What Has Happened?
The UK government has announced a major reform of the tax rules for non-UK residents holding UK real estate assets, including indirect holdings through companies or other legal entities. Under the proposed rules non-UK residents would be taxable on all capital gains arising on both commercial and residential UK real estate assets, and on capital gains arising on certain interests in “property rich entities”.
This is significant because the UK’s current tax rules mean that non-UK investors in UK commercial real estate are typically not taxed at all in the UK on capital gains. Non-UK investors’ gains on residential real estate are already taxable in certain circumstances under the so-called Non-resident Capital Gains Tax (“NRCGT”) and ATED-related Capital Gains Tax (“ATED-CGT”) rules. However, the NRCGT and ATED-CGT rules are comparatively narrowly focussed and contain exemptions that mean tax does not arise in relation to many residential property investments made on a commercial basis.
Although certain features of the proposed rules are subject to public consultation, the government is clear that it does not expect to change the basic scope of the proposed rules, their commencement date or other core features. Full details of the government’s announcement are here: https://www.gov.uk/government/consultations/taxing-gains-made-by-non-residents-on-uk-immovable-property.
When Will This Take Effect?
For companies, the proposed rules will apply from 1 April 2019. For other investors, the rules will apply from 6 April 2019.
Will Sales Of Shares Or Units In Property Owning Companies Or Property Unit Trusts Also Be Taxable?
A non-resident holding UK real estate indirectly through ownership of shares in a company or units in a property unit trust that owns the asset (a “PropCo”) may be taxable when they sell or otherwise dispose of those shares or units. However, whether they are taxable will depend on whether the PropCo is regarded as a “property rich entity”, and on the size of the non-resident’s interest in the PropCo.
A PropCo will be a “property rich entity” if 75% or more of its gross asset value at the time of disposal derives from UK land. The use of a gross asset value test means that loan finance will be ignored in applying this test. The rules will attribute value both to real estate assets held directly by the PropCo, and to real estate assets held indirectly through a chain of legal entities.
A non-resident will only be taxable in relation to their interest in a property rich entity if they either hold a 25% or greater interest in it, or have held a 25% or greater interest in it at some time in the five years preceding the disposal. The interests of connected persons and persons “acting together” will be aggregated for the purposes of this rule, so that it will not be possible to fall outside the rule by fragmenting holdings across groups of companies or other related entities.
Note that although the proposed rule targets UK real estate, for indirect disposals it may result in gains attributable to the value of non-UK real estate, or non-real estate assets, being taxed. If a company’s gross assets consist as to 75% of UK real estate and as to 25% of French real estate, it will be a property rich entity. A shareholder in that company would be subject to tax on any gain on sale of its shares if it had held an interest of at least 25% in the last five years, even though part of that gain might be attributed to the French real estate.
This might suggest that the UK assets should have been held through a separate holding structure such that only the gain attributable to the UK assets would have been taxed. That however would not be a straightforward decision because separate holding structures for the French and UK assets would mean that the gains deriving from the UK assets would be taxed irrespective of their value relative to the French assets.
Will Latent Capital Gains On Increases In Value Up Until April 2019 Be Taxed?
There will be special rules where assets are already held when the proposed rules take effect in April 2019 such that only gains attributable to increases in value from April 2019 will be taxable. This will be achieved by “rebasing” to April 2019 values. Rebasing to April 2019 will not however apply to residential assets that would already have been subject to NRCGT.
For direct disposals of assets it will alternatively be possible to elect to take the original acquisition cost as the tax basis. This means that if an asset stands at a loss relative to its original acquisition cost but at a gain relative to its value at April 2019, no tax charge will apply provided an election is made. However, the wording of the government’s announcement suggests that this may only be done to stop tax arising on the sale of an asset that stands at a loss relative to its acquisition cost. It isn’t clear whether it will be possible to avoid rebasing in a situation where an asset stands at a gain relative to its original acquisition cost but that gain is smaller than a gain relative to its April 2019 value. It will not be possible to elect out of rebasing in relation to disposals of interests in property rich entities.
Will Any Exemptions Be Available?
If the investor is exempt from UK tax on capital gains, for instance a UK registered pension scheme, certain non-UK pension schemes or a sovereign entity that qualifies for immunity from UK tax, then gains that arise to it directly should be exempt. Further, although the government has not specifically confirmed its stance, if gains arise to an exempt investor through an entity that is treated as transparent for UK tax purposes such as a partnership then they ought in principle to be exempt also. It is hoped that this latter point will be confirmed.
Where an exempt investor holds assets indirectly through entities that are regarded as opaque for the purposes of the proposed rules, such as companies and most property unit trusts, gains that those holding entities realise would in principle be subject to tax even if the investor would have been exempt had the gain arisen to it directly. This is subject to the application of a specific exemption known as the “substantial shareholdings exemption” (the “SSE”).
The scope of the SSE was recently expanded, and the effect ought to be that if a holding company (“HoldCo”) is owned as to at least 25% by “qualifying institutional investors”, then a gain arising to it on the sale of shares in a PropCo would be partially exempt proportionately to the interests of the qualifying institutional investors. If the qualifying institutional investors own 80% or more of the HoldCo, then the gain would be completely exempt. “Qualifying institutional investor” is restrictively defined for this purpose but includes UK registered pension schemes, certain non-UK pension schemes, and sovereign wealth funds. Note that the SSE would not exempt gains arising on direct asset disposals, i.e. if the PropCo sold the real estate asset itself.
This treatment should in principle also apply if the HoldCo is owned by a partnership, such as a fund partnership, in which at least 25% of the investors are “qualifying institutional investors”. Assuming that this is confirmed, it will represent an important exemption for many real estate funds.
Additionally, the government has announced that it intends to provide exemptions for certain institutional investors. It is assumed that these exemptions will be more far reaching than those outlined above, which to a large extent derive from existing law.
Will The Rules Apply To UK Real Estate Investment Trusts And Their Shareholders?
UK Real Estate Investment Trusts (“REITs”) will remain exempt on gains on real estate assets. A dividend paid to shareholders from gains on the sale of UK real estate assets would however be treated as a property income distribution and be subject to tax, but a REIT is not required to pay dividends from its gains so it could instead reinvest the gain without a tax consequence to its shareholders.
However, a REIT may be, and likely will be, a property rich entity. The rules described above for sales of shares in property rich entities will therefore apply to REIT shareholders selling REIT shares. The requirement for a 25% interest in order for the rules to apply should mean that for most non-UK resident portfolio shareholders in REITs no tax will arise.
Do Double Tax Treaties Help?
Double tax treaties will not generally affect the tax treatment of a gain arising on a direct sale of a real estate asset.
However, if the shares in a PropCo are held by a HoldCo that is able to rely on a double tax treaty with the UK, it may in principle be possible to argue that the HoldCo should not be taxable on a sale of its shares in the PropCo. This will depend on the terms of the particular double tax treaty in question. Certain of the UK’s double tax treaties specifically contemplate this scenario and allow the UK to impose tax, whereas many do not. Where the relevant double tax treaty does not contain such a rule, it could be argued that the UK is prevented by the treaty from taxing a gain arising to the HoldCo.
However, the government also announced an anti-forestalling rule, effective as from 22 November, which would deny HoldCo the protection of a double tax treaty if a structure or other arrangement has been entered into to obtain the protection of the double tax treaty, and that result is contrary to the “object and purpose” of the treaty. It remains to be seen how widely this rule will be applied, but it is clearly designed to target treaty protected structures implemented in jurisdictions such as Luxembourg with a view to escaping the new rules, e.g. by restructuring the ownership of assets into treaty protected HoldCos.
The extent to which this anti-forestalling rule will apply to assets that were already held in treaty protected structures on 22 November, or to assets acquired after 22 November into existing “platform” structures in treaty protected jurisdictions, is unclear based on yesterday’s announcement.
Will Any Tax Planning Be Effective?
It is difficult to assess what might be effective until draft legislation is published. However, there will be a specific anti-avoidance rule designed to defeat planning aimed at preventing a tax charge arising under the rules. This “targeted anti-avoidance rule”, or “TAAR”, will be in addition to the existing statutory general anti-abuse rule, or “GAAR”, and to case law based doctrines. The combination of these rules is likely to make it extremely difficult to structure around the proposed rules with any degree of certainty.
However, as noted above, if assets other than UK real estate are to be held it will be attractive to hold them within the same holding structure as UK real estate assets, provided it is anticipated that the UK real estate assets will represent less than 75% of the overall gross asset value. Further, REITs and other entities that are entitled to tax benefits specifically provided in UK tax legislation may become relatively more attractive as investment vehicles.
How Will HMRC Enforce These Rules?
Where a gain is realised that is taxable under the proposed rules, the person or entity that realises it will be required to report it and to pay tax on it. That person or entity may already be registered with HMRC, e.g. if they receive rental income from UK real estate. If they are not already registered, they will need to register.
For gains that arise indirectly through a disposal of interests in a PropCo, the government is proposing that UK advisers will be required to report the transaction to HMRC unless they can satisfy themselves that it has already been reported.
Are The Rules Relating To Rental Income Also Changing?
This proposal only relates to capital gains. However, earlier in the year the government had announced reform to the tax rules under which non-UK resident companies pay tax on rental income from UK properties. That proposal, which also included a much more narrowly focussed change in relation to capital gains, is here: https://www.gov.uk/government/consultations/non-resident-companies-chargeable-to-income-tax-and-non-resident-capital-gains-tax.
The suggestion in relation to rental income was broadly that non-UK resident companies would pay tax on rental income under the same corporation tax rules as those that apply to UK resident companies, rather than the income tax rules that have historically applied to non-UK resident companies. This change will likely mean that many non-UK resident companies would pay more tax on rental income than they currently do. This is because the application of corporation tax rules implies that additional restrictions on deductibility of loan interest would apply, and the ability to offset profit with losses carried forward from earlier accounting periods would be restricted.
The government has reconfirmed its commitment to this reform, but has put back the date it would take effect to April 2020.