The Chancellor of the Exchequer announced in his Autumn Budget on November 22, 2017 proposals to amend the rules governing the taxation of nonresident investors in U.K. property and impose tax in relation to U.K. commercial real estate.
In a nutshell, the proposals abolish the current exemptions and bring in capital gains tax for individuals or corporation tax on capital gains for companies ("CGT") for non-U.K. residents from April 2019 on:
- gains on disposals of directly held interests in any type of U.K. land (direct disposals); and
- gains made on the disposal of significant interests in entities that directly or indirectly own interest in U.K. land. For tax to be imposed, the entity being disposed of must be “property rich,” and the non-U.K. resident must have a “substantial indirect interest” (indirect disposals—see below).
The government’s intention is to level the playing field between offshore and domestic investors and align the U.K. with most other jurisdictions which have long taxed foreigners on their real estate gains.
The definition of an interest in U.K. land for these purposes follows existing definitions under the U.K. tax code and is designed to capture all profits relating to U.K. land and buildings. An “interest in U.K. land” includes:
- an estate, interest, right or power in or over land or buildings in the U.K.; or
- the benefit of an obligation, restriction or condition affecting the value of an estate, interest, right or power in or over land or buildings in the U.K.
The base cost for calculating the tax on indirect disposals of any shares in, for example, a Jersey company will be updated to April 5, 2019, and for commercial property the base cost of the Jersey company in the property will also be updated to April 5, 2019. This is to bring an element of fairness to the system so that pre-existing gains will not be taxed. The rate of tax is 20 percent for individuals and 19 percent for companies paying corporation tax on chargeable gains (though this will reduce to 17 percent from April 2020).
Property Rich and Substantial Indirect Interest
An entity is property rich if at least 75 percent of the gross market value of its qualifying assets at the time of disposal is derived from U.K. land. This will often lead to the need for valuations for all qualifying assets and not just real estate assets.
One aspect of the new regime which investors in U.K. real estate will need to consider is that a non-U.K. resident has a “substantial indirect interest” in a property rich entity, if at the date of disposal or at any time within two years prior to disposal, the non-U.K. resident holds, or has held directly or indirectly, at least a 25 percent interest in a property rich entity.
If the non-U.K. resident holds the 25 percent interest for an insignificant time period, the 25 percent test will not be met. This provision protects investors with a small interest who might not appreciate that the entity is “property rich.”
The legislation does not provide such a gateway test for the disposal of interests in collective investment vehicles ("CIVs") so even a small investment in a CIV would be caught under the new rules.
This puts a spotlight on whether the investments of the CIV meet the threshold to be considered “property rich” for the purpose of the new regime, as well as how this may fluctuate over time, so managers will need to keep a watching brief on this for their investors and there will be those who suddenly need to know the position over the past two years. This is the case even if the fund does not make an exemption election (see below).
There are also various circumstances in which investors are deemed to have disposed of their fund interest, crystallizing any gains at that point. This will apply in particular where a fund ceases to be property rich. The tax on this deemed disposal will not be payable until the investors actually receive their share of proceeds (provided this is within three years).
It may well be that fund documentation needs to be reviewed especially around carried interest wording to ensure that the fewest possible disposals are triggered.
Until the Finance Bill 2019 was published in November 2018 it was unclear whether special rules would apply for nonresident investors in CIVs.
Under the new legislation, the general rule for CIVs is that they will be treated as companies for these purposes and so any disposals they may make will be within the new extended U.K. tax net (subject to any other exemptions they may have).
This caused concern for the funds industry as such offshore structures are commonly used to enable tax exempt investors such as U.K. pension funds and charities to invest in U.K. real estate alongside taxable investors without paying more tax than they would do if they held assets directly.
The new regime, without any special treatment for these structures, would have meant that exempt investors in such structures could face new tax charges, when previously the vehicles they were using, while offshore, gave their investors no tax advantages. Furthermore, structures with multiple layers of holding vehicles could result in a single commercial gain being taxed at multiple stages throughout the structure as the proceeds were passed through to investors.
However, it isn’t all doom and gloom, as the new funds regime now addresses both of these concerns through the use of two possible elections. The first provides property unit trusts with the option to be treated as transparent for CGT purposes, the “transparency election,” and the second offers a CGT exemption to funds which meet the required conditions, the “exemption election.”
One option for an offshore CIV, which is already transparent for income tax purposes and is U.K. property-rich or which has published scheme documents stating an intention to invest predominantly in land, is to make an irrevocable transparency election. This means the CIV opts to be treated as a partnership for the purposes of U.K. CGT. The effect of the election is that the disposals of U.K. property are taxed in the hands of the holders of interests in the CIV, rather than within the CIV itself.
This transparency election will ensure that unit trusts continue to be efficient for most exempt investors, and it is particularly good news for overseas investors holding land through CIVs such as offshore unit trusts.
The transparency election ensures that those investors should, at least, not be in a worse position compared to holding property directly or via a partnership as there will not be a potential charge at the unit trust level and at the level of the units (the price of which would have eventually been dented by any latent capital gains).
Despite the likelihood that the conditions for transparency will be met by the majority of CIVs, there are a number of potential pitfalls which fund managers should consider.
Firstly, a consequence of transparency is that the investors in such structures who are not exempt, regardless of whether the proceeds are distributed to them, will face tax charges on disposal by the unit trust. This could lead to dry tax charges for CIVs which reinvest their gains. Secondly, the transparency election can only be made with the consent of all investors. This could be problematic in practice for widely held funds.
Fund Exemption Election
The exemption election allows the CIV to elect to be exempt for CGT if certain conditions are met. The exemption applies to the fund vehicle itself and all its subsidiaries and unlike the transparency election, there will be no gain for the investors in the CIV on a disposal of the underlying assets, effectively shifting the tax charge on any gains from the fund to investor level.
Likewise, for gains realized by funds with multiple layers of holding vehicles, tax charges will not arise more than once. The investors would still be charged if they sell the interest in the CIV, though there may be planning opportunities here.
The fund exemption under the new regime also deals with a situation in which a vehicle within a fund structure leaves the fund. In most cases, such a fund’s real estate assets will be rebased for tax purposes not to April 5, 2019, but to the date of the sale to ensure that a purchaser will not assume a latent tax gain and will not need to a seek a discount in the purchase price.
If a CIV which has made an exemption election owns an interest in a joint venture company, the company itself can benefit from a partial exemption from tax. It is possible to draft for the CIV to keep all of the benefit rather than share it with a taxable joint venture partner as this benefit derives from the election.
This exemption is considerably more complex than the transparency election and the election for exemption is not available to all funds. It is only available to non-U.K. resident companies that are the equivalent of U.K. real estate investment trusts (“REITs”) and some partnerships. An extensive set of qualifying criteria needs to be met in order to be able to make the election for exemption. In particular, these include a requirement for diverse ownership of the CIV.
The regime for REITs has also been changed, so that REITs are now exempt from tax on indirect disposals of land as well as direct sales of real estate assets. This may be especially helpful for REITs which own historic unit trusts as these can now be disposed of tax free provided no transparency election has been made. The purpose of these provisions is to ensure that offshore funds claiming the new funds exemption are not in a better position than onshore REITs.
However, unfortunately REITs are included in the definition of CIV which means that all shareholders are potentially within the scope of U.K. tax on gains on sales of shares in the REIT if the REIT is U.K. property rich.
Reporting and Payments
With effect from April 6, 2019, disposals of U.K. land by non-U.K. resident persons must be reported within 30 days of completion, and payment on account of the CGT liability must be made by the same date. This also applies to disposals made by non-U.K. resident investors in CIVs.
CIVs will be required to make annual filings with HMRC providing details of the CIVs’ investors and disposals. For CIVs established prior to June 1, 2018 where the manager is otherwise providing such information to HMRC for legal, contractual or regulatory reasons relaxed information gathering will be applicable, though the new regime looked very bad when first announced.
The changes being introduced by the government are designed to “level the playing field” in terms of taxation of gains between nonresident and U.K.-based investors in U.K. real estate, and this places a burden on international investors to assess the implications of U.K. CGT for their investments in U.K. real estate.
Since the new election procedures were announced which allow real estate investment to be structured in a way that ensures such investment is tax neutral for exempt investors, the impact will now not be so severe.
Fund managers will need to get to grips with the new conditions for fund exemption and transparency to ensure current and future investors receive the best tax outcome and that the demands of investors are documented appropriately within the fund documentation. Keeping directors and trustees of offshore portfolio vehicles will also be important.
Those owning high value residential real estate should review their holding structures.
The regime represents a fundamental change to the way U.K. real estate is taxed. One constant is that appropriate advice should be taken at as early a stage as possible.
Simon Rose is a Partner and Annabelle Trotter is an Associate at Mayer Brown, U.K.