Deborah Lloyd and Cathryn Vanderspar explore what the UK’s capital gains tax proposals could mean for pension funds, and how AREF is responding
The UK government’s proposed extension of capital gains tax (CGT) to disposals of immovable property by non-residents could have a significant effect on the real estate investment market.
In a complete reversal of the long-established position, there are two main proposals:
• Extension of taxation of CGT to non-residents on disposals of all UK immovable property, including commercial and residential real estate;
• A further extension of CGT to indirect disposals by non-residents of interests in ‘property rich’ vehicles, where they have had an interest of 25% or more in the preceding five-year period. Property rich means entities having 75% or more of the gross value of their interests in UK real estate at the time of disposal. The 25% test takes into account interests of connected entities and those with whom the investor is ‘acting together’ in relation to the investment.
The changes will catch gains from 1 April 2019 for companies and 6 April 2019 for others. At the same time, the existing exemptions for widely held entities from non-resident CGT (which currently takes many funds outside that charge), in the context of residential property, will be abolished, with no similar further exemption expected.
Is this relevant to pension funds? On direct investments, UK and most offshore pension funds will not pay CGT on gains, so the rules will not apply to them. Even if they invest indirectly, there should be no CGT cost if they simply sell their interest in the relevant vehicle.
However, many pension funds, particularly in joint ventures and funds, hold their investments indirectly, very often through offshore income-transparent unit trusts (such as Jersey Property Unit Trusts, or JPUTs), contractual structures (such as Luxembourg FCPs), and even through offshore companies with internal gearing. These could all be caught by the new provisions.
If so, potential CGT could reduce the returns attributable to gains accruing from April 2019. The problem is potentially exacerbated if investments are held through tiers of structures or funds of funds, as there could be tax at different levels, creating potential double taxation – for example, when an asset is sold under the direct tax charge and then again as proceeds are returned by redemptions through intermediate entities, reducing returns even further.
“Potential CGT could reduce the returns attributable to gains accruing from April 2019”
But this is not the end of the issue. Although not so widely publicised, the government also announced the abolition of indexation allowance for corporation tax payers from 1 January 2018. This allowance previously meant that gains were only applied to economic profits (an RPI-based allowance was deductible). Going forward, if there is a taxable gain, the amount taxed will arguably exceed the real economic gain, further eroding the expected profit. This change only exacerbates the potential issue.
Rather confusingly, two weeks after the budget proposals, on 4 December 2017 the Collective Investment Schemes and Offshore Fund Regulations were laid, with effect from 1 January 2018. These are intended to take certain income-transparent “offshore funds” outside the scope of CGT.
While these rules effectively retain the tax status quo for the relevant vehicles, they do not apply to all offshore funds (such as companies or indeed even to all JPUTs). The big question then is how these interact with the CGT proposals generally and will the intention of the regulations survive the April 2019 changes?
Helpfully, the government has stated that it does not wish to prejudice tax-exempt investors, including specifically non-UK and UK pension funds. Moreover, the government stated that it does not want to force property investment funds to come onshore. Indeed, this would appear to be contrary to the right to the free movement of capital – a right which the UK government has historically supported regardless of EU membership.
There are, of course, onshore structures that could be used instead in many instances, but for simple, in particular closed-ended, joint ventures and funds, these do not always offer the investor or manager the same flexibility for the chosen business model.
The CGT implications are not the only changes that could be relevant. For those investing via non-resident corporate structures, the additional proposals to bring these within the corporation tax regime from 6 April 2020, and the resulting implications for interest deductions in particular, also need to be considered.
Investors will have to look carefully at whether they need to restructure investments before April 2019 or whether the status quo can remain.
What has AREF’s response been?
The Association of Real Estate Funds (AREF) has been listening to its members to help inform its response to the consultation. It held two roundtable events, each giving an overview from Eversheds Sutherland and Deloitte, followed by a discussion session during which members could raise concerns and issues with the proposal in the consultation document. HM Revenue & Customs attended, so AREF was able to hear comments and concerns from members directly.
A great deal of the focus was on ensuring institutional investors were not adversely affected as a result of the changes.
There were two key elements to our consultation submission. Firstly, we focused on tax-exempt investors, seeking to ensure the rules do not create tax costs for UK or overseas tax-exempt investors, such as pension funds.
Secondly, regarding collective investment vehicles, we made the point that this is a complex area requiring time and care to ensure that exempt investors are not subject to tax charges or that other investors are not subject to double tax.
We also raised:
• Market concerns. The timing of the proposed changes being so close to Brexit could affect UK property values and market liquidity;
• Proposed solutions. We indicated that the optimal position will be to ensure any tax is levied directly on investors, not the investment vehicles;
• Infrastructure. We suggested that consideration should be given to excluding infrastructure assets from the definition of real estate;
• UK vehicle requirement. We also suggested that a suitable UK vehicle, which is appropriate for a mixed investor base and not required to be open-ended or listed, is required to provide an effective alternative to offshore vehicles.
AREF has the investors’ best interests at heart. There is a lack of clarity around these proposed CGT changes, prompting uncertainty. We have brought the industry together and intend to engage further with the tax authorities, both before and after detailed rules are published in the summer, to hopefully avoid the potential unintended consequences of these changes.
Deborah Lloyd is chairman of AREF, and Cathryn Vanderspar is a partner at Eversheds-Sutherland