Brexit and BEPS could lead to a UK-EU bifurcationin real estate funds. Andrew Månsson-Lowe and Melville Rodrigues consider solutions for pan-European managers with UK operations
There is continuing uncertainty on the form of regulatory equivalence that will apply between the UK and the EU following Brexit and any transition period. Determining the appropriate structure for current and prospective real estate funds – and also the optimal location of the fund management function – has become increasingly challenging with the combined effect of Brexit and the OECD Action Plan on Base Erosion and Profit Shifting (BEPS).
In the case of offshore funds holding UK real estate, these challenges are exacerbated by UK onshore dynamics – as a result of the UK government’s proposal to charge non-residents tax on capital gains on all UK real estate from April 2019 (see page 20).
Pan-European fund managers – who focus on continental European and UK real estate markets, as well as servicing mainland European and UK institutional investors – should focus on the structuring implications for current and prospective funds as well as their own operations.
Much will depend on the location of existing fund management and investment advisory operations. It seems likely that the UK will no longer retain full access to the European Economic Area (EEA) single market for financial services, relevant in the context of the Alternative Investment Fund Managers Directive (AIFMD) and the recast Markets in Financial Instruments Directive (MiFID II). Outside the EEA, the UK would operate on the basis of AIFMD third-country provisions and regulations that govern fund management and delegation services into the EEA. MiFID II has no similar third-country provisions.
The UK government is looking to preserve the right of fund managers to delegate portfolio management following Brexit, whereas the European Securities and Markets Authority (ESMA) has warned against UK-based managers creating ‘letterbox’ entities in the EEA after Brexit.
The Brexit regulatory dynamics dovetail with tax compliance requirements arising from BEPS. The OECD has announced that the BEPS Multilateral Instrument (MLI) will come into force on 1 July 2018. MLI signatories – more than 100 countries, including EU countries and the UK – are in the process of ratifying the MLI. As a result of ratification, it is expected that the MLI will start to have effect for existing tax treaties as from 2019.
Real estate fund managers should also monitor developments relating to BEPS. For example, there may be new ‘permanent establishment’ risks, and access to tax treaty benefits for funds could be more challenging. Benefits will depend on satisfying the ‘principal purpose’ and, depending on the countries involved, ‘limitation on benefits’ rules. Treaty benefits will be unavailable if the obtaining of the benefit was one of the principal purposes of a fund structure and depending on the countries involved.
Restrictions on interest deductibility are likely to reduce the ability to use shareholder loans as a tax shield, and may lead to managers consolidating fund-holding platforms. There will be a focus on non-tax drivers for selecting a fund structure location – for example, legal and regulatory framework, skilled workforce, investor familiarity and substantive activities.
There will also be a greater attention on the management and control and substance of fund vehicles involved in cross-border operations, although there may be limited scope for delegating advisory roles to another jurisdiction.
The EU has progressed with its Anti-Tax Avoidance Directive, aimed at tax planning practices used by multinational companies, and builds on the BEPS project. The directive affects multinational companies and will have consequences on structuring cross-border real estate funds. The UK is considered to be generally compliant with the directive – for example, having recently introduced anti-hybrid and interest-limitation rules. EEA member states must implement the directive by 1 January 2019 and, given this deadline, Brexit may impact on the UK’s obligation or willingness to continue to comply with the directive in the medium to long term.
To attract pension funds and other tax-exempt institutional investors, funds are commonly tax transparent or exempt. BEPS might lead to a greater popularity of domestic tax-transparent fund structures and/or the use of national REIT-like structures, which have inherent tax efficient characteristics.
We may well experience a bifurcation between the EU and the UK in structuring real estate funds on account of Brexit and BEPS. This bifurcation could be accelerated (in the case of funds holding UK real estate) by the UK government’s proposal to charge non-residents tax on real estate capital gains. Tax and regulatory structures will need to have a greater focus on the location of the underlying real estate and fund manager, in either the EU or the UK and, accordingly, equity from investors accommodated directly into the funds or via feeder funds. Bifurcation could be accelerated in the context of currency risk associated with the underlying real estate investments, with investors preferring to invest either in the euro-zone or the UK. During the period of the UK’s withdrawal from the EU, there may be increased currency volatility.
Managers operating on a pan-European platform – which includes a UK base – may well have to accommodate the bifurcation by consolidating or adopting parallel operations – one in an EU country and another in a UK-domestic solution, although there may be certain limited flexibility with delegated advisory roles.
Typically, where the underlying real estate and fund managers are located within the UK, the solution will be on a UK domestic structure. The focus should be on tax-transparent structures or exempt investors incurring no tax on distributions. The common UK tax-transparent or exempt real estate vehicles of choice are limited partnerships, property authorised investment funds (PAIFs) and real estate investment trusts (REITs). Another more recent domestic tax-transparent solution is the authorised contractual scheme (ACS). The choice for investors is essentially linked to their liquidity aspirations – closed-ended, open-ended or hybrid, and whether unlisted or listed.
Given the unfolding challenges, including those of Brexit and BEPS, pan-European real estate fund managers with UK operations will need to review current and future fund structures and consider the merits of parallel EU and UK operations. This may result in two-way traffic flows – re-domiciliation of funds to and from one of the remaining EU states and the UK, as well as dual operations in one EU country and in the UK.
Andrew Månsson-Lowe is managing director of North Star Corporate Finance, and Melville Rodrigues is a partner at Charles Russell Speechlys