The tax regime applicable to non-UK investors in UK commercial real estate continues to be relatively generous. The tax on acquisition is low and there is generally none on disposal. Moreover, tax on income would generally be charged at the basic rate of 20% and this liability is capable of being significantly reduced albeit subject to new limits on gearing set to be introduced next year.
The most tax-efficient structure is one that recognises that taxable elements need to be held separately from non-taxable elements. Therefore, where any 'trading' activity – for example, development as opposed to pure investment – is envisaged, it would usually be appropriate to set up a structure with one entity (typically, a non-UK company) to hold the property and another (typically, a UK company) to carry out the trading activity/development project.
There is flexibility to superimpose whatever ownership structure is desired above the 'special purpose vehicle' that owns the property, whether that be a joint venture structure or a specific holding structure suited to the circumstances of the investor(s).
This structure will mitigate any exposure to UK inheritance tax.
In principle, capital gains on commercial property made by a non-UK investor are not subject to tax. Therefore a non-UK entity, typically a company, should be used to hold the property. In order to benefit from this exemption, two key conditions need to be satisfied:
- The investor must not be engaged in 'trading' activity in relation to the property in question. Material redevelopment of the property or an intention at the time of purchase to sell the property within the first few years after acquisition would generally constitute trading. The UK is introducing new rules with the intent that the profits of any development activity carried on in the UK are subject to tax in the UK.
- 'Management and control' of the non-UK entity must take place outside the UK. Therefore, while UK agents may take day-to-day decisions in the UK, any more strategic decisions must be taken outside the UK.
Income derived from the property by a non-UK resident company will be subject to income tax at the basic rate of 20%. This tax is subject to a 'withholding' regime which means that the tenant or other paying entity must deduct the tax due and account for it directly to the tax authority, HM Revenue & Customs ('HMRC'). In most cases, the holding company or other owning entity will register under HMRC's 'non-resident landlord scheme' which will allow it to receive income gross, deduct expenses, calculate taxable profits, and submit a UK tax return in the usual way.
Deductible expenses for tax purposes can include interest charges on borrowing and so gearing will generally result in tax-efficiency as well as amplification of investment performance. Many investors introduce borrowing in order to achieve this result.
It is, however, important that any loan arrangement is demonstrably 'at arm's length', and so if the borrowing is from a 'connected' party, it must be on robustly commercial terms and loan amounts which do not meet that commercial threshold will not qualify as deductible.
Currently (subject to the commerciality test) all borrowing costs are deductible to reduce taxable profit, but changes targeted for April 2017 will limit the amount of deductible interest to 30% of the owner's EBITDA (broadly equivalent to income in the context of an SPV owning a single property let on a 'full repairing and insuring' (or in US terms, 'triple net') lease. This restriction is likely to apply equally to UK and non-UK owners and will bring the UK into line with a number of other 'competitor' markets.
Separating out operating elements
Where it is proposed to carry out a 'trading' activity of some description in relation to the property, including development, it has generally been appropriate to hive-off that activity into a separate entity. Thus, the typical structure in these circumstances is that of the property-holding company being combined with an operating company: usually a non-UK 'propco' to shelter capital gains and a UK 'opco' to carry out the trading activity.
Any development or other services to be carried out is undertaken by the UK opco. Any charges rendered by the opco to the propco should be allowable against the propco's taxable income. Moreover, any VAT charged to propco will be recoverable where propco has 'opted to tax' (see below).
However, this is set to change. In future, under new rules the non-UK propco may be deemed to have a 'permanent establishment' in the UK by virtue of its ownership of the development site/property. Consequently, the profits of the propco, whether capital or income in nature, will become subject to UK corporation tax. The timing of this change is uncertain and it is prudent to assume that any non-UK propco which owns a development site/property in the UK may well now find itself subject to UK corporation tax on its profits arising from April 2016.
It is not unusual for the seller's 'capital allowances' to be transferred, in whole or part, to the buyer. These are 'writing down' allowances against taxable profits in respect of historic capital investment in plant and machinery. The allowances are at the rate of 18% a year, with an 8% rate applying to 'integral features', and generally have effect on a 'reducing balance' basis. Each year the allowance is applied to the balance of expenditure after deduction of previous years' allowances, for example the 18% allowance is applied to 100% of the qualifying expenditure in the first year but to only 82% of the expenditure in the following year and so on. This means that around 75% of the expenditure is 'written down' over the first seven years.
On the sale of a property, the seller may well wish to retain any unused capital allowances. However, where the buyer would be able to benefit from them more than the seller, it may make more commercial sense for the seller to pass them to the buyer, generally for additional consideration.
Stamp duty land tax ('SDLT')
SDLT on the acquisition of commercial and mixed use property is charged at the following rates:
|Property transfer value||SDLT rate|
|Up to £150,000||Zero|
|The next £100,000 (the portion from £150,0001 to £250,000)||2%|
|The remaining amount (the portion above £250,000)||5%|
It is payable by the buyer. The purchase price will include any VAT, but fortunately this ‘tax on tax' is rarely levied for the reasons given below.
SDLT will be payable within 30 days after ‘substantial performance' of the transaction, which is usually completion.
If a non-UK propco (as opposed to the real estate it owns) is sold, no SDLT or stamp duty will be payable. If a UK propco is sold, stamp duty at 0.5% will be payable. However, such transactions are relatively rare in relation to commercial real estate
Value added tax ('VAT')
VAT at 20% may be charged on the purchase price of commercial or mixed-use properties. This will be the case with new buildings and those where the seller has ‘opted to tax'. In cases where the sale is subject to VAT, there will be little practical alternative other than to ‘opt to tax'. That will often have the effect of making the sale itself VAT-free (and consequently mitigating the SDLT payable).
Where there is no immediate need to opt to tax, you should consider the best strategy for the property as a whole, taking into account future expenditure plans and the likely tenant-mix profile as some tenants will not be able to recover the VAT paid on rent.
The commentary in this note is intended only for broad introductory purposes and is not intended to be relied on in relation to any specific transaction.