It has been clear for some time that, from April 2019, non-UK residents would become subject to UK tax on gains when disposing of investments in UK commercial property or substantial interests in UK “property rich” vehicles. Whilst draft legislation has been produced and consulted on, a missing piece of the jigsaw has, until now, been details of how non-residents who invest through “collective investment vehicles” such as offshore property units trusts and other collective investment schemes (CIVs) would be taxed.
CIVs are attractive as they can usually be structured to allow pooled investment in UK real estate in a stamp duty land tax efficient way, but without the CIV itself adding an additional layer of direct tax (compared to direct investments into property), and without prejudicing any tax exemptions of the investors. They therefore seek to replicate the direct tax treatment of direct property ownership. The concern has been that the new rules could unintentionally add layers of direct tax, with the CIV itself being taxed and not benefitting from tax exemptions that investors in the CIV may have. With the publication of the Finance Bill, and an additional Technical note from HMRC, we now have some much needed clarity on this issue. In the main it is good news, but with some caveats.
Under the new legislation, the default position for CIVs is that they will be treated as companies for these purposes and so within the new extended UK tax net (subject to any other exemptions they may have). So, for example, an offshore unit trust would be treated as a company and so disposals by the unit trust would be within the UK tax net. However the good news is that CIVs will be able to change that default position through one of two possible elections. The first is a “transparency” election, which allows CIVs that are already transparent for income purposes (such as offshore unit trusts) to opt to be treated as a partnership for the purposes of UK tax on capital gains. This would mean that disposals of UK property are not taxed within the CIV, but are taxed in the hands of the holders of interests in the CIV, subject to any exemptions that they may have. The second election is an “exemption” election. This allows the CIV to elect to be exempt from UK tax on gains if certain conditions are met – broadly that the CIV is offshore and sufficiently widely held and that various reporting conditions are met. Unlike the transparency election, there would be no gain for the investors in the CIV on a disposal by the CIV of the underlying property.
In practice these elections are likely to be 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 the property direct or via a partnership. The exemption election, where available, would improve the position further, but in practice this is only likely to be relevant for a smaller group of more widely held CIVs.
Regardless of whether an election is made, investors in a CIV will be subject to UK tax on gains when disposing of interests in the CIV. That is to be expected and is in line with the general approach of the proposals. But in this regard the new legislation adds some unwelcome, if not wholly unexpected, complexity. Offshore investors in property rich entities that are not CIVs will only within the scope of the extended UK tax net where they hold a substantial (25%) stake in the vehicle at relevant times. The logic for this gateway test is that investors with smaller stakes are unlikely to be aware that the vehicle they are investing in is “UK property rich”. But for disposals of interests in CIVs, the proposal is that there is no such gateway, so that a disposal of even a small stake in the CIV will be within the scope of UK tax on gains. The rationale for this is that investors should always know whether the vehicle they are investing in is predominantly invested into UK real estate and so there is no need for the 25% hurdle. This may though still pose practical difficulties, particularly where the investments of the CIV in UK land hover around the threshold for being “UK property rich”.
For offshore investors in UK REITs there is also a somewhat mixed picture. On the up side UK REITs will generally no longer be taxed on gains made on disposals of shares in property rich companies. On the downside REITS are included within the definition of CIVs, reflecting the fact that these are just another tax efficient vehicle for pooling investment in real estate. The elections described above should not be relevant to REITs, as REITs already benefit from exemptions from UK tax on property profits and gains. But for shareholders in REITs, treatment of the REIT as a CIV brings a clear disadvantage. It means that all shareholders in the REIT, however small their stake, are potentially within the scope of UK tax on gains on sales of shares in the REIT if the REIT is UK property rich. The difficulty is that this presupposes that it will be clear whether a REIT is UK property rich; for some it will be clear, but for those REITs with a more international investment portfolio, the position could fluctuate.
Overall, the picture is positive. Seeking to tax non-residents on capital gains made on direct and indirect disposals of UK land, simply brings the UK into step with most other jurisdictions. And the Government has listened to the concerns of the property industry, seeking to ensure that overseas investors are not left in a worse position (through the use of pooled investment vehicles) than resident investors. Allowing REITs to dispose of property rich companies tax free is also welcome, closing what had always seemed to be an odd gap in the REIT legislation. But the treatment of investors disposing of interests in CIVs, in particular REITs, looks to be an area where further consultation and guidance may be needed.