What was announced on Friday?
The UK Government published draft legislation which will result in non-UK residents being subject to UK capital gains tax or, for companies, corporation tax on chargeable gains (“CGT”) in relation to UK real estate. The rules will take effect on 6 April 2019.
This major change to UK tax rules was announced in November last year. Our summary of that announcement is here: https://www.goodwinlaw.com/publications/2017/11/11_24_17-uk-to-tax-non-residents-on-real-estate. The draft legislation confirms the following key features of the new rules that had already been announced in November:
- Sales of real estate assets held directly will be taxable.
- Many sales of companies and property unit trusts that derive at least 75% of their value from UK real estate (“PropCos”) will also be taxable.
- There will be “rebasing” of assets and of interests in PropCos to their market values at 5 April 2019 so that only gains arising from increases in value after that date will be taxable.
- Investors who would qualify for some specific exemption from UK tax beyond the fact that they are non-UK resident will continue to do so, e.g. exempt pension schemes, entities qualifying for sovereign immunity.
Is this old news then?
No. The draft legislation goes further than November’s announcement in certain key respects and fills in much detail missing from November’s announcement. Many of the additional features included in Friday’s announcement will be welcome. That being said, it is regrettable that detailed proposals to address the many issues faced by investment funds were not published on Friday. However, given the difficulty of these issues this is not entirely surprising and the delay will at least enable the Government to put forward more considered rules for investment funds.
In the remainder of this alert we outline some of the most important features of the rules that either did not feature in November’s announcement, or as to which the Government’s stance had been unclear. We also make some suggestions as to what real estate investors and fund managers should consider doing now in anticipation of the new rules coming into force in the Spring.
No new exemptions for the moment
No new exemptions have been included in the draft legislation, although the Government has said that it will consult on an exemption for offshore funds. The rules have also been designed not to apply to interests in entities that carry on a trade – see further below.
The Government has confirmed that existing exemptions from taxes on capital gains will continue to apply in this context. An investor that is exempt under current rules, otherwise than purely because they are non-UK resident, will therefore continue to be exempt on real estate related gains.
However, where an exempt investor holds its real estate investments indirectly through PropCos, the PropCos may themselves be subject to CGT. This would impact the return made by the exempt investor. The draft legislation does not address this issue, although in the context of funds and their investors the Government has said it will consult with a view to introducing rules that would go some way to addressing the point (see below). Further, for holding structures consisting of companies, the existing “substantial shareholdings exemption” may allow gains on certain sales of shares in PropCos to be either completely or partially exempt from CGT. This will depend on the level of investment by investors falling within one of the various categories of “qualifying institutional investor” (“QII”) for the purposes of the “substantial shareholdings exemption”.
Indirect sales: two year look-back and connected persons
The sale of an interest in a PropCo will be subject to CGT only if the PropCo’s assets consist as to at least 75% (by gross asset value) of UK real estate assets. In addition, a charge to CGT will generally only arise if the person selling the interest (together with any persons treated as connected with the seller) holds an interest of at least 25% at the time of sale, or has held such an interest within the two years preceding the sale. This represents a significant relaxation as compared with last November’s proposals, which had suggested a five year look-back.
Various concerns have been expressed to HMRC about the range of persons who may be treated as “connected” for the purposes of the 25% test. Some, but not all, of these concerns appear to have been addressed in the draft legislation or are subject to further consideration by the Government. Helpfully, it has been confirmed that partners in a partnership will not be treated as “connected” for this purpose.
In relation to funds, the Government has said that the 25% threshold will not be available to investors in “collective investment vehicles” investing in UK real estate assets. The precise scope of this rule is yet to be determined – see further below.
What to do about funds?
The proposals give rise to particularly difficult issues for the funds industry. These arise because it is axiomatic in fund structuring that an investor should ideally not be exposed to greater tax leakage in relation to an investment made through a fund than if it had invested directly.
These issues play out in two ways. First, if an investor would have been exempt from CGT if it had held an asset directly but the fund entities through which it invests would be subject to CGT, then investing through a fund will be unattractive as compared with a direct investment in the asset. Second, if a fund structure consists of more than one layer of taxable entity, then there is scope for economic double (or greater) taxation of the same economic gain. Note that the number of layers in fund holding structures is often dictated by a fund’s lenders (to give them the most robust security package) rather than by tax considerations.
The Government has recognised these concerns and stated that it will consult with a view to introducing rules that address them. It has said that the rules will build on the following core proposals:
- Offshore funds that are transparent for UK income tax purposes will be able to elect for transparency from the perspective of a non-UK resident investor for CGT purposes.
- Widely held offshore funds will be able to elect that the investor will be taxed on disposals of their interest in the fund rather than the fund itself being taxable under the new rules. This election will be possible whether the fund is transparent or opaque for income tax purposes.
The first of these proposals appears to be targeted at offshore funds that are transparent for UK income tax purposes but opaque for CGT purposes, such as offshore property unit trusts structured as “Baker trusts”, e.g. most GPUTs/JPUTs. The effect of an election would be that non-exempt investors, rather than the fund itself, would be liable for CGT both on sales of assets by the fund and on sale or redemption of interests in the fund. The tax charge will be based on the value of the underlying UK real estate held by the fund on a look-through basis, rather than on the value, cost or disposal proceeds of the investor’s interest. This may mean that investors will be taxed on amounts that differ significantly from the economic return that they actually receive. If no election were made then the fund would be taxable on a sale of an asset with any tax being ultimately borne in accordance with the fund’s legal documentation, while investors might still be taxable on a disposal of their interests in the fund.
The second of these proposals appears to be more broadly targeted and would apply whether the offshore fund was transparent or opaque for UK income tax purposes. In contrast to the first proposal, investors would be taxed by reference to their fund interest rather than the value of the underlying real estate assets. Special, as yet unspecified, tax reporting requirements would apply to a fund that made an election. The Government has not ruled out placing funds under an obligation to withhold tax from distributions to investors, most likely in relation to smaller retail investors.
It is not clear whether these proposals will affect the position of a typical private real estate fund structured as a tax transparent limited partnership and holding UK real estate assets through PropCos formed as subsidiaries of the limited partnership. The “substantial shareholdings exemption” may apply to fully or partially exempt gains of PropCos through which such a fund holds assets, depending on the proportion of investment in the fund represented by QIIs. It would not apply to exempt gains on a direct sale of a real estate asset within a fund. The Government will continue to consult on the application of the “substantial shareholdings exemption” in the context of funds.
Less welcome will be the announcement that the 25% ownership threshold necessary for an indirect sale to be taxable will not apply to investors in “collective investment vehicles”. The fact that an investor holds less than a 25% interest in a fund falling within the definition of “collective investment vehicle” will therefore not absolve it of liability to CGT when it disposes of its interest in the fund or, presumably, if a fund structured as a partnership sells an underlying holding company. It remains to be seen how broadly or narrowly the definition of “collective investment vehicle” will be drawn.
Trading companies and groups
The proposals made last November did not appear to distinguish between entities that hold real estate assets for use in a trade carried on by them and entities that hold assets purely for investment purposes. The Government has announced that it will consult on a new rule to the effect that where an entity holds UK real estate assets which are used for the purposes of a trade, then those assets will not result in a sale of shares or other interests in the entity being subject to CGT. In order to qualify, the trade must be carried on by the same company as owns the real estate, or by a connected person. This may be relevant to investors in many operating businesses in the healthcare, hotel and leisure, and retail sectors.
Note that gains on disposal of the real estate assets themselves, even if held by a trading company, will remain subject to tax.
The new rules aim to catch only the element of a capital gain that accrues on increases in market value after the new rules come into force. This will be achieved by “rebasing”, meaning that when the capital gain on disposal of an asset or an interest in a PropCo is being calculated its market value on 5 April 2019 will be taken as the CGT base cost.
As announced in November, it will be possible to elect out of this treatment such that the acquisition cost together with certain other costs will be taken as the CGT base cost. This might be attractive where an asset decreases in value between acquisition and 5 April 2019.
The announcement in November seemed to suggest that where an indirect sale is made through sale of interests in a PropCo, such an election could only be made if its effect would be to give rise to a loss. The implication was that if making an election would result in a smaller capital gain than would otherwise have arisen then no election could be made. This seemed unfair and was inconsistent with the rules for direct disposals of assets. The draft legislation does not restrict the making of elections to situations where a loss would arise, but if the effect of making an election on an indirect sale is to give rise to a loss it will not be an “allowable loss” that can be offset against other gains.
Will there be an exemption from SDLT to facilitate moving assets from offshore to onshore structures?
There will be no exemption from SDLT specifically targeted at this situation. Whether SDLT arises on a transfer of assets to a UK entity will be dependent on the application of normal SDLT rules, e.g. group relief.
Will third party advisers such as accountants, solicitors or surveyors be required to report clients’ transactions to HMRC?
In its announcement in November, the Government had suggested that third party advisers would be required to report indirect sales of UK real estate through the sale of interests in property owning vehicles. This would have represented a significant extension of the UK’s tax reporting regime by placing an obligation on third parties to report a transaction to HMRC even where there was no suggestion of tax avoidance or evasion.
The Government has now confirmed that it will not be proceeding with this element of its original proposals. Third party advisers may still of course incur reporting obligations to HMRC under various existing regimes of more general application, but these are generally targeted at situations where tax avoidance or evasion is involved.
What can investors and fund managers do now?
Although the legislation is still in draft and will likely change before it becomes law, April 2019 is less than a year away and there are several things investors and managers can start focussing on now in anticipation of the new rules coming into effect.
- Entity structures for investments. Does a traditional structure still make sense? It may be advantageous to consider holding assets in a REIT or a PAIF, or even in some circumstances a fully tax transparent structure. Goodwin can assist by reviewing existing structures and those that a particular investor has historically preferred and suggesting alternatives where appropriate.
- Legal documents for funds. The level of tax suffered by entities within a fund may depend in part on the tax status of the investors. More recent fund documentation will often contain a clause designed to apportion any tax cost arising as a result of the tax status of a particular investor, e.g. by reducing distributions to the investor concerned. Goodwin can assist by reviewing relevant documentation and suggesting changes where appropriate.
- Fund marketing documents. Private placement memoranda and similar documents for funds proposing to invest in UK real estate that launched after November’s announcement will often contain a disclosure to investors on the new rules. This will likely need to be updated for subsequent closings to reflect Friday’s announcement. Marketing documentation for funds that launched before last November’s announcement won’t contain any specific disclosure and will therefore need to be updated for any subsequent closings. Goodwin can assist in reviewing documentation and suggesting updates.
- Valuations. Assets and interests in PropCos will be “rebased” for UK tax purposes to their market value at 5 April 2019. It will likely be advantageous in negotiations with HMRC following a disposal of UK real estate to be armed with a third party valuation. The Spring of 2019 will be a busy time for valuers, so it would be prudent to book a valuation now for the Spring.
- Developments. Another point arising from rebasing in Spring 2019 is that it will be advantageous to have maximised development gain before the new rules take effect. Where possible, works programmes should focus on maximising development gain before then so that the rebasing of assets in the Spring gives the maximum UK tax basis. Note that this will only be relevant for developments that are treated as investments for UK tax purposes – the new rules do not apply to trading assets and these will normally be taxable under existing rules.