Will UK pension funds be hit by capital-gains tax on indirect real estate?

UK real estate funds held offshore will need to elect for tax-transparent status or special treatment in the future to ensure their pension-fund investors remain tax-exempt.

The real estate fund management industry is still digesting the latest update from the UK government on its plans to apply capital gains tax (CGT) to all non-residents holding real estate.

Although the government is targeting foreign real estate investors, its proposals announced last year risk catching domestic pension funds, which are exempt from paying CGT. This is because the government is targeting offshore collective investment vehicles, which many UK pension funds use to hold investments indirectly.

Last week, following a consultation, the government issued draft legislation for the new rules, and has provided a statement on how offshore funds could be affected.

Industry experts involved in the consultation have broadly welcomed the statement, which implies the government is prepared to support “flexible” solutions to avoid UK pension schemes from being taxed.

However, it seems that, to ensure UK pension funds are not hit with CGT, managers of offshore funds will have to either elect for tax-transparent status or special treatment. Funds will otherwise default to tax-opaque status and be liable for CGT.

Under a tax-transparent status, UK pension funds could maintain their CGT exemptions. But it is understood that this option is only likely to be workable if an offshore fund only direct investments in properties. If the fund itself holds indirect investments in other vehicles it is likely to need to elect for a special tax treatment.

The government has not included the treatment of offshore funds in its draft legislation, instead providing an annexe that summarises the responses to the consultation.

John Forbes, an independent consultant who participated in the government consultation, said: “This suggests a potentially flexible approach allowing managers to elect whether funds are treated as opaque or transparent for capital-gains tax purposes. 

“The statement is vague on detail and it is often in the detail that the challenges arise. However, in this case, I see this as a positive as there is a very clear request for further industry input. 

“I read this very much as [HM Revenue & Customs] recognising how complicated this is and reaching out to the industry for further help in designing something that works. That in itself is a big step forward from where we were six months ago.”

The Association of Real Estate Funds (AREF), which represents the UK property fund management industry, said it welcomed “the government’s commitment to build on the detailed consultation responses and dicussions”.

Will Chetwood, chair of the AREF’s tax committee, said: “In particular, we are pleased with the acknowledgement of the importance of avoiding tax for exempt investors and reducing the risk of multiple tax charges within fund structures.

“These are key points that AREF has previously raised with HMRC and HM Treasury. We intend to continue to engage with HMRC and HM Treasury to ensure that we can reach appropriate solutions that work for the industry whilst also meeting the government’s aims.”

Melville Rodrigues, a partner at law firm Charles Russell Speechlys, said managers of offshore funds servicing UK tax-exempt institutional investors should take note of the “government’s intention to further consult and find solutions to two outstanding issues” – the taxation of exempt investors and multiple tax charges in funds.

He said: “Managers should monitor developments and confer with their investors on strategic choices, which should be clarified following the further consultation.”

Rodrigues also suggested that the government’s proposals had implications for fund managers looking to launch new UK real estate funds aimed at domestic pension schemes.

“Managers looking to launch new unlisted vehicles will need to consider the choices and compare them with alternative solutions onshore,” he said, citing as an examples property authorised investment funds (PAIFs), authorised contractual schemes (ACSs), limited partnerships and unauthorised unit trusts.

“Fund managers and their investors may well face choices driven by tax transparency, reporting, liquidity and onshore/offshore dynamics,” he said.

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