While Government’s key announcements in the Finance Bill and other recent changes aim to provide certainty for the real estate sector, uncertainty still remains.
Seven months after one of the most unexpected Budget announcements in recent memory, the widening of the territorial scope of UK tax on gains on real estate to include non-residents, draft legislation for Finance Bill 2018-19 was published on 6 July 2018.
The last year brought other fundamental tax changes that will affect the real estate industry, many of which are the subject of provisions to be included in Finance Bill 2018-2019. Many complex matters have been deferred and the Government has announced a technical consultation on the draft Finance Bill which runs until 31 August 2018.
It is clear that the Government has been listening to industry and advisers and has attempted to drive certainty, for example the rewrite of complex legislation on chargeable gains and simplification of the new capital gains rules to mitigate the impact on smaller investors. However, with new rules due to come into force on 6 April 2019, uncertainty remains, particularly with respect to how the rules will apply to property funds and exempt investors.
Taxing gains by non-residents on UK immoveable property
The proposals were designed to “level the playing field between UK and non-UK investors” by bringing gains on disposals of all UK property by non-UK residents within the scope of UK tax from 6 April 2019.
The charge to tax extends to ‘indirect disposals’ of UK property (eg on shares in ‘property rich’ entities) where the following conditions are met:
1 “Property rich” test: at least 75% of the gross asset value of the entity being disposed of derives its value from UK land (termed a ‘property rich’ entity)
2 “Ownership” test: the person disposing of the interest in the property rich entity owns at least a 25% share, or has done in the period of two years leading up to the disposal
These proposals were the subject of a consultation, a summary of responses to which has been published alongside the draft legislation. Although the key measures remain as announced in November 2017, a number of the suggestions we made in our response have been adopted, including:
- an option to elect to use historic cost for indirect disposals, rather than rebasing to market value at April 2019, albeit losses arising from the use of historic cost will not be allowable
- a change to the ownership test, allowing a holding of 25% or more during the two-year period leading up to the disposal to be disregarded if it is for an ‘insignificant’ time – a potentially useful change for seed investors. The term “insignificant” is defined as whether “having regard to all the circumstances… it is reasonable to regard the value of the interest as insignificant.” This definition is imprecise and leaves the matter open to interpretation. We would expect to see some guidance
- simplification of the capital gains tax (CGT) regime by abolishing annual tax on enveloped dwellings (ATED)-related CGT, which charges CGT on gains arising on UK residential property within the charge to the ATED
- simplification of the ‘acting together rules’ for the benefit of smaller investors, meaning that for the purposes of the “ownership” test, interests will only be aggregated where companies are connected or for individuals where they are otherwise connected (eg spouses). There is also good news for investors in partnerships, who won’t be treated as connected with other partners
- existing reliefs, such as the substantial shareholding exemption (SSE) and the no-gain/no loss rules will apply to non-resident companies
- introduction of a ‘trading exemption’ – land used for trading purposes will be excluded in determining whether an entity is ‘property rich’. This is good news for land-rich traders, such as retailers, hotels, utility companies and infrastructure entities, who it was feared would have fallen within the scope of the original rules
- the original five-year look-back ownership test has been shortened to two years, to simplify the position for smaller investors. It should also reduce the administrative burden for funds, as they will only need to maintain records of investors’ holdings for a rolling period of two years, rather than five
- no reporting requirement for third parties.
Some of the less welcome updates and confirmations include:
- the introduction of ‘matching rules’, primarily to ensure that intercompany receivables aren’t used to boost non-UK land assets and bring land-rich percentage below 75%
- in relation to the “ownership” test, there is no concession to look at effective control through chains of entities. So, where a fund has a holding company which fails the ownership test, the sale of the holding company should be outside the scope of the new charge. However, where that holding company invests in wholly-owned subsidiaries, a sale of the individual subsidiaries would be subject to the charge because the ownership test is met (as the seller will own “at least 25%” of the subsidiaries). Funds may face tax leakage if they sell individual PropCos. This could mean that sales of portfolios could suffer a lower tax charge than the sale of a separate property-owning subsidiary, potentially stagnating the market as properties are broken-off and sold to different investors to get the best return. HMRC’s response is that those with a less than 25% interest are unlikely to know the nature of the underlying investment, whereas those with at least a 25% interest would have an “economic bond”. In our view this response misses the mark as the investor is no less likely to know what is in the underlying subsidiaries than in the holding company they are directly investing in. This is a point we consider should be further addressed.
Taxing gains by non-residents on UK immoveable property - Collective investment vehicles
The Government recognised that collective investment vehicles present different challenges and had made industry groups aware legislation on the changes for them would be deferred. However, a short statement of the proposals has been announced, to include the following:
- an option for non-resident investors to elect for transparent funds (such as Jersey Property Unit Trusts, JPUTs) to be treated as transparent for CGT purposes (they will default to opaque as under the current rules). This is expected to benefit investors qualifying for an exemption from UK tax
- a potential exemption for offshore funds, provided they are not ‘close’ and abide by certain reporting requirements. The definition of ‘close’ for these purposes is still to be confirmed, but would likely follow a similar test as used for UK real estate investment trusts (REITs).
One worrying suggestion on collective investment vehicles is a proposal to remove the 25% threshold, such that all investors in property funds would be charged to tax on an indirect disposal, regardless of the size of their holding. While this would simplify fund administration, meaning they would no longer need to maintain rolling records of investors and their holdings for at least two years, it would drag many more investors in real estate funds into the charge to tax. It would be unfair to treat investors in real estate funds differently from shareholders in property-owning companies, which would benefit from the 25% threshold.
These measures are subject to further consultation and there is still a significant element of uncertainty, despite being only eight months away from the new rules coming into force.
Taxing gains by non-residents on UK immoveable property – UK-Luxembourg tax Treaty
The UK and Luxembourg have now ratified the Multi-Lateral Instrument (MLI), introducing a number of Base Erosion and Profit Shifting (BEPS) recommendations into their double-tax treaty agreements.
The MLI includes a “property-rich” clause, meaning that gains on the sale of shares in a company deriving more than 50% of their value from real estate will be taxed in the country where the real estate is located. Whilst the UK has ratified the MLI to include this clause, Luxembourg has opted out. So indirect disposals of shares in Luxembourg companies could in certain circumstances be covered by the treaty so that the UK does not have taxing rights.
The Government confirms that it is “in discussion with Luxembourg” and will pursue inclusion of the land-rich clause. In the meantime, an anti-forestalling rule introduced in the Autumn Statement will operate to tackle treaty abuse.
Capital gains tax legislative rewrite
The Government has re-written existing CGT legislation and “consolidated” changes made since 1992, when the main CGT Act received Royal Assent.
The Government states that the re-write is purely a ‘restatement’ and will not change the operation of existing provisions. While we have not confirmed this to be the case, on first reading the final result appears to be a welcome simplification of the law.
Non-resident landlords – move from income tax to corporation tax
Non-resident landlord (NRL) companies will move from income tax to corporation tax from 6 April 2020. While NRLs will welcome the reduction in the rate of tax from 20% to 17% by April 2020, the corporation tax regime contains complex provisions, particularly with regard to interest deductibility, which NRLs will need to get to grips with quickly.
The timing will be frustrating for many corporate NRLs, which submit tax returns on the basis of their results to 31 March. They will have a five day period to report under income tax rules before the corporation tax rules kick in. There should be the option of an election to bring forward the start-date of corporation tax to 1 April 2020.
Reduction in deadlines for reporting and payment of tax
SDLT: The deadline for filing stamp duty land tax (SDLT) returns and paying SDLT is reduced from 30 to 14 days from the effective date of the transaction.
CGT: The reporting window for CGT disposals for non-residents or for non-corporate UK residents disposing of residential property not qualifying for principal private residence relief will be reduced to 30 days, with a payment on account of the CGT due within the 30 day reporting window.
Corporate Interest Restriction
A helpful practical point was the extension of the period for appointing a reporting company for a group from six to 12 months. A Group can now appoint a reporting company shortly before filing its Corporate Interest Return.
Capital allowances – OTS review and simplification
The Office of Tax Simplification (OTS) review of capital allowances was announced in June 2018, concluding that capital allowances should remain as the primary method for obtaining tax relief on capital expenditure, rather than a move to a depreciation-based tax system.
Further amendments are expected, including proposals to simplify capital allowances, widening its scope to include expenditure on all business assets without the need for any kind of segregation exercise.
The technical consultation on the draft legislation runs until 31 August 2018 and we can expect further draft legislation in the autumn. The Government is currently renegotiating the UK-Luxembourg double tax treaty as outlined above.
In the medium-term, we expect property funds to be considering their structures and portfolios and to be setting up measures to monitor shareholdings. We may see a consolidation of structures, whereby OpCo PropCo models are combined to take advantage of the new trading exemption or possibly the substantial shareholding exemption (SSE), rather than separating out the property assets from the trading company.
In the longer-term, we can expect these rules to be tweaked as they bed in and as various issues come to light. Finally, we wonder whether the Government may in future introduce a SDLT charge on the acquisition of property rich entities. Currently, such acquisitions are charged to stamp duty at 0.5% but SDLT charges could rise to 15% for residential properties. While this has not yet been publicly considered, the CGT legislation is now written in a way that could easily be adapted to cover this possibility.