-exempt Property Investment Business. That part of the income that arises from the property rental business (IFM04130) should be calculated as usual but with certain exceptions:

• any overseas rental income and expenses are included in the calculation;
• loan relationship and derivative contract credits and debits are not disregarded where 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.

Derivative contracts

A derivative contract is a hedging instrument in relation to a PAIF (in this case the deemed company which carries on the tax-exempt business) if or in so far as it is acquired as a hedge of risk in relation to an asset or the income of the business. For example, the PAIF may have a USA property portfolio yielding a dollar rental stream and the PAIF wants to ensure its income in sterling does not decline, so enters into a dollar/sterling swap.

An embedded derivative contract is one that has a host contract with a derivative embedded into it and takes the meaning provided in the derivative contracts legislation in part 7 of the Corporation Tax Act 2009. More information on these definitions can be found at in the Corporate Finance Manual at CFM52500.

An example of an embedded derivative entered into for the purposes of the tax-exempt business is where a lease contains a provision that the rent is adjusted upwards every year at five times the increase in the retail price index. The index-linking term is a derivative embedded in a host contract (the lease), and because the inflation adjustment is leveraged, the PAIF may have to recognise the derivative separately in its accounts. Provided the lease itself is within the ring-fence, the embedded derivative will also 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 the property), movements in the value of the PIC are within regulation 69Z1(3) SI 2006/964 (as it relates to the tax-exempt business).

Although shares in property companies or units in property unit trusts are normally outside the ring-fence though they may appear to be property-related. Debits and credits arising on derivatives where these are the underlying subject matter are excluded for the purposes of calculating the profits of the tax-exempt business. This does not apply to those shares in property companies that are UK REITs or their foreign equivalents as these are specifically brought within the property investment business in the legislation. See IFM04150.

A contract that is not a derivative contract for the purposes of Part 7 of the Corporation Tax Act 2009 by virtue of section 589(2)(c) is also excluded from being taken into account for the calculation of net income of the tax-exempt business (regulation 69Z1(6) of SI 2006/964).

Capital Allowances - Example

Assume this is the final full 12 month accounting period of property rental business ‘A’. Its taxable profits, before capital allowances, are £125,000 and it has a capital allowances pool with a written down value (wdv) brought forward of £30,000. Its chargeable profits are therefore as follows:

Accounting Period (A/P) ended 31/03/2018
Net profits, adjusted for tax	£125,000
less capital allowances –
wdv £30,000 x 18%	(£5,400)
Profits chargeable to corporation tax	£119,600
[wdv carried forward: £30,000 less £5,400	£24,600]

The open-ended investment company then converts to a PAIF at, say, 30 September 2018 and so the Property Rental Business has a six-month AP ended 30/09/2018. Assuming taxable profits, before capital allowances of, say, £70,000 the position is as follows:

Accounting period 01/04/2018 to 30/09/2018
Net profits, adjusted for tax	£70,000
less capital allowances –
wdv £24,600 x 18% x 6/12 (short A/P)	(£2,214)
Profits chargeable to corporation tax	£67,786

The value of the capital allowances pool is now £22,386 (£24,600 less £2,214), and this is the value at which the pool is transferred when the deemed transfer of the property rental business takes place. The effect of this is that there is no further allowance or charge on the taxable Property Rental Business, and the tax exempt business bases its calculation of ‘shadow’ capital allowances on the deemed sale/ acquisition price. This will work as follows for the tax exempt business’ first accounting period to, for example, 31 March 2019:

Accounting period 01/10/2018 to 31/03/2019
Net profits (calculated as for a taxable property rental business)	£72,000
less capital allowances –
wdv £22,386 x 18% x 6/12 (short A/P)	(£2,015)
Income of the tax exempt business	£69,985
[‘shadow’ wdv carried forward: £22,386 less £2,015	£20,371]