UK capital gains tax on non-UK residents selling real estate

In a carefully timed shock to the system, the UK has finally announced, after 53 years, that it will be applying capital gains tax to gains made by non-UK residents on their sales of UK real estate.

The UK did not tax capital gains at all until 1965, and so when the system was introduced it represented significant change and was accordingly rather narrow in interesting ways. Most of the idiosyncrasies have been ironed out over the years, but one of the most significant remained - that the UK does not impose this tax on non-UK residents even where the property being disposed of is in the UK.

Most jurisdictions around the world tax their real estate - including most of Europe and the United States. That the UK does not is therefore something of an oddity, but one which has undoubtedly boosted the UK real estate sector and made it doubly attractive to overseas investment. As international flows of capital have increased over the last 20 years this advantage has boosted cash flows and investment into the UK and may have had a greater role in the prosperity of the UK than other factors that are more widely appreciated.

On the other hand, the inflation in UK asset prices has clearly had a social downside in the residential sector. One might look at it as the largest and most effective tax incentive for investment ever created.

However, tax incentives are expensive and the Government has turned its attention to the real estate industry and decided to bring the party to an end - surprisingly, coming into effect only three days after Brexit, on 1 April 2019.

For close followers of the tax system, there were of course some rules on capital gains on residential property held by non-residents introduced in 2015, but those didn’t apply to commercial property or even to residential property let on a commercial basis, so they didn’t affect the real estate investment sector more widely. This change is the real thing.

What is happening and when?

Although this was announced as a consultation on Budget day 2017, the detail has only just been published and so only now are investors able to begin to see what this means.

From 1 April 2019 (6 April 2019 for individuals) non-UK residents who dispose of UK real estate will be taxed on any gains they make: however, crucially, and unless they elect otherwise, only to the extent that the gain increases above its value as at that date.

This "rebasing" of assets means that even if a property is standing at a huge gain on 31 March 2019, none of that gain will be taxed (unless one elects otherwise). If it then increases in value further, that increase will, however, be taxed. While HMRC is happy for people to rely on a balance sheet value for these purposes, clearly where there is a significant amount at stake, investors will want to procure a full red book valuation (an asset valuation that has adhered to the "red book" of mandatory rules and best practice for professionals as published by the Royal Institution of Chartered Surveyors) as at 1 April 2019. It ought to be a good year for surveyors.

What will it apply to?

For any non-UK resident who holds property directly, the rules are fairly simple. Capital gains tax applies and a tax return will need to be filed.

However, if the tax only applied to direct interests in UK real estate it would be too easy to avoid. One could simply use a company to buy the property and then, instead of ever selling the property, sell shares in the company. To prevent this, and to ensure that the value of UK real estate is efficiently taxed in general, the tax will also apply to the sale of shares in a company (and some other entities) which is "property rich".

A vehicle is property rich if at least 75 per cent of its value derives from UK land. This is tested at the moment of sale and so, if a company has UK and non-UK land, or has UK land and other investments hovering around the 75 per cent mark, then the precise values on the day of disposal may be crucial.

The draft legislation contains anti-avoidance rules designed to prevent artificial manipulation of a vehicle’s balance sheet with a view to failing this "property rich" test.

Some of the UK’s double tax treaties currently provide protection for their residents from this tax, but the government is seeking to renegotiate these. The UK-Luxembourg treaty is the conspicuous one, however the government has noted that it is already in discussions to amend this, and in any event, anti-avoidance rules to stop investors moving to take advantage of these treaties have been introduced.

There are two important exemptions from the charge on indirect disposals.

The 25 per cent exemption

The charge only applies if the investor holds at least 25 per cent interest in a property rich vehicle, or has done in the last two years (ignoring some insignificant fluctuations). The 25 per cent does include any interests held by connected parties to prevent disaggregation of holdings. However, this is still a huge exemption for privately held structures. Importantly, however, it is not going to apply to funds. If you are invested in a non-UK property fund investing in the UK, you need to read on.

Trading exemption

Where a property rich entity uses its property in a trade there is an exemption - so pubs, care homes, hotels and the like (provided the property is traded from rather than let out) will be outside of the charge. There are some complexities here so advice needs to be taken.

Funds

The 25 per cent exemption will not apply if you are invested in a fund. Non-UK resident investors who invest in UK-based (and at least 75 per cent UK real estate invested) funds will be subject to capital gains tax on any gains in their holdings.

The largest area of concern - and a source of ongoing uncertainty - relates to the treatment of UK real estate funds that use non-UK vehicles, and the treatment of UK exempt investors such as pension funds, many of whom invest in these funds. As it currently stands, the new regime would leave exempt investors in a worse tax position than they would be in if they held real estate assets directly (which they often cannot do for commercial reasons), and make investment in the sector via funds and joint ventures less attractive.

The Government has been receptive to these concerns and is continuing to consult with industry bodies on how the rules can be tailored so as not to prejudice these investors or make investment in UK real estate funds unattractive. Their initial proposal is that certain funds and joint venture structures will be able to elect to be treated as transparent or exempt for CGT purposes. This is still a work in progress; however, the hope is that it will enable investment via fund vehicles to be tax neutral for pension funds and non-UK investors.

Summary

As the shock subsides, this measure might be seen as overdue. Despite its unwelcome timing it was surely only a matter of time before the government imposed this tax. In general the approach taken has been proportionate, with the rebasing ensuring that no one is penalised for holding UK real estate already, and the government’s attitude towards funds - although we await the final outcome - has been constructive and engaged.

Planning points

The new rules will obviously be a significant factor when deciding what holding vehicle should be used by investors and funds acquiring UK real estate.
Overseas investors should review their property portfolio to determine if there is a UK property rich vehicle.
If a disposal is anticipated after April 2019, a valuation will need to be undertaken to determine the impact of rebasing.
Investors and fund managers will need to monitor closely the ongoing consultation on the special regimes for fund entities, and funds may need to restructure prior to April 2019 to ensure that they qualify.

This article originally featured on Bloomberg Tax: https://www.bna.com/insight-uk-capital-n73014482310/

Authors

James McCredie Partner