Recent UK Real Estate Tax Changes

Historic position

By way of recap, until very recently, non-UK resident investors buying UK commercial property for a medium to long term hold faced a fairly benign UK tax regime.  First, the use of leverage, both from third party and shareholder or other connected lenders often enabled non-UK resident investors to ensure a relatively low level of UK tax on rental income.  Second, there was generally no UK capital gains tax chargeable on any increase in value of the property over the period for which it was held.  Both of those points are changing as set out in further detail below.  Third, the use of single asset special purpose companies ("PropCos") or Jersey property unit trusts ("JPUTs") allowed for transfer duty efficiency, i.e. stamp duty land tax ("SDLT") efficiency.   

The main sets of changes

There are three major changes in the offing.  One of these changes (the so-called structures and buildings allowance) is good news for taxpayers in that it reduces their tax bill by increasing the amount upon which tax deductions can be claimed.  The other 2 changes are, in many cases, much less positive for taxpayers.  The first is the introduction of the corporate interest restriction.  The second is the introduction of capital gains tax on all commercial and UK real estate even where the owner is non-UK resident.

This article looks at those changes in the context of investment into UK commercial real estate only.  There are other issues for residential property and/or developers that are not covered below.

Tax on net rental income – impact of corporate interest restriction

As noted above, many investors have utilised interest on both bank debt and shareholder debt to reduce their UK taxable income.  There were some limitations, most pertinently under the so-called transfer pricing rules.  Those rules capped the amount of tax deductible interest to the amount that would have been payable to unconnected third party lenders.  In times of plentiful liquidity, particularly where mezzanine investors were lending at high LTVs, those rules did not prevent material amounts of allowable UK tax deductions, even on interest on shareholder debt.  Investors which utilised such planning needed to consider their home jurisdiction tax treatment of the interest receivables but in many cases the careful utilisation of shareholder debt increased post-tax internal rates of return ("IRR").

That is now changing.  In large part due to the Organisation for Economic Co-operation and Development ("OECD")'s recommendations about certain aspects of multi-national tax planning, known as their base erosion and profit shifting (aka BEPS) initiative.  The OECD BEPS recommendations have a number of aspects but the one most relevant here is that they recommend that countries introduce much more restrictive rules around interest deductibility.  The corporate interest restriction ("CIR") rules form part of that change (and are sometimes therefore known as BEPS Action 4).  In this context those rules essentially cap the amount of tax relief for interest that is available.  

The detail of how those rules work is well beyond the scope of this article but, in practice, many PropCos or JPUT investors will find that, as from April 2020, their interest costs will be capped at the highest of the following:

• £2 million (reduced if the PropCo/JPUT investor is part of a "group" as defined for IFRS purposes);
• 30 per cent of the PropCo/JPUT investor's EBITDA; or
• the genuine third party interest costs (i.e. no deductions for shareholder interest).

The result of all that is that in a wide range of cases, as from April 2020, PropCos or investors in JPUTs will be allowed tax deductions for the third party interest costs but not for shareholder interest costs (unless they can avail themselves of the £2 million rule). The modelling we have seen shows that change having a material impact on post-tax IRRs.¹

Other tax attributes and Structures and Buildings Allowance ("SBA")

The potential impact of the CIR rules has meant that many investors have been looking much harder at the availability of other tax attributes. For example, we are seeing much more interest in the availability of either: (i) brought forward tax losses; or (ii) what the UK calls "capital allowances" (which are the tax equivalent of depreciation).

For many years, capital allowances have been available on items such as elevators, fire alarms, heating and cooling systems, sprinklers and the like, known in the tax legislation as "plant and machinery". Whilst that initially seems pretty restrictive, in many buildings we find that anywhere between 5 and 65 per cent of the build cost on a new building could be made to fall within this head. However, for the remaining build cost, there was no tax deduction available.

That has changed with effect for new construction expenditure incurred pursuant to construction contracts entered into on or after 29 October 2018 on commercial buildings. There is going to be a straight line 2 per cent per annum tax deduction to be made available. That is good news, but in a sense it is only a timing benefit. That is because the amount of SBAs claimed will reduce the base cost of the building for CGT purposes and will effectively therefore be recaptured on a sale. Nevertheless, that timing benefit could have a marked impact on IRRs, particularly where there is a long hold period.

Non-resident Capital Gains Tax ("NRCGT")

From 6 April 2019:-

• where a PropCo or JPUT itself sells land, there will be UK tax charged on any increase in the value of the land accruing after April 2019; and
• where any entity sells shares or units in 'property rich' vehicles, there will be UK tax charged on any increase in value of the shares/units accruing after April 2019. PropCos and JPUTs will very commonly be "property rich" for these purposes. ²

The main possible reliefs are that:

1. certain tax treaties (most notably the UK/Luxembourg treaty) may not allow the UK to levy tax on a sale of shares in a PropCo by its Luxembourg-resident holding company. The UK Government is seeking to amend the Luxembourg treaty as a matter of urgency;
2. any gain which accrued prior to April 2019 will not be subject to NRCGT. One can either obtain a valuation as at April 2019 or, in some cases, an alternative statutory rebasing may be preferable;
3. importantly, but perhaps somewhat oddly, the charge at (ii) above does not bite where the seller is itself owned as to at least 80% by certain types of "qualifying institutional investors". The question of what that term covers in an international context is assuming increased significance and is something we are seeking further clarity on from HMRC; and
4. there is an exemption for disposals of interests in "property rich" entities that themselves use the land for a trade carried on by them or their group both before and after the disposal. That exemption will be more useful for many property-intensive businesses (e.g. retail or hotel operators) but not for pure property investors.

Issues

The NRCGT rules could cause multiple levels of tax and can cause issues for funds, where some investors are exempt due to their status (e.g. as a sovereign wealth fund or certain pension schemes) and some are not tax exempt. Accordingly, the Government has introduced two elections that can be made by certain types of fund vehicles. The elections are called the "Transparency Election" and the "Exemption Election". Each has been introduced to deal with the specific issues faced by funds.

The Transparency Election

This is mainly relevant to JPUTs and the remainder of this section of this note focuses exclusively on JPUTs. Absent the Transparency Election, as set out above, the JPUT will itself become subject to tax on capital gains on disposals of UK land. The effect of the election, which is irrevocable and must be made with the unanimous consent of unitholders, is to treat the JPUT as a (tax-transparent) partnership so that each unitholder is deemed to own a fractional share of the underlying assets. Accordingly, a direct disposal by the JPUT of an interest in UK land is treated as a direct disposal by each of the unitholders. That will be useful for investors who have a complete exemption from UK tax; key examples being UK pension funds and certain sovereign wealth funds and similar state bodies which benefit from sovereign immunity from UK taxation.

The Exemption Election

This is a complicated elective regime designed primarily for multi-asset funds which meet certain conditions. The election is made by the fund manager and can be made at any time in the investment cycle of the fund (although it only applies to disposals made after the election). The election may also be revoked. Some key points:

• the basic idea behind the Exemption Election is to permit qualifying funds and their subsidiaries to make disposals (direct or indirect) on a tax free basis to enable the proceeds to be reinvested;
• gains are nevertheless still taxable on repatriation to end investors on the winding up of the fund or, if earlier, where the qualifying conditions for the election cease to apply;
• there are wide annual reporting requirements pursuant to which the fund manager is obliged to notify HM Revenue & Customs of the names and addresses of all investors in the fund, the values of any disposals of fund interests during the relevant year and certain other information; and
• disposals of interests in the fund vehicle at a gain remain chargeable to UK corporation tax on chargeable gains (however small either the investor's total interest in the fund vehicle or the interest disposed of).

Impacts of those changes

The overall impact of all the changes has yet to bed down but we can already see a number of trends:

1. the impact of these rules (and a number of analogous rules in other major EU jurisdictions) mean that pan-European real estate funds may become more popular than single jurisdiction real estate funds;
2. for many investors the loss of shareholder interest deductions will materially impact their expected return and they are naturally very disappointed by the introduction of the CIR rules. However some classes of investor (particularly taxpaying investors in countries with historically high rates of tax such as the US and Japan) were generally unable to efficiently utilise shareholder loans. From such investors' perspective, the fact that shareholder interest will rarely be deductible in full as from April 2020 could well level the playing field somewhat;
3. certain types of property will become more tax efficient. In particular, the SBAs discussed above only apply to works carried out pursuant to contracts entered into after 29 October 2018 which will make those new buildings more tax efficient investment opportunities. Similarly, the £2m de minimis rule under the CIR means that buildings under circa £60-70m may become a popular target for some investors - particularly in a club deal context where the IFRS grouping rules will not apply to dilute the benefit of the £2m de minimis across the group;
4. the issue of how to discount the price of a PropCo (or JPUT where there is no exemption election) to take account of any "pregnant" gain will assume increased importance in the UK market;
5. fundamentally, the use of single asset PropCos and JPUTs is likely to remain prevalent, at least in the short term, for a number of reasons;
6. historically, non-UK pension funds have not looked too hard at whether they ought to be allowed the same UK tax breaks as UK pension funds. That will change. Similarly a number of non-UK quasi-governmental funds or pension schemes may want to reconsider whether they can claim sovereign immunity from UK tax;
7. the position for a UK REIT is now close to that of an offshore fund that has made an exemption election. The good news for UK REITs is that their capital gains exemption has been extended. The bad news for REITs is that investors in their shares will now generally face a tax charge on the increase in value of those shares accruing after April 2019; and
8. the tax modelling we are producing has become more complex. There needs to be much greater focus on efficient utilisation of losses, interest and capital allowances given the various different caps and rules around their uses. 

Outlook and Future Changes

The pace of change has slowed more recently. A general election leading to a Corbyn-led Labour Government would undoubtedly bring more changes. But, absent that, we would expect to see a period of some consolidation (with tweaks as problems emerge) rather than further wholesale change over the next few years. That is, of course, assuming that the Government is not tempted to introduce a charge to SDLT on transfers of interests in "property rich" vehicles, now that they have a definition of that concept.

If want to drill down into any particular aspects of our thinking in this article, please contact the authors of this article or your usual Ashurst contact.

2. More particularly, vehicles will be "property rich" where both: (i) the shares or units directly or indirectly derive at least 75 per cent of their value from UK land; and (ii) the seller (or persons connected with him) holds at least 25 per cent of the interests in the vehicle whose shares or units are being sold. Where the vehicle also constitutes a "collective investment scheme", condition (ii) above is, in effect, deemed satisfied.