International Investment in UK Real Estate
Contributed by IBSA, by Roy Saunders
30 September, 2014
Roy Saunders examines the means and methods by which international investors can invest in UK real estate.
It is common for international investors to invest in UK properties through a non-UK real estate fund. The purpose of the fund is to trade in properties or receive rental income and the fund is typically an investment company established in a tax jurisdiction with a benign tax regime. The regime should typically impose a low rate of corporation tax, exempt from tax capital gains and dividends and levy no withholding tax on distributions. The residence of the fund depends on the circumstances but usually it is either one of the EU States - Cyprus, Luxembourg, Malta, the Netherlands - or a non-EU jurisdiction - Jersey, Isle of Man, British Virgin Islands, etc.
The UK taxes property rental, property investment and property trading activities differently, as examined in their turn below.
Under UK law a non-resident company can be subject to corporation tax or income tax. A non- resident company is liable to corporation tax only if it carries on a trade in the UK through a permanent establishment (PE). In general, it is then chargeable on:
· trading income arising through or from the permanent establishment;
· any other income from property used or held by the permanent establishment;
· capital gains from the disposal of assets situated in the UK and used or held by the PE.
Where the non-resident company is not subject to corporation tax due to the absence of a PE or it derives income which is not connected with a PE it is liable to income tax, but only if derived from UK sources. UK source income consists of the following categories:
· trading profits from UK sources not related to a PE;
· interest income;
· rental income from immovable property situated in the UK; and
· royalty income.
With regard to capital gains, non-resident companies are only liable to corporation tax to the extent the capital gains are attributable to a PE. Additionally, it is proposed that under Finance Bill 2013 disposals by non-resident non-natural persons (essentially, companies) of UK residential real estate with the value of and exceeding £2 million will also be subject to UK tax liability.
UK tax charge
Non-residents who receive rental income from direct investments in UK real estate are subject to UK tax under the income tax regime. On the basis that the fund is not resident in the UK for tax purposes and provided it is not carrying on a trade in the UK through a PE (see further below), UK income tax will be due at 20% on the net income from the rental business.
The basis of assessment is the tax year that runs from 6 April of one year, to 5 April of the following year.
Most expenses incurred in the rental business, other than those of a capital nature, are deductible, provided they are incurred wholly and exclusively for the purposes of the UK rental business. These will include items such as agents fees, insurance, advertising, repair and maintenance costs.
Interest on debt is also, in principle, deductible where the interest is paid wholly and exclusively for the purposes of the UK rental business. To this end, it is common to structure internally generated finance through a separate finance company to lend to one or more offshore special purpose vehicles (SPVs) that would own the individual UK properties. This is one way to reduce the tax on the rental income. However, where the interest is paid to a connected party, the relief for interest will be limited to an amount equal to the interest that would be payable if the loan was between third parties under UKs extensive transfer pricing rules.
Withholding tax issues
Usually, where the tenant pays rent direct to a non-resident landlord, the tenant will deduct basic rate income tax at 20% from the gross rent payable, less any deductible expenses paid by the tenant. Where rental income is paid via a registered agent, the agent will similarly deduct basic rate income tax from the gross rent payable, less any deductible expenses paid by the agent.
However, a non-resident landlord can apply to HMRC to be subject to UK income tax under the self-assessment regime. Such applications are approved by HMRC on the understanding that the non-resident landlord will self-assess at the end of the year to determine whether they have any liability on the rent. If the application is approved, the non-resident landlord will be entitled to receive rental income without the deduction of UK tax.
Where rent is received after deduction of tax, the non-resident company is not obliged to file an income tax return, or notify HMRC of its investment in UK real estate. However, as stated above, the non-resident landlord can elect to file a tax return, and it will usually be to the landlord's benefit to do so in order to receive rental income gross and claim relief on all relevant expenditure.
Investment vs. Trading
As regards the sale proceeds realised by the fund on the sale of the UK real estate, the treatment of such profit for UK tax purposes depends upon whether the fund holds the real estate as an "investment" or a "trade". If the transaction is regarded as an investment, the sale proceeds upon a disposal are considered to be capital gains and thus not taxable since a non-resident is not liable to UK capital gains tax unless it carries on a trade in the UK through a PE. However, the gains arising from the disposal of the UK real estate by the fund will be subject to UK tax as trading profits if:
· the property was sold in the course of a trade; and
· the trade was conducted in the UK.
With regard to land transactions, it should be noted that HMRC regard "trading" as a question of fact and each case is assessed separately. When deciding whether the real estate was acquired for investment or trading purposes, a number of factors are taken into account. HMRC would look at the intention at the moment the fund acquires the land. The questions that are normally asked to determine whether a trade exists include:
· What is the motive of the acquisition of the property?
If it was to generate income, the transaction is likely to be an investment; however if it is to generate a profit on sale it is likely to be dealing in UK property and thus trading.
· What is the evidence available to substantiate the claim to motive?
Do board minutes (or other documentation where the owner is not a company) exist which evidence the intentions of the directors to acquire property for investment or trading?
· What is the method of finance?
If the funds are short term in nature this is indicative of an intention to quickly dispose of the property and therefore indicative of an intention to deal/trade in UK property.
· Is the property income producing?
If a property produces no income it is difficult to show that it was bought as an investment.
· What is the period of ownership?
Property investments are normally held for a period of several years whereas a trading transaction would normally be one where the property is acquired, possibly renovated and then sold at a profit within a relatively short period of time. There is very little case law on this particular matter so to give any firm indication of what is an appropriate length of time is very difficult.
· What is the expertise of the owner?
HMRC generally contends that a property developer is more likely to acquire a property for dealing than as an investment.
Income or Corporation Tax?
The general rule is that if the profits derived by the fund represent trading income derived from a UK source, the tax liability will be income tax at the basic rate of 20%. However, if the UK activities are carried out through a PE in the UK, the profits will be subject to corporation tax at a rate of 24%.
The definition of a PE is found in the UKs double tax treaties, but this varies from treaty to treaty. Where a treaty does not apply, the UK definition is relevant.
No liability to either income or corporation tax on trading profits (or investment income) will arise if the non-resident company is resident in an appropriate double tax treaty jurisdiction, meaning that a treaty applies that, absent a permanent establishment, does not allow the UK to tax gains realised directly or indirectly on the disposal of immovable property. In such a case, the relevant double tax treaty will override the domestic definition of a PE, so as to shift the taxing rights in respect of those profits from the UK to the foreign country in question.
With respect to income or gains from real estate, double tax treaties usually contain several articles (that is, income from immovable property, business profits and capital gains) that would allow a State in which the real estate is situated to subject the income and gains to tax. Which specific article to apply depends on how the income or gain is characterised under the law of the State in which the real estate is situated.
If the profits of the proposed transaction would be considered to be trading income for UK tax purposes, gains realised on the sale of land in the case at hand would be characterised as trading income (business profits), and indeed this is the treatment which would prevent the application of section 752ff. ITA 2007 (see below). It follows that the taxation of these profits can only be allocated to the UK if all the conditions of the Business Profits article of the treaty are met; that is, if there is a PE through which the Fund is trading.
According to Article 5 of the OECD Model Tax Convention, which has been used as the basis for most of UKs double tax treaties, a PE will exist in the State (in this case the UK) if the business of the fund is carried on through a fixed place in the UK, such as an office or place of management. The mere buying and selling of land in the UK does not of itself constitute a PE under the Article 5 definition. In this regard it is important that the fund does not use a fixed place of business in the UK or has management activities carried out in the UK. Furthermore, it is important that the fund does not have a dependent agent in the UK or someone who has the authority to negotiate and conclude contracts on its behalf.
Therefore, provided the fund does not have a PE in the UK, and effective management and control is genuinely exercised at the place of its purported residence, the profits derived from a transfer of the site should not be taxable in the UK by virtue of the Business Profits Article 7(1) of the treaty, which typically states:
"The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment."
Section 752 et seq. ITA 2007: Transactions in Land
Capital gains derived by a non-resident of the UK are generally outside the scope of UK taxation. Of particular importance are the provisions of s.752 et seq. ITA 2007, which treats capital gains made from the disposal of UK land as capital profits derived from a trade (basically, "business profits"), and subjects them to an income tax charge (in the absence of a PE) at the basic rate of 20%. The main purpose is to prevent property dealing profits being disguised as tax exempt capital gains.
Section 752 can apply to any dealings with UK land which have the effect of realising a "gain of a capital nature" from a disposal of an interest in land. For s.752 to apply a "gain of a capital nature" must be realised in one of three specified circumstances. The three circumstances are as follows (s.756(3)):
· land, or property deriving its value from land (for example shares in a property owning company) is acquired with the sole or main object of realising a gain; or
· land is held as trading stock; or
· land is developed with the sole or main object of realising a gain from disposing of the land when developed.
If none of these circumstances is present s.752 cannot apply. Even if one of the above circumstances is present the section will not apply unless a gain of a capital nature is obtained from the disposal.
If the intention at the time the UK real estate is acquired is to realise a gain on disposal, it is clear that s.752 could potentially be invoked. The provisions of s.752 are, however, blunted where the company realising the gain is resident in a jurisdiction that has concluded a favourable double tax treaty with the UK, such that the taxing rights belong to the foreign jurisdiction absent a PE existing in the UK provided that such company shows the trading nature of its activities. Under s.752 the gains from the sale of land are characterised as trading income (business profits) and as a result the UK is, in principle, only allowed to tax those profits if the conditions under the Business Profits article of the relevant treaty are satisfied. As explained above, the conditions of the Business Profits article will not be met where there is no PE in the UK.
In relation to the definition of the term "gain of a capital nature", s.772(1) stipulates that: "capital in relation to a gain, means that the gain does not fall to be included in any calculation of income for purposes of the Tax Acts otherwise than as a result of Part 18 of CTA 2010 (which stipulates similar rules for the purposes of calculation of UK corporation tax)". Part 18 of the CTA 2010 contains the same reference to the relevant provisions of the ITA.
To fully understand the implications of this definition, it is necessary to determine whether the gain to be realised would be included as income for income tax purposes, and again, the question of whether the transaction can be characterised as an 'investment' or a trade' is relevant. If the transaction is considered to be an 'investment', the gain realised would not be included in the calculation of income for income tax purposes due to the fact that the proceeds from such disposal would not constitute UK source income on which non-residents would be charged to tax. However, if the transaction is regarded as a trade, the sale proceeds upon a disposal are considered to be trading income which would be included as income for income tax purposes.
Although in the absence of the UK PE under the applicable treaty no tax would actually be levied on the fund, because it may in principle be subject to UK income tax (and therefore have these profits included in an income tax computation), the profits are not within the definition of a gain as stated in s.772(1). Thus, since the conditions of s.756(3) are not met, the charge can not apply to the fund.
If treaty relief is claimed so that the trading profit is not taxed in the UK but in the treaty Contracting State, a question arises as to whether there is in fact a computation of income for UK tax purposes. However, because s.772(1) relies to such an extent on there being a "gain of a capital nature", it is recommended that the fund files a UK self-assessment tax return with a computation of income for the purposes of income tax. At the same time, treaty relief should be claimed so that the computed income is not actually taxed in the UK but in the treaty Contracting State. In practice HMRC have indicated that they do not require a treaty claim to be made if the taxpayer feels the profit is indeed treaty protected. However, because of the potential exposure to s.772 for the fund, a computation of income should be included on the self-assessment return and an appropriate claim for relief made.
Roy Saunders is the founder and Chairman of The International Business Structuring Association (IBSA). He qualified as a chartered accountant in 1967 and created his own niche international tax practice, International Fiscal Services (IFS), in 1971. Roy has a wealth of experience in international tax matters having authored the book International Tax Systems and Planning Techniques (Sweet & Maxwell) and teaching on the MA Course on International Taxation at the Institute of Advanced Legal Studies at the University of London.
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