Changes to the taxation of real estate held by non-residents

Introduction

As part of the Autumn Budget on 22 November 2017, the UK Government announced significant changes to the UK taxation of capital gains realised by non-residents from direct and certain indirect disposals of UK property to have effect from April 2019.

The Government has now published its response to the consultation on these changes, alongside draft legislation covering some, but not all, aspects of the changes.

These changes have the potential to impact significantly on the UK tax liability of non-residents holding real estate across the whole spectrum of structures through which UK property is currently held.

There now follows a technical consultation on the draft legislation and the Government’s further proposals.With less than 12 months to implementation, non-resident investors in UK property should be considering the potential impact of these changes for their existing and planned investments, and whether, in particular, it will be necessary to consider a restructuring of existing arrangements.

Direct disposals

As announced in November 2017, direct disposals by non-residents of investments in UK land, whether residential or non-residential, will be within the charge to UK tax with effect from April 2019. This extends the charge to tax on non-residents to non-residential property for the first time and means that diversely held entities which can currently claim exemption from non-resident capital gains tax on the disposal of residential property, will come into the charge to tax on gains from residential property.

As originally proposed, for assets already held as at April 2019, any gain will be calculated based on a rebasing to April 2019 market value, subject to an option to apply historic cost.

Non-resident capital gains tax will continue to apply to direct disposals of residential property, but ATED-related capital gains tax will be abolished from April 2019.

The proposed treatment of collective investment vehicles is more complex - see further under “Partnerships and other collective investment vehicles” below.

Indirect disposals

As originally proposed, with effect from April 2019, non-residents would be liable to UK tax on a disposal of an interest in an entity which directly or indirectly derives at least 75% of its value from UK land at the time of disposal. This was subject to the non-resident, with certain related persons, having held a 25% or greater interest in the entity at any time in the previous five years.

It remains the case that any gain will be calculated based on the value of the asset disposed of (eg the shareholding in a company owning UK land, not the land itself) and that the 75% test will be based on gross asset values.

However, several notable changes have been made to the original proposals in light of adverse feedback during the consultation process:

• The charge will only now apply if a 25% or more interest was held at any time in the previous two (rather than five) years - this, though, may still present issues where funds have been seeded with assets or a joint venture created over formerly wholly owned assets.
• In assessing whether the 25% threshold is breached, much more narrow categories of persons are treated as “connected”. In particular, there will be no aggregation of interests merely by reason of being partners in the same partnership and the Government has confirmed it will not apply the wide concept of “acting together” recently introduced elsewhere in the UK’s tax rules, although a targeted anti-avoidance rules (TAAR) will remain to capture avoidance.
• As for direct disposals, for assets held as at April 2019, non-residents will be able to elect to calculate their gain based on historic cost, rather than the rebasing to April 2019 market value. Where an asset stands at a loss as at April 2019, this should reduce the possibility of a taxable gain in excess of the non-resident’s economic gain. However, any loss from electing for historic cost will not be allowable.
• Rebasing to April 2019 market value will also be available to companies which become UK resident after April 2019.
• There will be an exemption for disposals of interests in entities which use UK land in a trade. This is intended to simplify the application of the new rules to investments in land rich businesses, such as supermarkets. There is no proposal to provide a specific exemption for infrastructure projects. However, this “trading exemption” may apply where the infrastructure is used as part of a trade.

As originally announced, the new rules will contain an anti-forestalling provision to prevent structuring on or after 22 November 2017 in order to benefit from one of the limited set of UK double tax treaties under which the UK is not entitled to impose tax on gains from indirect disposals of UK land.

The UK-Luxembourg double tax treaty is the most obvious example of such a treaty and the Government has confirmed that it is in discussions with Luxembourg to amend this treaty to preserve the UK’s taxing rights over indirect disposals of UK land. It is prudent to assume that structures in existence prior to 22 November 2017 may not, therefore, be grandfathered.

Again, the proposed treatment of collective investment vehicles is more complex - see further under “Partnerships and other collective investment vehicles” below.

Exemptions

Non-residents which are currently exempt from UK tax on gains otherwise than because they are nonresident will be exempt from tax on both direct and indirect disposals. This means that investors granted sovereign immunity from UK direct taxes should be exempt on such disposals, as well as non-UK pension schemes which meet the somewhat restrictive current definition of “overseas pension scheme”. However, the Government appears open to further representations with regard to extending exemption to wider categories of overseas pension schemes.

Partnerships and other collective investment vehicles

There appears to be no intention to change the existing transparent treatment of partnerships for chargeable gains purposes so that, for example, a disposal of a UK land directly held by a partnership will be a disposal by each partner of its proportionate share in the UK land. As the consultation response notes, the classification of non-UK entities owning UK property as transparent or opaque for relevant purposes will be increasingly important when analysing the impact of these rules.

Concerns were raised in the consultation process of the impact of the new rules on investments held in UK land held through collective investment vehicles which, unlike partnerships, are not transparent for chargeable gains purposes, or which hold interests via underlying entities.

In particular:

• Exempt investors, such as pension funds, which invest in UK land via entities treated as tax opaque for chargeable gains purposes (eg non-resident companies or Jersey property unit trusts) would incur the cost of UK tax on an asset level disposal by the entity, notwithstanding that they would be exempt on a direct disposal.
• The possibility of multiple tiers of taxation within fund structures.

The Government has been engaging with stakeholders in relation to issues raised by collective investment and is considering how to address these issues.

Their current proposals, which are subject to further consultation, are as follows:

• Entities such as Jersey property unit trusts qualifying as “transparent offshore funds” would be able to elect to be treated as transparent from the perspective of non-UK resident investors. This would, for example, allow exempt investors in such funds to avail themselves of exemption for disposals of UK land by a Jersey property unit trust in which they hold units. It seems odd that the consultation document suggests that this exemption will only be available in respect of non-resident investors. The position where a UK pension fund invests into a Jersey property unit trust would need to be clarified, as we would expect that no asset level tax would apply.
• Entities qualifying as “offshore funds” (whether transparent or opaque) and which are not closely held would be able to elect for special tax treatment under which gains realised by the fund or within its structure would not be taxable. Instead an investor would be taxed on disposal of their interest in the fund, based on the value of their interest, not the underlying UK land. This treatment would be subject to reporting obligations.

The concept of closeness would be based on similar requirements to the close company requirement applicable for UK real estate investment trusts. As such, these proposals could allow funds to qualify even where under the ownership of only a small number of institutional investors.

For underlying entities which are not wholly owned by the top-level fund, exemption would be proportionate to top-level exempt fund’s holding in the underlying entity and:

• the exemption for indirect disposals where an interest of 25% or more has not been held will not apply to interests in funds. Alongside this, the Government is considering whether it would be appropriate for funds to withhold tax on redemptions, potentially reducing the need for small retail investors to report and pay tax directly on their gains. The consultation response is not clear on which arrangements would constitute a fund falling within the scope of these proposals.

Since they were announced in November, these changes have increased the focus on the possible use of UK REITs to mitigate the UK tax costs of collective investment in UK real estate for non-residents. The proposals above provide an alternative possible route for mitigation and will need to be followed closely.

Administrative aspects

For non-resident companies, the charge will be to UK corporation tax, not capital gains tax. This means that non-resident companies letting UK land will, for the tax year ended April 2019, have to file an income tax return to report their property income and, in addition, a corporation tax return to report any chargeable gains from disposals of UK land. From April 2020, when non-resident companies will be brought into the charge to corporation tax on their property income, only corporation tax returns would be required.

A non-resident will need to report a gain to HMRC within 30 days and, with one exception, will need to make a payment on account of tax due at the same time. The sole exception to this is that non-residents already within self-assessment will not need to make payments on account for disposals made prior to April 2020.

The Government originally proposed that third-party advisers should have an obligation to report disposals within 60 days in circumstances where the non-resident had not itself reported. They have now confirmed that no such obligation will apply.

Other matters

Amongst the responses to the original consultation, it had been suggested that consideration be given to the creation of a UK onshore lightly regulated property fund structure, potentially combined with an SDLT seeding relief to encourage onshoring of UK property ownership. As these matters do not go to the core of the Government’s proposals, they will not be taken forward.