UK 2017 Budget: Tax in Islamic Real Estate Finance Transactions - transcript

Ashurst Talks - 10 January 2018

Speakers: Abradat Kamalpour and Simon Swann 

Hello everyone.  I'm Abradat Kamalpour, Partner here in the Ashurst London Finance team and Global Head of our Islamic Finance practice.

Hello everyone.  My name is Simon Swann.  I'm a partner in the Tax department here at Ashurst in London, and my practice principally is involved in the taxation of real estate.

So Simon, the budget.  Lots of discussions you and I have had with various clients.  Some matters for a temporary period, you know, were put on hold by clients and they reconsidered their position, and some have taken off, some haven't.  Could you please summarise for everyone some of the significant points and what has come out of that budget.

So in the budget then of 22 November 2017 there were two major announcements.  One was expected, one was not.  One was slightly good news, and one was most definitely was not.  So let's deal with the expected one first.  Non-resident investors currently pay income tax on their rental profits that they derive from holding UK real estate.  Income tax, not corporation tax.  And they pay income tax at the basic rate of 20 per cent.  They can also deduct all interest or returns under a sharia compliant arrangement without limit, whether that's related party, that interest, or whether it's third party arrangements, provided that those arrangements have been made on arm's length terms.

So if you do it on a sharia compliant basis, as long as the return component under sharia compliant financing is done on an arm's length basis, you can make the deduction?

Absolutely right.  And, of course, when you enter into a sharia compliant arrangement with a bank, it will by definition be on arm's length terms.

Now, that's the position at the moment, and we all knew that that was expected to change.  And the change is that non-resident investors will cease to be within the income tax regime and will be brought into the corporation tax regime from a certain date.  And bringing non-resident investors into the corporation tax regime, as Abradat, I think we went through this on the previous podcast, had some good news and some bad news.  The good news about being brought into the corporation tax regime rather than income tax is that the corporation tax rent is currently 19 per cent and is scheduled to go down to 17 per cent by 2020, whereas income tax rate, as we've said, is 20 per cent.  The bad news about being brought into the regime for corporation tax is that non-residents would become subject to restrictions on the deductibility of interest, and also restrictions on the way that losses can be used going forward.

Well, that's not good news.

That's not good news.  And those rules are already in place for UK corporates.

Right.

And so the question that we were all expecting to be answered in the budget was from what date would these changes happen?  Now, when I came into work on the morning of November 22, I would've said to you that I would've thought those changes would happen in April 2018.

Well, that was the … yes, that was always the original guess.

That was always the guess.  Being optimistic, I might've said April 2019.

Okay.

Surprisingly, in the budget, the announced date for those changes to take place is April 2020.

Okay.

So we have a period of grace.

We have a window now.

We have a window.

Yeah.

So if there was any good news in the budget, and there wasn't much of it, that was it.

Yeah.

So let's move on now to the unexpected and not so good announcement, and that concerns the taxation of gains made by non-residents on disposals of UK real estate.  Currently, gains made on disposals of commercial real estate by non-resident investors are not subject to UK tax, and that feature has been one of the prime tax reasons why UK commercial real estate has been perceived to be so attractive for non-resident investors.  The budget announced that that will change from April 2019.  The budget saw the publication by HM Revenue and Customs and HM Treasury of a consultation document where the proposed changes are set out.  And so, as we said, from April 2019, gains made on the disposal of commercial real estate by non-residents will become subject to UK tax.  Now, the changes the proposed apply to direct disposals of real estate to asset sales and to indirect disposals.

Right, so both direct and indirect?  Okay.

Very far reaching, wide ranging …

This is quite significant, isn't it? 

This is very significant.

It's very significant.

So let's now look at each one in turn.  We'll focus first on direct disposals and then we'll look at indirect disposals.  So direct disposals, what do we mean?  Well, we mean, for instance, a non-resident company who is holding UK real estate and sells it after April 2019.  Now, the proposal is that gains made on direct disposals after April 2019 will become subject to UK tax, but only the gain that accrues from April 2019.  

So not before?

Not before.  How do they achieve that?  Well, what they propose is that there will be a rebasing of the asset to market value as at April 2019.

I see.

And it's only the gain that accrues after that that will become subject to tax.  Now it may well be that, depending on where you are in the property cycle, that the rebasing as at April 2019 is actually not helpful.  The value might've dropped.  So what they have said is that in that case, a tax payer will be able to use historic base cost if that is more favourable for it.

Okay.

So that's direct disposals.  Now what about indirect disposals?  Because that is more complicated.  And the idea here is to tax gains made on sales of companies or units in unit trusts that invest in UK real estate.

Which is more … it is very relevant for Islamic finance transactions, isn't it really?  Most Middle Eastern investors invest that way.

Absolutely.  And here, there is a two-part test.  First, what you are disposing of directly or indirectly has to be an interest in a property-rich entity.

Property-rich, right?

Property-rich.  So what do we mean by property-rich entity?  That means that broadly, at the time of disposal, 75 per cent or more of the entity's value is derived from UK land.

Okay.  Interesting.

Okay?  Seventy-five per cent.  That could actually, I think, have been less generous.  Seventy-five per cent is not a bad place to start off with.  Let's hope that that number does not go down.  And when we talk about 75 per cent of the value, what we mean is a gross asset test.  So that is what you are disposing of, and you could be disposing of that indirectly or directly.  So that if, for instance, you sell shares in a holding company, and the holding company owns a property-owning company, then you would still be caught.

It traces it all the way up?

Absolutely.  

Okay.  

It traces it all the way up.

 Which makes sense.

The second test is that the person making the disposal must at the time of the disposal hold 25 per cent of the property-rich entity.

That's interesting.

Again, directly or indirectly.  There's a nasty little rule though about this 25 per cent test.  At the time of disposal you must hold 25 per cent, or if you have held at least 25 per cent within the last five years …

Five years?  Wow.  

… five years prior to the disposal, you are still caught.  And so what I think they're getting at there is to prevent people from doing fragmented sell downs prior to April 20 … and just dipping below 25, though it has unfortunate and quite harsh consequences, for instance, on seed investors, you know, who have put assets into a fund and then sold their interest down.  They will always have held more than 25 within the last five years, and they're caught.  Now it may well be that there is some relaxation of that test because … and we're going to repeat this, and I'm not going to apologise for repeating this.  At the moment, all these measures are are proposals in a consultation document.  They may change.

Well, thank goodness for that.

However, the direction of travel, I think, is quite clear.  Notwithstanding all of the consultations that is going on and all of the lobbying that is going on, these rules are going to be introduced …

In one form or another, right?  We just don’t … you know, hopefully they will consider, for example, the seed asset investor in a bit more detail and come up with some sort of exemption for that, because that's really … in my mind, that will catch nearly every initial investor in a fund.

Absolutely.  So that then is the indirect disposal. Broadly, those are the proposals. 

Yep.

Now shall we have a look at some of the consequences of these proposals?  First, let's talk about latent gains.  Suppose an investor holds the entire issued share capital of a company, a non-resident company, that owns UK real estate.  As at April 2019, the real estate held by that company is rebased to £120 million, for the sake of argument.  I've plucked these numbers out the air.  Well, leaving aside gearing for a moment, that must mean that the shares in the company are also worth £120 million.  Now let's suppose that one year later, in April 2020 for instance, that the asset has risen in value to £160 million.  I know that's a very drastic increase but let's keep the numbers simple.  So it's risen from 120 to 160.  So, by the same token, the shares … the value of the shares must have risen …

Gone up as well, yeah.

… from 120 to 160.  Now suppose that the shareholder wants to sell all of the shares.  He knows that he is going to be subject to UK tax on the difference between 160 and 120, a gain of 40, and he will pay tax on that.  But there's a problem here because, if you think about it, a purchaser of those shares is going to say, "Well, hang on a minute.  These shares are not actually worth £160 million".  Because if the company, if the target company, was to sell its assets for 160 million, it would have a tax liability of 40 in it, the difference between 160 and 120.  And so therefore there is a pregnant or deferred liability in this company of tax on 40.  So at the rate of 17 per cent, that's 17 per cent of 40 million.  So actually the company itself is not worth 160 million, it's worth 160 million less 17 per cent of 40.

And so there's going to be … so in effect then one is looking at a tax effect at two levels there, and that's quite common, I think, in European jurisdictions.  But because of the nature of the UK tax system to date, that kind of issue has never been a problem for non-resident companies and sales of shares in those companies, but it will become an issue after April 2019.  There has to be some form of commercial price negotiation there.  So that's the latent gain issue.  Consequences?  Well, particularly for offshore funds.  For existing offshore funds, those funds would've been set up on the basis that the fund, being a non-resident fund, could make disposals of UK real estate, commercial real estate, tax free and reinvest the proceeds.

Yes.

That assumption, that key assumption, on which these funds were established no longer holds true after April 2019.  What else will we see in the run up to April 2019?  Well, I suppose there will be a pressure to obtain optimistic, let's say, valuations of assets as at that date, though that's really of limited use because the best you can do, I suppose, is an optimistic valuation rather than anything more than that.  I further think that if you were looking, say, in 2018 at the possibility of re-gearing any occupational leases in the building that you own, then all of those things, anything that you might do which would be value accretive, you want to get done before April 2019 … 

Without a doubt.

… so the effect of those acts is felt in the rebasing.  In some ways I guess though one is at the mercy of the property cycle in relation to any particular asset, in relation to where we are come April 2019.  What effects will this have on offshore funds?  Well, perhaps some of them will consider coming onshore and converting to REIT status.

Yeah, we discussed that, didn't we, with a couple of clients.

We've discussed that a lot.  So a real estate investment trust does not pay tax in income as regards rental profits, nor does it pay tax on gains, on disposals of real estate assets.  The quid pro quo for an exemption from tax on rental profits is that those rental profits have to be distributed out to shareholders and are treated as rent in the hands of shareholders.  If you have, for instance, in an offshore fund, exempt investors, pensions funds, entities that benefit from sovereign immunity, who invest alongside tax paying investors, then one thing that may happen is that those exempt investors no longer wish to invest in that type of fund because, if they invested directly in the asset, then they would enjoy tax privileges.

That's going to be a bit of a game changer, I think.

That will be a game changer.  Now it may well be that in the course of the consultation, the government accepts some form of pro rata rule.  Let's say, for instance, that you have a unit trust …

Sixty per cent  owned by …

By exempts, 40 per cent owned by tax payers.  If the unit trust sold an asset, then only 40 per cent of the gain should be taxable.

Yeah, I see.

Perhaps.  Perhaps that's where we might go.  And I think we should end here by stressing again that the consultation is ongoing and will be ongoing for at least a month, and then there will be replies to the consultation and the process will carry on.  Ashurst are both liaising with HMRC and HM Treasury directly, and also through representative bodies such as the British Property Federation.

We're right at the cutting edge of that and we're on top of what's going with the market, we're on top of that.

So I think, having set the scene, it would be useful for us to return and give an update to our listeners later on in the spring 2018, when the government's responses to what is said to them as part of the consultation is known.

Absolutely, absolutely.  Well, Simon, thank you very much.  It's a very helpful summary.  No doubt there's going to be much more questions coming back and forth to us from clients.  It would be interesting to see what market observers say about the April 2019 date, whether there's going to be any shifts in assets up to that date by …

Absolutely.

It would be interesting to see how that goes.  Perhaps we can discuss that at the next update as well.  But thank you, Simon.  I'm Abradat Kamalpour, Global Head of Islamic Finance, and a partner in the Finance team at Ashurst.

And I'm Simon Swann, Tax Partner in the London office at Ashurst.

Thank you very much.

Thank you.