Final piece in the jigsaw – funds rules for taxing non-UK residents’ gains on UK property

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Summary: The Finance Bill published on 7 November 2018 included legislation on the capital gains treatment of “collective investment vehicles” holding UK property. This draft legislation is the final piece in the jigsaw of the proposed extension of UK tax on capital gains to cover most gains made by non-UK residents investing in UK property from April 2019.

In summary:

  • 25% ownership threshold does not apply to “collective investment vehicles” (“CIVs”) that are “UK property-rich”
  • CIV is a very widely defined term and covers both overseas (eg JPUTs) and domestic (e.g. PAIFs, UK REITs) vehicles
  • Two elections:
    • Transparency election – certain offshore “UK property rich” CIVs (including JPUTs) can elect for transparency for the purposes of UK tax on capital gains;
    • Exemption election – funds, that meet certain conditions, can elect for special tax treatment.  This means gains by a fund (or within its structure) will not be taxable BUT investors will be taxed on disposal of their interest in the fund in line with their tax statuses i.e. when they receive value whether by a sale of units or distribution of gains
  • Modifies the UK REIT regime to exempt certain share sales

1.  No 25% ownership threshold for CIVs

From April 2019, a non-UK resident person will be subject to tax (corporation tax for a corporate investor and capital gains tax otherwise) on a gain on a disposal of:

  • directly held UK land (a “direct disposal”); or
  • interests in “UK property rich” entities (an “indirect disposal”).

An “indirect disposal” of property occurs when the:

  • entity being disposed of is “UK property rich”.  This will apply where 75% or more of the gross asset value of the entity being disposed of derives from UK land; and
  • non-resident has held a 25% or greater interest in the entity at any point in the 2 years ending on the date of disposal.

The new legislation specifies that where an investment has an “appropriate connection” with a CIV, there is no 25% ownership threshold i.e. if the UK property richness condition is satisfied, any disposal of that investment is potentially a taxable indirect disposal of the UK property. 

A CIV is defined to include:

  • collective investment schemes (eg a PAIF, an AUT, a JPUT, an FCP, a fund in the form of a limited partnership)
  • alternative investment funds
  • UK REITs
  • foreign REIT equivalents.

Accordingly, subject to the possible application of a tax treaty or other exemption, any disposal by a non-UK resident of any size of interest in a UK property fund in the form of eg a UK REIT, a PAIF, an ACS, a JPUT, or ELP is likely to be taxable.

2.  Exemption Election

Arguably the most exciting element of the CIV legislation is the “exemption election”.

If an eligible vehicle (see below) so elects, all capital gains on direct disposals and indirect disposal of UK property made by that vehicle are exempt from UK tax on gains. Moreover:

  • all capital gains on direct disposals and indirect disposals of UK property made by entities directly or indirectly owned by the electing vehicle also are exempt from UK tax on gains
  • the exemption extends to UK resident entities owned (directly or indirectly) by the electing vehicle, in addition to covering non-UK resident entities
  • partial exemption also extends to entities partially-owned (directly or indirectly) by the electing vehicle. Once a 40% ownership threshold is exceeded, the partially-owned entity benefits from an exemption corresponding to the degree to which it is owned by the electing vehicle
  • a company wholly-owned by certain institutional investors is exempt from tax on any gain made on a disposal of units in the electing vehicle
  • there is a rebasing of base costs in certain circumstances.

The effect is that an elected fund should be able to carry out direct and indirect acquisitions and disposals of UK properties, organise itself to have various levels of sub-holding entities, and carry out internal reorganisations, all without triggering UK tax on capital gains. Tax on capital gains should only occur on the gains actually realised by investors, either when they make gains by disposing of units in their fund, or when they receive from the fund amounts representing the proceeds of capital disposals.

In exchange for electing, the electing vehicle has to undertake various reporting requirements, notably including reporting annually to HMRC details of any disposals by investors of units in the vehicle.

The eligibility requirements for the election are complex. In broad terms, an election may be made in two circumstances:

  • by an offshore vehicle (in whatever form other than a partnership) that is “UK property rich” and generally is either widely- or institutionally-held; or
  • by a company (which can be resident in the UK or elsewhere) and at least 99% owned by either a partnership (from any jurisdiction) or a UK co-ownership authorised contractual fund (a “CoACS”). The partnership or CoACS must be widely- or institutionally-held. Where the company is owned by a partnership, the company must be “UK property rich”, and where the company is held by a CoACS, it is the CoACS that must be “UK property rich”.

This second limb is needed because neither partnerships nor CoACS have legal personality for the purposes of the UK taxation of capital gains, and so the election must be made by an entity they own. Unlike the first limb, this second limb could permit an election to be made with a UK-only structure.

There are rules concerning the operation and taxation of elected vehicles and their wholly- and partly-owned sub-entities and these bear careful study. However, it is clear that this election regime has introduced a major new tax regime for structuring both offshore and onshore funds investing into UK property.

3. Transparency Election.

The new legislation permits any offshore CIV that is:

  • transparent for the purposes of the taxation on income (e.g. JPUTs and FCPs); and
  • “UK property-rich”

to make a “transparency” election.  A CIV that has made the transparency election is regarded as transparent for all taxation of capital gains purposes, ie not limited to matters connected to UK property.

There are various rules regarding the making of an election – in particular:

  • Election requires the consent of all unit holders, and
  • Election must be made within 12 months of the CIV first acquiring UK property, though existing CIVs have until April 2020 to make an election in relation to historic property holdings.

4. Modifications to the UK REIT regime

Having created the new elective exemption regime, the UK Government appear conscious of the need of maintaining broad parity with the existing onshore structures for investing in UK property.

At present, UK REITs are exempt from tax on capital gains on property sales but subject to tax on share sales. With effect from April 2019, UK REITs will benefit from exemption on an indirect disposal of UK property, eg on the sale of a “UK property-rich” subsidiary. However, where the sale of the vehicle takes place within 3 years of completion of a development, the exemption does not apply if the cost of development exceeds 30% of the fair value of the property.

The less positive aspect of this parity (as mentioned above) is the removal of the 25% ownership threshold for UK REITs.

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