Sovereign immunity from direct tax: proposed changes

The government proposes to exclude sovereigns from benefitting from exemption from UK taxation on both capital gains and rental income derived from investment in UK real estate. On 4 July 2022, the government published a consultation outlining their proposal to:

• set out a clear legislative basis for sovereign immunity from UK direct taxation; and
• narrow the applicability of sovereign immunity to non-commercial, passive investment income.

The government suggests the proposed approach would bring the UK closer to international norms.

New legislated regime

Currently, a sovereign may make an application to HMRC to confirm their status as immune from direct taxation (under the assumption that they usually will be). Applications are assessed on a case-by-case basis, with very limited published guidance as to HMRC's views as to the law.

Under the new proposals, immunity will only be granted following HMRC's approval of a formal application. The government is proposing to set out the specific requirements for sovereign immunity in legislation, to both narrow the exemption and provide greater certainty.

To benefit from immunity under the proposed new regime:

• an entity would need to be a type of entity classified as eligible for immunity; and
• the income stream itself would have to be subject to a sovereign exemption.

Examples of specifically legislated categories of qualifying foreign sovereign are given as being central banks, government agencies and sovereign wealth funds, as well as the Head of State themselves (although not their family). Whilst the proposal does not currently set out precisely which manifestations of a government would qualify (instead it welcomes views on this), areas flagged for specific consideration are pension schemes (on the basis that they may be otherwise exempt, notwithstanding that this may require a degree of restructuring) and government wholly owned entities (given the general emphasis upon directing immunity towards entities generally associated with sovereign functions rather than commercial activity), each of which are likely to prove controversial and the subject of much consultation feedback.

The government proposes that qualifying sovereign non-natural persons would be treated as non-resident companies and that qualifying sovereign natural persons would be treated as taxable UK natural persons. They would therefore be prima facie liable to UK corporation tax or income tax (as applicable) to the extent any UK-derived income received is not otherwise exempt (including through the proposed new sovereign immunity legislation). This means that certain sovereign persons would become liable to register for corporation tax or to file a Self-Assessment tax return for the first time.

Which income streams could be affected? 

Debt and equity investment

The government's proclaimed aim is to refocus the sovereign immunity exemption towards passive investments and/or assets that are more commonly held as part of undertaking sovereign functions. It is proposed that this could be achieved primarily by ensuring a sovereign's income from debt and equity investments are exempt from tax. Given the UK does not currently tax non-residents on UK source dividend income anyway, this outcome could be achieved by simply providing a new exemption for foreign sovereigns from UK source interest income (over and above any existing exemption, such as that applying to Quoted Eurobonds).

Real estate direct investment

As recognised in the consultation, by virtue of the proposal to refocus sovereign immunity on interest income, sovereign investors would no longer benefit from exemption from UK taxation on capital gains and rental income derived from investment in UK real estate by virtue of their sovereign status. The government expects that the greatest impact on the Exchequer from the proposals would be due to sovereign immunity from direct tax no longer applying to UK property income and gains.

We note that nothing would change in relation to indirect taxes which may arise on UK real estate transactions (such as VAT and SDLT), where sovereign immunity does not generally apply under the current regime. 

Special regimes and indirect investment

Under the current system, in certain cases sovereign immune investors are deemed to be "qualifying investors", in order that their sovereign immune status is not disturbed simply by investing indirectly, rather than directly, in certain assets by using holding or fund structures. The proposal gives the examples of REITs, the Substantial Shareholding Exemption (SSE), the Qualifying Asset Holding Company Regime (QAHC), Long Term Asset Funds, Exempt Unauthorised Unit Trusts and property-rich Collective Investment Vehicles.

It is recognised that each of these regimes will need to be "considered carefully" alongside the proposed new sovereign immunity regime. The government states that it wishes to differentiate between regimes targeted specifically at institutional investors and those which simply deem a sovereign as a "qualifying investor" to mirror their otherwise general immunity from UK direct tax. The QAHC regime is given as an example of the former, given its purpose is to identify investors for which a holding company is commonly and legitimately used; sovereign investment being just one among many such instances. As such, to disqualify sovereign immune investors would "not be justified" and would negate the purpose of the QAHC regime.

On the other hand, it is suggested that to leave each of these regimes unchanged in respect of sovereign investors would undermine the overarching goals to limit sovereign immunity to passive and portfolio-like investments and to broaden the UK tax base. On this basis, it may be that the REIT regime could be amended in respect of sovereign immunity, given sovereigns' real estate income and gains are elsewhere specifically flagged as a target of the proposed new rules. The SSE is another regime driven by the specific tax status of the investor, and as such may also be subject to amendment in respect of sovereign immunity on the basis of the government's rationale.

Next steps

The consultation process lasts until 12 September 2022. The proposed new regime may be subject to significant change following the consultation and could also be affected by any change in policy approach initiated by the UK's new Prime Minister. It is currently intended that any new rules would apply from 1 April 2024.

Whilst many of the details remain to be finalised, it is clear that the new regime is intended to be tax generating and as such, entities which previously benefitted from full sovereign immunity are likely to be brought within the scope of UK tax, to the detriment of such entities' returns on investment. 

However, despite the impetus behind the proposed changes stated as being to increase the UK tax base and to equalise tax treatment of sovereigns undertaking commercial activities with that of other UK or non-UK residents, the government is at pains to emphasise that any such changes must be fair, proportionate, in line with prevailing international practice and must not impair the UK's ability to attract foreign investment. An example of this approach is the recognition that it would be inequitable to tax capital gains accrued before the new rules came into effect. As such, sovereign persons currently treated as immune would be able to rebase the cost of their acquisitions based on their market value on the day any such new rules come into force (despite this significantly reducing the immediate revenue raising potential of the proposed rules). The government adopted a similar approach when implementing changes to the taxation of capital gains tax on UK property held by non-UK vehicles in 2019.

Please get in touch if you would like more information on the potential impact of the proposed changes on you or your business.