UK: Taxation Of Investment In UK Commercial Real Estate

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.

Typical structure

The most tax-efficient structure is one that recognises that taxable elements need to be held separately from nontaxable 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, an offshore company) to hold the property and another (typically, an English 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 offshore holding structure suited to the circumstances of the investor(s).

This structure will avoid any exposure to UK inheritance tax.

Capital gains

In principle, capital gains made by a non-UK investor are not subject to tax. Therefore an offshore entity, typically a non-UK 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.

‘Management and control’ of the offshore 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

Income derived from the property will be subject to income or corporation 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.

Gearing

Deductible expenses 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.

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 would generally be 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 will be 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).

Capital allowances

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 is charged at 4% on purchase prices over £500,000. 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.