There have been numerous changes to the tax rules relating to UK real estate in recent years. It would appear that real estate has become the “go-to” source of tax revenues for the UK Government. Given the volume of tax changes in this area in recent years, it would, perhaps, have been reasonable for foreign investors to expect real estate to have been given a pass in the Chancellor’s Autumn Statement which took place on 23 November. However, this was not the case as the UK Chancellor announced in the Autumn Statement a proposal to bring non-UK resident companies in receipt of UK source rental income within scope of UK corporation tax.
What is the current position?
At present, non-UK companies pay basic rate income tax on their annual net rental profits (the rate of tax payable is 20%). In calculating the net rental profits, a tax deduction is generally allowed for interest paid by the company on loans relating to the rental business, assuming the interest is representative of arm’s length terms. Also, brought forward tax losses of the UK rental business can be offset against current year rental profits without restriction.
What are the proposed changes?
The Government will consult in 2017 on how to bring non-UK resident companies within scope of UK corporation tax. Consequently, there is uncertainty over what exactly the new regime will look like. On the face of it, bringing non-resident companies within scope of UK corporation tax is a positive proposal from the perspective of the foreign investor as the rate of corporation tax will be 19% from April 2017 (and will reduce to 17% by April 2020). Currently, non-resident companies pay 20% income tax on their rental profits.
However, the Government have stated that they “want to deliver equal tax treatment to ensure that all companies are subject to the rules which apply generally for the purposes of corporation tax, including the limitation of corporate interest expense deductibility and loss relief rules”. Introducing restrictions on deductibility of interest and the offset of brought forward tax losses could have a significant impact, depending on a company’s particular circumstances. The corporation tax rules which restrict the offset of tax losses and deductibility of interest both contain de-minimus limits such that the new rules should only apply to “large” companies or groups. The tax loss restrictions, for example, are subject to a £5 million allowance per group. Many non-UK companies holding UK real estate are stand-alone entities and are not part of a group. As such, for many non-UK companies, the proposed restrictions may simply not apply. We will have to wait and see if the Government will attempt to amend how these rules will apply to for non-UK resident companies.
One potential issue which has not been mentioned by the Government to date is how, if at all, the profit on disposal of a UK property will be impacted by these changes. Currently, non-UK companies investing in UK real estate are taxable on gains arising on the sale of UK residential properties; however, disposals of UK commercial properties are not taxable. It is possible the Government could, as part of this regime change, bring all disposals of UK properties within scope of UK tax (regardless of whether the property is used for residential or commercial purposes).
Impact on corporate investors into UK real estate
Bringing non-UK companies within scope of UK corporation tax could, depending on how the rules are drafted, have a considerable impact on the return of an investor into UK real estate. In particular, the proposed restriction on interest relief, depending on how a company is funded, could have a significant impact. Often non-UK companies finance the purchase of UK rental properties by a combination of third party and connected party (ie shareholder) debt, potentially resulting in a high loan-to-value ratio. If all of the debt is interest bearing and the interest treated as tax deductible, the new proposals, if they are eventually enacted, could have a big impact on such companies as they may be facing an unexpected tax cost in the near future. Furthermore, if all profits on disposal of UK real estate were brought within scope of UK tax (removing the capital gains tax exemption for investing in commercial property) it could mark the end of there being any fiscal incentive to invest in UK real estate.
Written by Kevin Loundes, Associate Director