Investment into UK commercial property

Background

Investment into UK commercial real estate has typically been structured as an acquisition through either a non-UK resident company in a low tax jurisdiction, or a non-UK resident property unit trust. Such structures have usually delivered the expected tax returns, namely an income tax charge on net rental income and the ability to sell the vehicle or the asset itself free of UK capital gains tax.

Two key changes to the way in which such vehicles are to be taxed now lead us to question the optimal UK commercial property acquisition structure. These key changes are:

• The extension of UK tax on capital gains on direct and indirect disposals of commercial property by non-UK resident investors which will come into force in April 2019 and affect gains accruing after this time (subject to certain exemptions).
• Bringing non-resident landlords, who are subject to UK income tax (currently at the rate of 20 per cent), into the scope of UK corporation tax in relation to their income with effect from April 1, 2020 (currently at the rate of 19 per cent, but potentially falling to 17 per cent by 2020).

As a result of these changes, traditional property holding structures should be re-considered; the impact on the financial modelling of the different scenarios is key.

Non-resident capital gains tax – a summary

The UK will extend the scope of capital gains tax to direct and indirect disposals of UK commercial property by non-UK residents. This change will take effect from April 2019, and will apply to any gains which accrue and are realised on or after April 2019. Whether there is a direct or indirect disposal, the base cost of the property will be the market value of the property in April 2019 (April 1, 2019 for companies and April 6, 2019 for individuals and other non-corporates) or alternatively at the option of the taxpayer, the base cost on acquisition. Existing tax exempt entities, such as UK pension funds and their non-UK equivalents, will remain outside the scope of this tax.

The extended capital gains tax will not apply to shareholders on an indirect disposal who hold, and who have held in the last two years, less than 25 per cent of the interest in the property owning vehicle (provided such vehicle is not a collective investment vehicle). In addition, certain double tax treaties may allocate taxing rights on an indirect disposal to the non-UK jurisdiction (subject to anti-forestalling provisions). There are also certain investment vehicles that benefit from a UK exemption from capital gains tax, such as Real Estate Investment Trusts (REITs).

The non-resident capital gains tax charge will be applied differently to collective investment vehicles, which will have the option of making certain tax elections, with the objective that the tax is collected at the investor level.

The corporate interest restriction – a summary

As income tax payers, non-resident landlords are not currently subject to the UK’s corporate interest restriction rules. With effect from April 2020, this position will change. The basic position will be that if a non-resident landlord has interest for tax purposes in excess of £2 million it will only be able to deduct interest of up to 30 per cent of the company’s UK tax EBITDA. However, there are two possible elections that a real estate company could make and these should have the consequence that interest on third party debt remains deductible.

Possible holding structures, post April 2019

A number of factors are relevant when structuring an investment into UK commercial property. From a tax perspective, there may no longer be a material difference in tax outcome by choosing to hold UK commercial property through a non-UK entity as compared to a UK entity. Reliance on the UK’s double tax treaty network may in some circumstances mean that an indirect disposal is outside the scope of UK tax. In addition, we may see an increased reliance upon domestic exemptions from the tax, for example through the use of REITs. AREIT must be UK tax resident, listed and widely held (among other things); however it is sometimes possible for a REIT to satisfy these requirements within a ‘light’ regulatory regime and with shares held by five or more investors.

Key UK taxes payable on acquisition, during the ownership period and on sale

Taxes on acquisition

On an asset purchase, the key taxes are Stamp Duty Land Tax (SDLT) and Value Added Tax (VAT). SDLT is charged by reference to the VAT inclusive consideration paid for the transfer of the property. SDLT for commercial property is charged on a “slab” system, with the highest rate being 5 per cent. VAT may be payable on the transfer of the property, depending on whether the landlord has “opted to tax” the property (i.e. charges VAT on supplies of the land, including rents). In some circumstances, the transfer of the property will be outside the scope of VAT as a transfer of a business as a going concern. Capital allowances, a form of tax depreciation on certain plant and machinery, may be available and can be passed from the seller to a buyer at an agreed price.

Alternatively, property can be purchased through an acquisition of a vehicle which owns the land (such as shares in a company or units in a unit trust). Depending on the nature of the vehicle and its tax residence, the acquisition may be outside the scope of SDLT or stamp duty and should not be subject to VAT. However, such transactions often come with higher transaction costs, as further due diligence is required and possibly a Warranty and Indemnity insurance policy to cover historic liabilities.

Taxes throughout the ownership period

If the property is rented out, net rental income will be subject to UK tax: income tax (currently at the rate of 20 per cent) if held through a non-resident company or corporation tax (currently at the rate of 19 per cent) if held through a UK company.

Borrowers are generally entitled to tax relief on loan interest; however the corporate interest restriction (which already applies to UK companies and which will apply to non-UK resident companies with effect from April 2020) restricts the deduction on tax interest above £2 million to up to 30 per cent tax EBITDA. In some circumstances, an election can be made so that interest which is paid on a third party borrowing should be deductible.

Borrowers should take advice on whether UK withholding tax applies to payments of interest on loans, particularly shareholder loans or loans which are secured over UK land. The UK levies a 20 per cent withholding on payments of “UK source” interest, subject to certain domestic exemptions or a claim for double tax treaty relief.

Taxes on sale

A direct or indirect sale of commercial property which has been held as an investment by a non-UK resident is not currently subject to UK tax. With effect from April 2019, gains which accrue and are realised on a direct or indirect sale of UK commercial property by a non-UK resident will be subject to UK corporation tax, subject to certain exemptions.

The key exemptions/reliefs are: entities that are already subject to an exemption from UK tax, such as UK pension funds (or their non-UK equivalents) or sovereign wealth funds; an extended Substantial Shareholding Exemption; the option for certain real estate funds to elect for a tax exemption within the fund in exchange for a reporting obligation on the investors themselves (so that it is the taxable investors who bear UK tax as and when they sell their interest in the fund); certain double tax treaties may allocate taxing rights on an indirect disposal to a third country; shareholders who hold less than 25 per cent of a UK property rich company and have done so for at least two years are exempt on sales of property holding companies; domestic exemption for certain vehicles such as Real Estate Investment Trusts and Investment Trusts.