A decision to scrap plans to relax the self invested pension plan rules was the surprise announcement of this year’s Pre-Budget Report. Rather than allow SIPPs to invest in residential property, vintage cars, fine art and fine wine, Chancellor Gordon Brown now says there will effectively be tax penalties for such moves.

At a stroke, he reversed policy that had been on the statute books for many months, prompting statements of dismay from even normally staid players, such as posh wine merchants, Berry Brothers & Rudd.

‘We are hugely surprised at yesterday's u-turn by the Treasury’, said the firm. It was ‘especially disappointing’ that after 18 months of preparing for a new SIPPs regime, the Chancellor should leave it to just four months change before the change to change his mind. But change his mind he did, saying the system would be too open to abuse.

Certainly, once the proposed widening of the SIPPs rules had first been floated, creative thinkers had been rubbing their hands with glee and proposing all kinds of novel investments including even jewellery, yachts and racehorses.

But warning bells should already have been ringing before the Chancellor dropped his bombshell. Most of the hype surrounding SIPPS was froth designed to boost sales of fine wine, artworks or foreign property without any consideration of their suitability as an investment for a pension fund. Many of the tax advantages due to be conferred by the promised SIPPS changes were irrelevant to the proposed investments, anyway. For instance, investment in a UK holiday letting business already benefits from an attractive set of tax reliefs without the need for a SIPP. Conversely, a SIPP would not have offered shelter from foreign taxation on a holiday home abroad.

It seems that the Treasury was particularly concerned about wealthy people taking advantage of the proposed rule changes to fund second homes, particularly after concerns were raised by MPs from popular holiday areas about the effect of rising house prices on local home seekers.

Perhaps the section of the investment community entitled to feel most aggrieved by the Chancellor’s last minute change of heart were those planning to include buy to let property within their pension portfolios. For, it was this type of investment that would have benefited most from the now scrapped widening of the SIPP investment rules. True, landlords would have had to trade a certain amount of flexibility and higher management charges for the promised tax concessions, but this would have suited many, especially those not wishing to be involved in hands on property management.

The new rules will not only withdraw tax the proposed advantages for including residential property within SIPPs, they will actively dissuade people from investing in such assets. The problem for both pension investors and landlords now is that there is both confusion surrounding SIPPS and similar schemes, and the prospect of extremely severe penalties for those who get things wrong. Any attempt by pension trustees to invest in ‘prohibited assets’ will attract tax penalties on the member of the pension scheme (at 40 per cent) and on the pension fund itself. If the value of prohibited assets exceed 25 per cent of a scheme value, it could de-registered and suffer a 40 per cent tax charge on its total value. Tough talking from the Treasury...

But all is not lost so far as property investors are concerned. According to recent announcements, the Government ‘is minded’ to allow investment in assets such as residential property through ‘genuine diverse commercial vehicles’, such Real Estate Investment Trusts (REITs). But it warns it will monitor use of such vehicles to ensure that funds are not used to circumvent the new rules on prohibited assets. REITS are set to be introduced following the 2006 Budget.

Like many of the Government’s new ideas, REITs originated in the United States, where they were introduced by President Eisenhower in 1960. Basically, a US REIT is a publicly traded investment trust which invests the capital of its shareholders in property.

Some REITs, called 'Equity REITs', take equity positions in property, receiving income from rents and capital growth from selling buildings. Others specialise in lending money to property developers, their income coming from interest payments on those loans. Hybrid REITs do a mixture of both equity investing and property lending.

REITs are ‘pass through entities’, which means they are designed to pass profits on to investors through the purchase of income producing rental properties.

The investment trust owns and manages a pool of residential and/or commercial properties and mortgages and other real estate assets, while at the same time, shares in the trust can be bought and sold on the stock market. Provided 75 per cent or more of their income comes from property and 95 per cent or more of their net earnings is distributed to shareholders each year, REITs enjoy special tax advantages.

Here in the UK, the Chancellor has been talking about REITs for some time, and gave a green light for their introduction in the same announcement that he used to withdraw the proposed widening of the SIPPs rules. Effectively, this means that investors can still add private and foreign properties to their SIPP but only by way of the more strictly controlled REITs vehicle. And they will not be able to be involved in the management or use of those properties.

According to Assetz Fund Management, ‘initially a REIT will take the form of a quoted company on the stock market, but one which is not itself liable to tax on its profits. Instead, provided it distributes 95 per cent of its net income to its shareholders, it is they who will pay tax on their receipts, rather than the company.

Assetz claims there are ‘likely to be limitations on trading (as it is expected that 75 per cent of the income must come from rental income) and gearing is also likely to be restricted, which may limit the scope for growth funds’.

REITs are likely be ‘useful for investors seeking income directly without a company taxation structure causing them to lose some irrecoverable tax before the income reaches them for gross income purposes’, Assetz adds – although it warns that, while REITs have been very successful in other countries, ‘in most cases they have taken many years to become well established’.

Government proposals indicate that REITs will take the form of closed companies. Their activities will be divided into two pools – one for property ownership and the income it generates (which will be ring-fenced), and one for all other activities (for example, property development, trading and management). To qualify as a REIT, the ring-fenced business will have to generate at least 75 per cent of the company's gross income with 75 per cent of its capital value comprising real estate used in that ring-fenced business, and 95 per cent of the income arising from it must be distributed, although capital gains need not be.

The Royal Institution of Chartered Surveyors recently submitted its response as part of the Government’s consultation exercise on the introduction of REITs. RICS concluded that: ‘REITs will improve the attraction of property as an investment, both to institutions and to smaller investors. They will achieve this through their liquidity and tax transparency. For both forms of investor they offer a more stable investment asset than equities has proved to be in the last five years and thus could be an important boost to the Pensions industry’.

And it said: ‘REITs offer the chance to attract substantial institutional investment into the residential private rented sector. This will help the balance of tenure in the residential sector which is currently overwhelmingly owner occupied.

‘The UK is one of the last leading economies to embrace a REIT type structure. REITs have been particularly successful in the US and Australia in recent years and their introduction should sustain the attractiveness of UK property to overseas investors’.

Unlike the ill thought through SIPPs proposals, it looks like REITs may serve up an acceptable compromise between tax advantages and lightness of regulatory touch, while also avoiding distortion of the UK residential property market. If that is the case, REITs are probably here to stay.

On their own, though, REITs only protect income from taxation within the Trust. Once the income is distributed, the recipients become liable for income tax at the prevailing rate.

Nick de Cent is a freelance journalist specialising in business issues. He can be reached by email at nick@creative-element.co.uk or via the website www.creative-element.co.uk.