The new regime for taxation of non-resident property gains

Peter Jackson and Harriet Revington discuss the new regime for taxation of non-resident property gains

The draft Finance Bill extends the charge to tax to the disposal of UK commercial property by non-UK residents. The draft legislation includes some significant changes from the consultation proposals, most notably concerning the rules for indirect disposals. When considering whether a company is property rich, an exception will apply where interests in UK land are used for the purposes of a trade, though further clarification is needed. The substantial indirect interest test to determine whether the new rules apply to a particular non-UK resident investor has been reduced to a two year period; and a narrower view is taken of when an investor’s interests are to be aggregated with those of connected persons. The proposed rules need to be considered in the context of any applicable double tax agreement between the UK and the country of residence of the non-resident person making an indirect disposal of UK property. Despite the draft legislation taking effect from April 2019, a considerable number of complex principles and issues remain to be resolved, particularly in relation to collective investment schemes.

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The draft legislation seeks to introduce a level playing field for both UK resident and non-UK resident persons in relation to UK taxation of gains on property disposals. ATED related CGT was introduced in 2013 for disposals of "enveloped" residential property. The introduction of non-resident CGT (NRCGT) for disposals of other residential property in close ownership followed in 2015. The "transactions in land" rules were widened in 2016 to capture gains and other profits arising from property dealing and development. Accordingly, the focus of the new regime is on non-UK resident investors in UK commercial property who are not currently within the charge to UK tax. This is reflected in the draft legislation which introduces a new residual category of charge to tax after consideration of existing taxation provisions concerning UK land. The draft legislation also removes the existing exemption from UK tax for residential property owned in widely held vehicles and simplifies the taxation of residential property by dispensing with ATED related gains. Despite the stated objective of introducing a level playing field, the summary of responses to the November consultation (the Summary) contains proposals which seek to distinguish both the taxation treatment of certain collective investment schemes from other investment structures and the tax position of non-UK resident and UK resident investors in relation to such schemes.

The draft legislation includes a re-write of TCGA 1992 Part 1, in conjunction with additions to introduce a new charge to CGT or CT on non-UK resident persons making gains on direct or indirect disposals of UK property (for ease, both charges to tax will be referred to as CGT in this article). Other than the new rules, the re-write is "a re-statement of the existing law and makes no change to the way the existing provisions work".

The draft legislation imposes a charge to CGT on non-UK residents making a direct or indirect disposal of an interest in UK land. Indirect disposals will be caught where the asset disposed of is:

• an interest in a property rich entity (i.e. the asset derives directly or indirectly at least 75% of its value from UK land); and
• where the person has a substantial indirect interest in that entity (substantial being an interest of 25% or more).

Changes from the initial proposals

The draft legislation includes some significant changes from the consultation proposals as a result of comments received from stakeholders.

The most notable changes are to the rules for indirect disposals. To determine whether the property rich test is met on the disposal of an interest in a company, the value of the company's "qualifying assets" must be considered. Where at least 75% of the value of the qualifying assets of a company derives from interests in UK land (using a tracing mechanism for UK land held in structures in which the relevant company has an interest), then the company is property rich. It is now proposed, however, that there will be an exception when considering whether a company is property rich where interests in UK land are used for the purposes of a trade (TCGA 1992 Sch 1A para 4).

The trading exception applies where all of the interests in land (other than those of an insignificant value) are used in a qualifying trade. A qualifying trade must have been carried on for at least one year prior to the disposal and it should be reasonable to conclude that the trade will continue to be carried on after the disposal.

This is a welcome exception and should, for example, benefit non-UK resident investors in companies operating retail, utility and hotel businesses. However, it is not uncommon for such businesses to sub-let excess capacity and it is not clear how such arrangements will align (if at all) with the trading exception which, in relation to the trading requirement, is a more stringent test than the trading test which applies for the substantial shareholdings exemption (SSE). A company which does not meet the trading exception, may still meet the SSE trading requirement so that gains made by companies on indirect disposals may be exempt from charge. Indeed, the SSE may apply to fully exempt gains on indirect disposals made by companies where the investee is not trading at all provided the investor is a company which is owned as to 80% or more by qualifying institutional shareholders. HMRC confirms in the Summary that reliefs (such as the SSE) available to UK resident investors should also be extended to non-UK resident persons. It remains to be seen, however, what policy limits may apply to such reliefs, for example, will roll-over relief for capital reorganisations be permitted if interests are exchanged in a property rich entity in consideration of the issue of interests in an acquisition vehicle which is not property rich?

There will be many situations involving indirect disposals where the SSE cannot apply such that the application of the trading exception will be crucial (including disposal of shares by individuals and trustees and disposals of creditor positions in respect of non-normal commercial loans (e.g. debt delivering profit related returns)). In this context, further consideration could be given to closer alignment of the requirements for the trading exception to apply to indirect disposals made by all non-UK resident shareholders with the trading requirements for the application of the SSE.

The Summary confirms the intention that the trading exception should extend to leased infrastructure assets provided there are linked disposals of two or more companies which together own the relevant infrastructure asset.

In determining whether the 75% property richness test is met in relation to linked disposals, all of the assets are to be treated as if they were owned by a single company and if that company would not then be treated as a property rich company none of the companies which are the subject of the linked disposals are to be treated as property rich notwithstanding that, on a standalone basis, a company would be property rich (TCGA 1992 Sch 1A para 5).

A further change relates to the substantial indirect interest test in determining whether the new rules apply to a particular non-UK resident investor in a property rich company. A person is a substantial investor if they have held an investment of 25% or more in the company at some point in the two years prior to the disposal unless this was for an insignificant period (TCGA 1992 Sch 1A para 6). This two year look-back period has been reduced from the five years proposed in the consultation. Further, a narrower view is taken of when an investor's interests are to be aggregated with those of connected persons (applying the definition at TCGA 1992 s 286 but without subsections (4) and (8)). This means that a person who is a partner in a partnership is not now to be regarded as connected to another partner. The definition of "connected person" does, however, still include situations where two or more persons are "acting together" to secure or exercise control over the company and as a result it may still be difficult for certain minority investors to establish if they are acting together in such a way as requires them to be treated as connected with another investor.

In the consultation, for the purposes of computing gains on direct property disposals rebasing could apply such that the market value of the asset at 5 April 2019 would be taken into account or, to reduce the burden for taxpayers of obtaining a new valuation for direct disposals there was the option of electing for original cost to apply. However, in the consultation, rebasing of interests by reference to market value at 5 April 2019 was mandatory for indirect disposals. In the draft legislation (TCGA 1992 Sch 4AA para 4(1)), it is now possible to elect for original cost in computing gains made on indirect disposals provided that, if using original cost produces a loss, this is not an allowable loss (TCGA 1992 Sch 4AA para 4(2)). HMRC confirms in the Summary that rebasing to market value as at 5 April 2019 or adopting original cost remain the only accepted methods of computing gains under the new regime for commercial property and it will not be possible to time apportion gains to periods pre and post 6 April 2019.

A key further change of particular relevance to tax advisers is the removal of the HMRC reporting requirement for third party advisers, with the government recognising that the original proposal had "the potential to create significant cost, burden and uncertainty".

International structuring

The Summary acknowledges that the proposed rules need to be considered in the context of any applicable double tax agreement (DTA) in place between the UK and the country of residence of the non-resident person making an indirect disposal of UK property (the UK will invariably enjoy sole taxing rights for direct disposals of UK property under applicable DTAs). Certain treaties to which the UK is a party contain "securitisation" provisions which permit the UK to subject indirect disposals to UK CGT where the relevant entity is UK property rich but others (e.g. the UK-Luxembourg DTA) restrict taxing rights on such indirect disposals to the jurisdiction of residence of the disponer (such that any UK legislation imposing a tax charge is overridden). The Summary confirms that the government is in discussions with Luxembourg on the provisions of the UK-Luxembourg DTA. The government’s intention is that "securitisation" provisions should apply to all DTAs to which the UK is a party. The confirmation of discussions with Luxembourg highlights the likelihood of change to the UK-Luxembourg DTA which may affect existing structures that would otherwise fall outside the charge to UK tax under the new proposals.

The anti-forestalling principles that have applied since 22 November 2017 to abusive "treaty shopping" arrangements have now been drafted. Specific reference is made in the Summary to these provisions targeting the "moving" of existing investment structures to Luxembourg from other jurisdictions. It remains unclear whether and to what extent the anti-forestalling rules would apply to the exercise of a legitimate choice of investment jurisdiction (such as Luxembourg) in the context of what is considered to be an abuse of the object and purpose of an applicable DTA.

The draft legislation confirms that if a company becomes UK resident after 5 April 2019 and then makes a disposal of UK land, it will still be eligible to benefit from market value rebasing as at 5 April 2019 (TCGA 1992 Sch 4AA para 16). Any company considering becoming UK tax resident as a result of these rules, should not do so until after 5 April 2019 if it wishes to benefit from market value rebasing as at 5 April 2019. Other persons (e.g. individuals and trustees) who are currently non-UK resident but become UK resident after 5 April 2019 and then make a disposal of UK land will not be eligible to benefit from rebasing of direct or indirect property interests to market value as at 5 April 2019.

Core proposals for collective investment vehicles

The Summary and explanatory notes to the draft legislation confirm that any final legislation will contain special rules for non-resident investors in collective investment schemes and, where appropriate, exempt investors investing in other investment structures. This is problematic as both UK resident and non-UK resident investors need to be able to review existing structures in advance of April 2019, and understand their future UK tax position, yet there is currently no draft legislation dealing with such issues as potential tax leakage for exempt investors who have invested in UK property through one or more intermediate offshore investment vehicles. The government appears willing to address these issues through further consultation with stakeholders but remains committed to a 6 April 2019 commencement date for the new regime.

The Summary sets out the following core proposals for introducing specific rules for collective investment schemes:

• Offshore funds which are transparent for income (e.g. JPUTs which confer absolute entitlement to income on unit holders) will be able to elect for transparency for the purpose of capital gains as regards the position of non-UK resident investors (but UK resident investors will retain their current tax treatment).
• Offshore funds that are not closely held and which agree to reporting requirements will be able to elect for special tax treatment, whereby gains made by the fund (or entities below it) will not be taxable but the investor will be taxed on disposals of their interest in the fund (this would apply whether the fund was transparent or opaque).
• For exempt investors who have invested in other structures which embody the same principles of joint investment, the government will consider "other solutions".
• The 25% or more substantial indirect interest test will not apply to investors disposing of interest in funds (at least where the fund is clearly a UK property fund) on the basis that those who invest in such funds know that they are investing in UK land.

It is appreciated that the government is trying to deal with difficult issues in relation to both UK and non-UK exempt investors holding interests in offshore structures but the core proposals demonstrate the potential for considerable tax complexity. For example, a JPUT can elect to be treated as transparent for gains in relation to non-UK resident investors only such that one level of UK taxation will be incurred with the relevant base cost relating to the interest treated as held in the underlying property. This treatment becomes more complex, however, where unit acquisitions and disposals are made between non-resident investors and UK resident investors. UK resident investors will still have to consider potential tax leakage within the JPUT on a direct property disposal with, it is assumed, chargeable gains needing to be apportioned between the JPUT and non-resident unit holders.

Non-close offshore funds (including JPUTs) who agree to reporting requirements can elect to be exempted from taxation for gains made within the fund such that investors are taxed on indirect disposals instead. It is assumed that these rules under which gains are only taxable at the investor level, and not within or below the level of the offshore fund, will still operate if the relevant investor holds interests in an offshore fund which is not itself a property rich fund (and where an applicable DTA may in any event preclude imposition of a UK tax charge on gains).

A further complication of these proposals is the intention that the 25% or more substantial indirect interest test will not apply to interests held in funds. The government's comment that those who invest in property funds know they are investing in UK land may be relevant for PAIFs and UK REITs but may not be true for other funds permitting investment in multiple jurisdictions. This is also a departure from the consultation and, presumably, is intended to catch all non-UK resident investors who invest in, for example, UK REITs but will have minority interests.

Valuation complexities with indirect disposals

The Summary confirms that further guidance will be published to make clear the amount of due diligence that is needed to determine whether the property rich test is met by a company in relation to its qualifying assets. The Summary suggests that in most cases a balance sheet or similar statement will be sufficient for this purpose. That may be the case for disposals of property owning SPVs but where there are additional activities carried on by the company or its subsidiaries such valuation exercises will become much more complex.

Interaction with non-resident CGT

For wholly residential property currently within the charge to NRCGT, the 5 April 2015 value will continue to constitute the relevant rebasing value (unless there is an election for retrospective cost or for straight line apportionment). Where there is mixed residential and commercial use of a property asset, the staggered extension of the scope of the UK tax net requires rebasing in both 2015 and 2019, with the relevant proportion of the pre-2019 gain or loss on the assumed sale in 2019 added to the actual gain on the disposal (TCGA 1992 Sch 4AA para 13).

Compliance

Transactions within the charge to tax will need to be reported within 30 days of completion (as is currently the case for NRCGT). Although this may not be an issue for direct disposals (provided that information about base cost is gathered in advance to avoid delays in calculating the gain), it may be more difficult for indirect disposals especially when it is not immediately clear if the 25% threshold has been exceeded within the previous two years. For CGT disposals made by individuals and trustees, tax may need to be paid on account at the filing date for reporting the transaction. For CT disposals made by companies the payment on account provisions will come into effect on a date to be appointed by Treasury instrument.

Conclusion

Although some beneficial changes have been made, such as the introduction of a trading exception and the reduced two year look-back test for substantial indirect interests, the legislation is still very much a work in progress. We await the outcome of further discussions between HMRC and stakeholders in relation to the collective investment scheme proposals, but abolition of the 25% test for certain non-UK resident fund investors will be an unwelcome development for investors who will now be in the regime but were not expecting to be based on the consultation. Investors will need to reassess structures and consider whether they will be caught by the new rules, but this will be hard to do when the rules remain in such a state of flux.

This article first featured in Tax Journal as the lead article on 27 July 2018 and is reproduced with the kind permission of the editors.