Making investments in UK real estate - a tax haven for non-UK residents?

This analysis concerns investment in UK real estate by non-UK residents. The investor is assumed to be a company. It must not be resident in the United Kingdom. It must not carry on a trade through a permanent establishment in the United Kingdom.

What do we mean by "non-UK resident"?

The investor must not be incorporated in the United Kingdom.

Even if non-UK incorporated, the investor will still be resident in the United Kingdom where it is centrally managed and controlled from the United Kingdom. Strategic business decisions must be made outside the United Kingdom. Such decisions are most likely to be made by the directors. The directors should be non-UK resident and board meetings should be held outside the United Kingdom.

Principal UK tax advantages for a non-UK resident

• No liability to UK corporation tax for a non-UK resident with no UK permanent establishment.
• Profits treated as capital for UK tax purposes are free of UK tax entirely.
• UK income tax on rental profits is payable at a rate of 20%.
• Generous tax allowable deductions are available to set against rental income, including:
  • capital allowances - the UK's statute-based
  • tax relief for depreciation of plant and machinery and other expenditure in respect of certain real estate;
  • tax relief for interest paid on loans used to acquire UK real estate; and
  • tax-allowable deductions on all revenue expenses incurred in running and maintaining the rental business.
• The United Kingdom has a particularly extensive double tax treaty network. Double taxation should be avoided by the investor provided that it is located in a major economy.
• Early contact with HM Revenue & Customs, the UK tax authority, should ensure that tenants (or UK agents through whom rents are paid) do not need to withhold and account to HM Revenue & Customs for tax when making rental payments to the investor.
• Normally, no business rates are payable by the investor in respect of tenanted real estate.

Each of these features is considered in more detail below.

Avoiding UK corporation tax

A non-UK resident company is chargeable to corporation tax only if it carries on a trade in the United Kingdom through a UK permanent establishment (broadly a fixed place of business). Pure investment in real estate (carrying on a property rental business) is not a trade. Real estate development might constitute a trade where the intention is to sell the development soon after practical completion. Here the profits are likely to be subject to UK corporation tax, as the development site itself would constitute a permanent establishment. On the other hand, where the intention is to hold the completed development for rent producing in the medium to long term (as well as capital appreciation), this is unlikely to be regarded as a trading activity.

Capital profits The investor is not subject to UK capital gains tax or UK corporation tax on the realisation of UK investment real estate. There is no withholding tax on the repatriation of capital profits.

Anti-avoidance tax rules apply where real estate is acquired or developed with the sole or main object of realising a gain from its disposal[1]. The effect of these rules is to re-characterise the amount of the gain as income, and so subject it to UK income tax. Where the object is to hold the real estate as a source of income and for medium to long term capital growth, these provisions will not be relevant.

The investor may receive what looks like a capital payment. A capital payment is outside the scope of UK tax. Such a payment may, however, be deemed to be income (at least in part) and so render it assessable to UK income tax.

For example:

• Where a lease of less than 50 years (a short lease) is granted in return for a premium, part of the premium is treated as rental income and taxed accordingly. The shorter the lease, the greater is the proportion of deemed income.
• Similar rules apply where the investor-landlord receives a lump sum for agreeing to vary the terms of an existing lease.
• Where a short lease imposes on the tenant an obligation, for example, to refurbish or make good dilapidations or to build on the premises, a premium is deemed to have been received by the landlord and a proportion is subject to income tax accordingly.

On disposal of UK real estate, there may be a liability to income tax where the investor has claimed capital allowances (see below for more details about capital allowances). Where, on a disposal, capital allowances are effectively clawed-back, a charge to income tax might arise by reference to the amount over-claimed. Care needs to be taken, therefore, in agreeing a proper apportionment of the sale proceeds to the items on which capital allowances have been claimed.

Payment of UK income tax on rents

A non-UK resident company is chargeable to income tax on income profits arising to it in any tax year from a source in the United Kingdom. Income from UK real estate clearly has a UK source. Income tax is therefore chargeable on taxable profits arising from a property rental business. The rate at which income tax is chargeable is the "basic" rate, currently 20%. The period of account is the UK fiscal year, beginning on 6 April and ending on the following 5 April. A self-assessment income tax return must be submitted, and any tax due paid, by 31 January following the end of the fiscal year.

Computation of rental profits

Profits arising from a property rental business are calculated (broadly) on commercial accounting principles.

• If more than one UK real estate interest is owned, then all interests are aggregated and constitute the same "property rental business" for the purposes of taxation.
• There are a number of deductions from gross rent which are allowable in order to calculate the taxable rental income. In particular:
  • Expenses of a revenue or income nature are deductible if they are incurred wholly and exclusively for the purposes of the UK property rental business.
  • Expenses of a capital nature are not deductible. These would include, for example, legal and other professional fees incurred in respect of the acquisition of the real estate. Such fees on first letting or sub-letting of real estate are similarly regarded as capital unless the lease is for a year or less. On the other hand, such fees on renewing a lease will be revenue if the lease is for less than 50 years (but any part of the legal or other professional fees relating to a capital sum or premium on the renewal is to be treated as a capital expense).
• Expenditure on repairs is an allowable deduction from rent but expenditure on improvements or alterations is regarded as capital (and therefore not deductible against rental income).
• Interest expenses incurred on a loan to acquire, or refinance an acquisition of, UK real estate are deductible even where the loan is raised outside the United Kingdom.
• Costs relating to swap, cap or other interest rate hedging contracts constitute allowable deductions (but profits arising from such contracts are taxable as property rental income).

Losses

Capital profits are not subject to UK tax. The corollary is that capital losses (for example, a disposal of UK real estate for less than its cost) do not qualify for relief.

The use of revenue losses is more flexible. The main method of giving relief for losses is to carry them forward and deduct them from future rental business profits[2].

A rental business revenue loss cannot be carried backwards, and so cannot be used to offset property rental profits in earlier periods and reclaim income tax previously paid.

A revenue loss cannot be set against other non-rental source UK income arising to the investor on a current year basis other than to the extent that the revenue loss is due to capital allowances.

Capital allowances

Generally, neither capital expenditure nor accounting depreciation for capital assets (e.g. real estate) are deductible from profits of a property rental business for tax purposes. The investor may, however, make claims to shelter its liability to UK income tax by claiming capital allowances. In effect, capital allowances provide for prescribed rates of tax-allowable depreciation for certain types of capital asset.

Plant and machinery allowances

The purchase price for UK real estate will include expenditure on plant and machinery. Most commonly these will form part of the real estate - they will comprise fixtures such as air-conditioning equipment, lifts and escalators.

The investor is entitled to claim, as a deduction from its rental income, a proportion of that part of the purchase price attributable to the plant and machinery in the real estate acquired. The rate of plant and machinery allowance is generally 20%, but 10% in respect of integral features, per annum on a reducing balance basis (it has been announced that this will reduce to 18% and 8% from April 2012).

Integral features comprise: electrical systems, cold water systems, space or water heating systems, powered systems of ventilation, air cooling or purification, lifts, escalators and moving walkways and external solar shading.

For example:

• where UK real estate is purchased for £7 million and £1 million is attributed to plant and machinery of which half is in respect of integral features, a deduction of £150,000 ((£500,000 × 20%) + (£500,000 × 10%)) can be claimed against rental income arising in the year in which the plant is purchased; and
• in year two, a further £125,000 can be claimed. With real estate rich in plant and machinery (in particular hotels and offices), capital allowances represent a particularly substantial and valuable tax shelter.

The Government is currently considering changes to the existing plant and machinery allowances regime to prevent tax leakage that it considers is being suffered by the Exchequer as a result of fixtures effectively being written-off more than once during that fixture's useful economic life.

It is expected that the Finance Act 2012 will contain provisions that will make the availability of capital allowances to a purchaser of fixtures conditional on:

• previous business expenditure on qualifying fixtures being pooled before a subsequent transfer on to another person[3]; and
• the value of fixtures being fixed formally (typically by way of an election) within two years of a transfer.

Business premises renovation allowance (BPRA)

BPRA provides 100% first-year capital allowances for the capital costs incurred by the investor in converting or renovating qualifying business premises, located in designated disadvantaged areas and that have been vacant for a year or more, in order to bring them back into business use.

Premises used for the purposes of a trade, profession or vocation (including an office used for such purpose) are qualifying business premises.

Annual investment allowances  (AIA) The AIA provides a 100% first-year capital allowance for qualifying expenditure up to £100,000 (£25,000 from April 2012).

Flat conversion allowances (FCAs)

FCAs provide a 100% first-year capital allowance for the capital cost of renovating or converting vacant, or under-used, space above shops and other commercial premises to provide flats for rent[4].

Enhanced capital allowances (ECAs)

ECAs provide a 100% capital allowance for qualifying expenditure on designated energy-saving plant and machinery and environmentally beneficial plant and machinery.

Enterprise zones (EZs)

In the 2011 Budget the Government announced that EZs will be introduced across 10 Local Enterprise Partnership areas of England. In addition, there will also be an EZ in London. In total, up to 21 new generation EZs will be established. EZs will have certain benefits, not all of which will relate to tax, which may make the area more attractive to occupiers - for example, a 100% business rate discount for five years for businesses that move to an EZ.

Tax relief for interest

Interest payable by the investor on a loan to purchase UK real estate (and the costs of other funding arrangements) can be deducted from property rental business income in calculating UK property rental business profits. This deduction is available:

• for both interest and other financing costs (for example, interest or currency hedging instruments); and
• on loans from third parties and (subject to what appears below) to loans and funding arrangements with associated entities.

UK "thin capitalisation" rules

As a general principle, interest paid by the investor on loans to acquire UK real estate can be deducted from UK-source rental income when calculating taxable profits in the United Kingdom.

It is obvious that, to minimise its liability to UK income tax, it would be beneficial for the investor to achieve as large an interest deduction as possible against its UK taxable profits. In particular, if the investor's parent (or a company in its group) finances the investor largely with debt (rather than equity) and then deducts substantial interest payments under this debt then it could substantially reduce (or even eliminate) the investor's liability to UK income tax.

There are, however, "thin capitalisation" anti-avoidance tax rules in the United Kingdom that apply to both UK and non-UK companies that are funded with excessive levels of debt by:

• related UK or non-UK entities; or
• a bank (or other unrelated third party) where an entity related to the borrower has provided a guarantee or other financial comfort to the bank.

Thin capitalisation means that, compared to what a third party would have lent to the investor without any such guarantee or financial comfort, the amount of the borrower's debt is excessive. In other words, the borrower has an excessive debt-to-equity ratio or is too highly geared.

A company that is too highly geared will only be able to deduct from its UK profits a proportion of the interest payable. There is no single test to determine whether or not a company is too highly geared and there are no "safe harbour" debt-to-equity ratios in the United Kingdom.

The UK tax rules require the application of an "arm's length" test - would the investor have been able to borrow the whole amount actually borrowed (and on the same terms including the interest rate) from an unrelated third party lender without any related party guarantee or other financial support?

If the investor could have borrowed the whole amount in these circumstances, then it is unlikely that the "thin capitalisation" rules will apply even though the loan has been made by a related party or with the support of a guarantee from a related party.

Withholding tax on payment of interest

Withholding tax (at 20%) may be deductible from payments of annual interest (i.e. interest on a loan intended to be outstanding for a year or more) made by the investor to a non-UK resident lender. This is also relevant to the investor in relation to any interest paid to non-resident companies in its group under intra-group funding arrangements or to a non-UK bank (where the loan has not been made from a UK branch).

A non-UK resident lender is liable to UK income tax on interest received where that interest has a UK source. Where the interest has a UK source, the borrower-investor is obliged to withhold tax from interest payments made and account to HM Revenue & Customs for the amount deducted. Whether the interest has a UK source is a question of fact [5]. HM Revenue & Customs regard the most important, although not sole, factor to be residence of the borrower and the location of the borrower's assets. It appears to be the practice of HM Revenue & Customs to regard a loan as not having a UK source where one non-UK resident lends to another non-UK resident even where UK real estate is given as security.

If withholding tax is payable (because the interest has a UK source), then the non-UK resident lender may be able to claim relief under the provisions of a relevant double tax treaty. That treaty may provide that no withholding tax is payable, or alternatively that the rate of tax payable in the United Kingdom may be reduced. Provided that an authorisation has been obtained from HM Revenue & Customs, it will be possible for the investor to pay the withholding tax at this lower (or nil) rate. Alternatively, the investor should borrow from a UK bank (or the UK branch of a non-UK bank) and so avoid the obligation to withhold entirely.

Deduction of tax at source from rental income

Under the United Kingdom's non-resident landlord scheme, the investor has the option of either:

• suffering income tax deducted at source from UK rents; or
• agreeing to UK income tax self-assessment.

If the investor does nothing, then the tenant (or UK letting agent) must deduct income tax (currently at 20%) from each payment of rent made and account for that tax to HM Revenue & Customs. A tenant will be anxious to comply with this obligation, as HM Revenue & Customs will require from it the amount of tax that it should have deducted - whether or not it has done so. Where the landlord has a UK letting agent to whom the tenant pays rent, the tenant is relieved of its tax collecting obligations - but the onus of deduction at source is shifted to the agent.

Opting for UK income tax self-assessment requires the consent of HM Revenue & Customs. This is a relatively straightforward procedure. Provided that the investor has no outstanding UK tax liabilities, it should be possible to obtain permission for the tenant to make gross payments of rent.

Applications for UK income tax self-assessment are made by the investor to HM Revenue & Customs. It would be prudent for the investor to make that application early, and certainly it should be made before UK real estate is actually purchased. This is because the tenant must deduct income tax from UK rents at source unless and until it is notified by HM Revenue & Customs that the investor is entitled to receive rent gross.

Value added tax (VAT)

VAT is a turnover tax. It is generally payable at the standard rate (currently at 20% in the United Kingdom).

VAT charged by suppliers to the investor will be recoverable (by tax credit or repayment of tax) in full by the investor (and so will be no more than a cash-flow cost) where:

• the investor is registered for UK VAT with HM Revenue & Customs; and
• the investor is making wholly taxable supplies (see further below).

Subject to certain exceptions, transactions relating to UK real estate (such as a sale, the grant of a lease or those on-going supplies made by a landlord under an existing lease in return for rent) are exempt from VAT. They are not "taxable supplies".

If an investor makes such VAT-exempt supplies to third parties (for example, to buyers and to tenants), then this would mean that none of the VAT incurred by the investor would be recovered. In these circumstances, VAT is a real and significant cost to the investor.

The VAT cost can, however, be avoided. In particular, the investor may exercise the option to tax in respect of supplies of real estate made by the investor. Broadly, this means that:

• the investor can make only taxable supplies. The investor must charge UK VAT on the supplies made by the investor (for example, to a buyer or a tenant); but
• the investor is then able fully to recover the VAT charged to it.

Provided tenants of the investor are fully able to recover the VAT charged to them by the investor, the costs to the tenants are merely cash-flow costs. Care should be taken, however, to ensure that the terms of leases already in place do not prevent the investor exercising an option to tax or result in the investor being penalised. In addition, the investor should consider carefully whether the exercising of an option to tax would render the investor's UK real estate significantly less attractive. In particular, if the investor charges VAT on rents to its tenants, then certain types of tenant (such as banks, insurance companies and other financial institutions) who cannot recover all the VAT charged to them by the investor would not find occupation attractive.

Transfers of existing property rental businesses as a going concern (for example, tenanted UK investment real estate) are usually free of VAT. In most situations, however, "transfer of a going concern" status for purchases will not be possible unless the buyer (investor) has itself exercised the option to tax the real estate.

Stamp duty land tax (SDLT)

SDLT was introduced on 1 December 2003 to replace UK stamp duty on all acquisitions of UK real estate.

The rate of SDLT is 4% [6] on all purchase consideration paid (whether in money or money's worth) including lease premia. On the grant of a lease, SDLT at a rate of 1% is due, in addition, in respect of the net present value of the aggregate rent due under the lease.

Whilst initially SDLT planning techniques emerged, recent Finance Acts have resulted in anti-avoidance provisions rendering ineffective many schemes and "off the shelf" products. However, there may still be opportunities to implement bespoke planning to mitigate the SDLT liability.

Business rates

Business rates (sometimes referred to as uniform business rates) are the way in which occupiers of non-domestic real estate contribute towards the costs of local authority services.

Business rates are calculated using the rateable value (determined by the Valuation Office Agency) of the real estate and the multiplier[7].

Normally business rates are borne by the tenants as proprietors and the landlord only incurs a charge (subject to limited reliefs) where real estate is unoccupied.