In the second article in the “when the dragon meets the lion” series on Chinese investment in UK real estate, Alex Barnes looks at the complex tax implications of buying, selling and letting property
Despite being an attractive investment location for overseas property investors, the UK tax system and its complexities can be something of a minefield – particularly to Chinese investors who currently incur few taxes when acquiring property.
UK residential property has in recent times been the subject of attack by the UK government and has for many non-UK investors ceased to be as attractive as it once was.
However, with careful planning the UK tax system can be successfully navigated and tax-efficient ownership structures put in place for Chinese investors when acquiring, exploiting and disposing of UK commercial property.
Acquiring commercial property
The first point to be considered when acquiring UK commercial property is the type of vehicle through which to make the purchase, in particular whether this is a UK or non-UK vehicle and whether it is opaque or tax transparent. Typically, but not exclusively, property is acquired by non-UK residents in offshore companies and there are several reasons for this, which are explored in more detail below.
Stamp duty land tax (SDLT) is payable on the acquisition of most property interests and is payable at up to 5% on such part of the purchase price as exceeds £250,000.
In certain circumstances value added tax (“VAT”) is payable in addition to the purchase price for a property. At 20%, this can be a significant liability.
If VAT is payable on the purchase price then SDLT is payable on the aggregate of the purchase price and the VAT, making SDLT a tax on a tax in these circumstances. For example, on the acquisition of a property for £10m plus VAT of £2m, the SDLT payable on the VAT would be £100,000.
It is possible to acquire property free from VAT if the acquisition can be structured as a transfer of a going concern (“TOGC”). If the acquisition can be a TOGC then, using the above example, there would be a saving of £100,000 of SDLT.
There are a number of conditions that need to be satisfied if property is to transfer as a TOGC and one point that can cause problems is the VAT registration status of the vehicle acquiring the property if it is, as is often the case, a newly established special purpose vehicle (“SPV”). This is not an insurmountable problem but does need to be considered early in the acquisition process.
Any VAT incurred in respect of the acquisition of the property (eg on the price or professional fees) may be recoverable from HM Revenue & Customs (“HMRC”) and, if so, VAT should only be a cashflow cost and not an absolute cost. With careful planning even the cashflow cost can be mitigated or possibly avoided.
If borrowings are used to fund the purchase, UK withholding tax can apply to payments of what is known as “UK source interest” if the interest is “yearly interest” payable by a UK/non-UK entity to a non-UK entity. If a withholding is incurred this can in certain circumstances cause a borrower to have to gross up interest payments, which will increase borrowing costs. It is often possible to avoid such a withholding if a successful application to make the payments gross can be made to HMRC under the relevant double tax treaty or if the lender holds a Double Taxation Treaty Passport.
Exploiting commercial property
UK corporate landlords are currently subject to tax on rental income at 20% (reducing to 17% by 2020). Chinese or other non-UK corporate landlords are subject to income tax at 20%. Non-UK individuals owning property in their own name or via a tax transparent entity such as a partnership would be subject to UK income tax on rental income at up to 45%. Owning property in a company allows the rental profits to accumulate at a lower tax rate which is helpful if the monies are to be used by the company for re-investment.
For a UK resident company it is currently relatively straightforward to obtain a deduction for interest costs (if debt funding is used to acquire the property) against rental income under what are known as the loan relationship rules. Chinese and other non-UK landlords will typically only be able to obtain a UK tax deduction for interest costs if they are incurred wholly and exclusively for the purpose of the rental business, which is more restrictive and can be a difficult test to satisfy. Interest deductibility is likely to limited under the new rules announced in the 2016 Budget, which are to implement the proposals of the Organisation for Economic Co-operation and Development’s base erosion and profit shifting plan.
Rents paid to non-UK landlords will be subject to UK withholding tax before the payment is made overseas, unless the landlord has made a successful application to HMRC to be paid gross under the non-resident landlord scheme.
Capital allowances can be claimed in respect of expenditure incurred on certain fixtures and fittings in the property acquired. These allowances can be used against the rental profits and will reduce the tax payable on such profits.
VAT needs to be considered, in particular whether VAT incurred in connection with any refurbishment, letting or maintenance can be recovered from HMRC. This will depend on whether the landlord is making taxable supplies in respect of the property. Careful consideration needs to be given to the use of the property, any existing letting and the possible tenants that are likely to occupy the property before a landlord decides whether to make the letting subject to VAT.
Diverted profits tax (“DPT”) has recently been introduced and DPT taxes diverted profits at a rate of 25%. DPT can in certain circumstances apply on real estate structures albeit it is unlikely to apply on a straight investment by an offshore vehicle into UK real estate.
Disposing of commercial property
If a non-UK property investment owning company manages to maintain its tax residence outside of the UK, it will not be subject to UK tax on any gain made on the disposal of the property. This is one of the principal reasons for holding UK real estate in a non-UK company.
However, a variety of anti-avoidance legislation can give rise to UK tax on gains for non-UK companies and this needs to be considered carefully.
It may be possible to sell the shares in the offshore company and this will save the purchaser from having to pay SDLT, as this is not payable when acquiring shares. These savings could enable the seller to increase the price of the shares.
The government has over the last few years attacked individuals and corporate entities owning UK residential property. For this reason the attractiveness of UK residential property to Chinese and other non-UK residents is declining.
For those purchasers acquiring property in excess of £1m the SDLT payable can be considerably more than it would have been just over 12 months ago. The SDLT rates as regards residential property are different to those applicable for commercial property. The SDLT rates for residential property go from 0% for such part of the consideration which does not exceed £125,000 up to 12% on any part of the consideration which exceeds £1.5m. This is a big difference to the top rate of SDLT (5%) on commercial property.
SDLT is, subject to some exceptions, now payable by offshore companies and other “non-natural” persons (including partnerships) at 15% on the whole price paid for residential property over £500,000.
With effect from April 2016 the rate of SDLT payable by purchasers of buy-to-let properties is to be increased.
There is an annual tax on residential properties valued at over £500,000 owned through corporate vehicles and collective investment schemes. This annual tax can be up to £218,200 on properties with a value in excess of £20m.
Capital gains tax is often now payable on gains made by non-UK individuals, companies and other non-natural entities on the disposal of residential property unless private residence relief is available.
Tax relief for interest payable on borrowings used by individuals to fund the purchase of buy-to-let residential property is to be restricted under rules to be introduced in 2017.
The value of good advice
The tax rules are complicated in relation to UK property investment but can be navigated with care. The key to investing in UK real estate is to take tax advice at the earliest possible opportunity to structure the acquisition tax efficiently and to ensure that there is no unnecessary tax leakage.