Summary: The proposal in Wednesday’s Budget for overseas investors to pay capital gains tax on disposals of all UK property and property rich entities heralds one of the biggest structural changes in the tax system for some time. A bold move in the context of Brexit and the potential negative impact on the UK’s ability to attract overseas investment.

The proposal in Wednesday’s Budget for overseas investors to pay capital gains tax on disposals of all UK property and property rich entities heralds one of the biggest structural changes in the tax system for some time. Although crafted as a consultation, the inference is that these rules are going to come into force and it is merely the details that are open to consultation. A bold move in the context of Brexit and the potential negative impact on the UK’s ability to attract overseas investment. The changes would mean that non-UK investors (e.g. overseas companies) would no longer have the benefit of different tax treatment on their disposal of UK commercial investment property or disposals of interests in entities which own UK property. It potentially affects nearly all UK property investment and fund structuring, and we think that a likely consequence is an increased utilisation of onshore property-owning structures.

The Budget announcements also included a number of other measures with particular significance for fund managers and investors: we have set out some overview points and our headline comments below.

Overseas investors to pay capital gains tax on disposals of all UK property and property rich entities

Non-residents will be chargeable on their gains from disposals of both UK property and direct or indirect interests in “property rich” entities. The latter rules regarding disposals of interests in property rich vehicles will be of particular interest to funds. In outline, a non-resident will make an indirect disposal of UK property if it disposes of an interest in a property-rich entity where 75% or more of that entity’s gross asset value derives from UK land and the disposing person holds or has, at any point in the last 5 years, held a 25% or greater interest in that entity. The tax charge is based on the gain on the interest being disposed of (i.e. the units or shares), rather than on changes in value in the underlying UK property. There will be detailed rules around how the 25% is calculated and interests of associates will be taken into account.

The other main features of the proposals are set out below.

  • The rules will apply to gains arising from April 2019 onwards (i.e. pre-April 2019 gains should not be subject to charge).
  • Gains will be calculated on the value of the interest disposed of (i.e. the value of the property on a direct disposal or shares/units on an indirect disposal).
  • Gains will be subject to tax at either the capital gains tax rate for individuals (currently 20% for non-residential or 28% for residential property) or the corporation tax rate for companies (currently 19%, falling to 17% in April 2020).
  • Certain jurisdictions may not be subject to certain aspects of the rules. This will need to be assessed on a country by country basis and will depend on the terms of the eventual legislation and the relevant double tax treaty.
  • There will be exemptions for entities which are exempt from UK capital gains (such as certain pension funds or sovereign wealth funds).
  • Anti-forestalling rules apply from 22 November 2017 (dealing with Tax Treaty abuse) and there will be a targeted anti-avoidance rule.
  • These changes will mean losses and reliefs (such as the substantial shareholding exemption for institutional investors) become relevant to and potentially important for non-resident investors.
  • Widely-held companies and institutional investors are outside the scope of the current non-resident capital gains on residential property. The current exemption, which only applies to residential property, will be withdrawn when the new non-residents regime is introduced. However, the Government indicated that the new regime might include targeted exemptions for institutional investors such as pension funds. This is likely to apply for both residential and commercial property.
  • The Government recognises the value of collective investment in property and has promised to carefully consider the impact of the proposed changes in a further consultation.

Practical points to highlight

We would highlight some initial thoughts as follows:

  • UK tax advantaged vehicles (e.g. REITS, PAIFs and EUUTs): the consultation indicates that these vehicles would at face value be within the indirect disposal rules for property rich entities, so a non-resident holding a 25% or greater interest would be subject to UK tax on a disposal of all or part of that interest.
  • For foreign funds, the consultation states that funds previously outside the scope of UK tax by reason of being non-resident will be brought into the charge to tax at fund level in respect of disposals of properties. HMRC sees this result as consistent with the aims of the legislation.
  • The likely effect of the new rules is that:
    • at fund level:
    1. there will be tax on disposals of properties for entities that are (e.g. companies), or are deemed to have (e.g. JPUTs and FCPs), personality for CGT purposes; and
    2. there will still be no tax for disposals of property by UK tax advantaged funds (e.g. REITS, PAIFs and EUUTs) or funds that do not have personality for CGT purposes (e.g. ACSs); and
    • at investor level, there will be tax on:
    1. disposals of UK property by a tax transparent entity (to the extent of the investor’s interest); and
    2. any disposal of an interest in a “property rich” entity by an investor that has held a 25% or greater interest in that entity in the last 5 years.

In the meantime, on a practical note, in the case of a UK-focussed fund currently being marketed, managers should update or supplement their PPMs/marketing materials now to alert prospective investors of this change and the impact that it could have on fund returns.

Corporation tax on rental income of non-resident companies from UK real estate

The Government has confirmed that non-resident companies will be subject to UK corporation tax (rather than income tax) on their income from UK property, but this change will be introduced later than expected in 2020. The upside in the delay is that the new BEPS corporate interest restriction (which restricts interest deductibility), the hybrid mismatch rules (similarly), and the rules that limit the ability of carried forward losses to shelter profits (to 50% of profits each year), will not apply until April 2020. However, non-resident landlords will have to wait until that date to benefit from the lower rate of tax. By April 2020 the rate of corporation tax should be 17%, in contrast to the current income tax rate of 20%. Overseas investors may need to look again at their financing arrangements to check they are not adversely affected from April 2020.

CGT – no more indexation

In an unexpected move, the Government announced it is freezing indexation allowance on corporate capital gains for disposals on and after 1 January 2018. The allowance for subsequent disposals will be frozen at the amount that would be due based on the Retail Price Index for December 2017.

Other announcements

We have set out in brief below three more minor announcements which could affect a particular fund or manager, depending on the facts.

  • There have been a number of detailed changes to the Venture Capital Schemes (i.e. the Enterprise Investment Scheme (EIS), Seed EIS and VCTs), including steps seeking to ensure investments are made in assets consistent with the wider purpose of these schemes (i.e. higher risk assets) and also to “encourage more investment in knowledge-intensive companies”. The Government will also consult in 2018 on the introduction of a new knowledge intensive EIS fund structure in which funds would have flexibility to deploy capital raised over a longer period.
  • In 2015, the Government introduced rules seeking to ensure that carried interest within the CGT regime was subject to (what the Government regarded as) the correct level of tax. There was grandfathering for payments attributable to disposals of fund assets occurring before 8 July 2015. This has now been withdrawn as the Government considers that all payments should have been made by now and they are concerned about the possibility of abusive use of the exception.
  • The Government will correct the relatively new rules restricting corporate interest relief and preventing hybrid mismatches to deal with minor errors. One correction announced ensures that two separate groups would not be consolidated for the purposes of the corporate interest restriction rules simply because they had the same asset manager.

You may also be interested in our briefing Autumn Budget 2017: Hidden Tax Blow to Real Estate Sector, which includes other real estate budget announcements that impact the real estate sector.