In March of this year HM Revenue & Customs (“HMRC”) published a consultation document in respect of non-resident companies who are chargeable to UK income tax and/or non-resident capital gains tax (“NRCGT”), particularly aimed at those owning UK property. The main purpose of this consultation was to help the government explore the case for bringing such entities within the corporation tax regime. Such a move could have far-reaching implications for the common real estate ownership structures employed by non-resident investors.
The consultation is now closed and an update on the outcome is not expected until later in the year. In the meantime, in this edition of Tax Adviser Update, Jonathan Hornby considers some of the key consequences, many of which are already being evaluated by real estate investors in anticipation of the potential changes.
The current position is that net rental income from UK real estate assets held on investment account by a non-resident company is subject to income tax at 20 percent. Any capital gain arising on the disposal of a real estate asset is not subject to UK capital gains tax provided that the asset is commercial property (i.e. property that is not used as a dwelling). Capital gains on the disposal of residential property have been subject to NRCGT since April of 2015.
Under the proposals, net rental income would in future be subject to corporation tax rather than income tax. The current rate of corporation tax is 19 percent and this is due to fall to 17 percent starting in April of 2020.
The gains currently subject to NRCGT would also be brought into the corporation tax regime. It is important to note that at this stage there is no suggestion that gains arising to non-residents on commercial property would be brought within the charge to tax as part of these changes.
The rationale for this is to bring non-resident investors onto a similar footing as their domestic counterparts when it comes to the application of recent tax reforms which to a large part have been driven by the OECD’s BEPS recommendations. It is felt by policy makers that the most straightforward way of achieving this is to subject non-residents to corporation tax rather than having to rewrite the income tax code to accommodate all of these provisions.
From a timing perspective, there has not been an announcement concerning any proposed commencement date (if the changes happen at all) but this author shares the view of other commentators that 6 April 2018 could be the operative date.
It is worth considering in further detail the key changes for corporation tax payers that could affect non-resident real estate structures when they are brought into the regime.
Corporate Interest Restriction
The UK is implementing a new regime restricting corporate interest deductions with effect from 1 April 2017.
The rules apply on a group-wide basis and so the first issue is the identification of ‘the Group’ for these purposes. The Group will typically comprise an ultimate parent plus any consolidated subsidiaries. Broadly this will be the consolidated group as defined by reference to International Accounting Standards. It should be noted that unlisted partnerships cannot normally be the ‘parent’ of the Group and so for private equity and other fund structures the Group will be determined by reference to the ‘top’ corporate entity in the ownership chain which will not itself necessarily prepare consolidated accounts. Where a fund vehicle owns more than one such entity then there may be multiple Groups to consider.
A further point of particular relevance to this sector is the existence of non-consolidated subsidiaries which are excluded from the Group. In particular, an entity will be a non-consolidated subsidiary where it is required to be measured at fair value as a result of it being a portfolio investment of an investment entity under international accounting standards. Such non-consolidated subsidiaries are likely to then form their own Groups for the purposes of applying the corporate interest restriction.
Turning to the restriction itself, the basic rule (known as the fixed ratio approach) is that the total net UK interest deductions of all of the UK entities/ permanent establishments in a Group will be limited to 30 percent of the aggregate UK EBITDA of those entities. There is a de minimis rule such that the first £2 million of UK group interest will always be deductible regardless of EBITDA capacity.
Given that real estate is naturally a relatively highly geared sector, the fixed ratio approach could potentially result in a disallowance of financing costs even where such expenses are wholly payable to third parties. In such circumstances a group ratio approach can be employed instead whereby the interest capacity is determined by reference to the overall interest: EBITDA ratio of the wider Group of which the UK real estate entity is a member. A key point to note here is that when determining the group ratio, related party debt is ignored. On the face of it this could cause deductibility issues in those situations that rely on an additional tax shield from deductions in respect of shareholder debt.
Under both of these approaches a further restriction (the debt cap) can apply where the Group’s UK net interest expense exceeds the entire worldwide Group’s net interest expense.
Also of relevance to real estate businesses is the Public Benefit Infrastructure Exemption (“PBIE”). In the UK, in addition to traditional ‘infrastructure assets’, buildings that have been let to third parties can potentially qualify for PBIE. In broad terms, where a PBIE election has been made, third party interest costs can be left out of account for the purpose of determining amounts under the corporate interest regime. Again, in basic scenarios, this seems unlikely to increase capacity to permit ongoing tax deductions for shareholder debt where the basic 30 percent threshold has been exceeded.
The UK has already implemented rules counteracting tax advantages arising as a result of hybrid mismatches for corporation tax payers. Whilst the mention of hybrids causes many people to immediately turn their attention to their financing arrangements it is important to remember that the rules can apply to most payments including management fees and rental payments.
The typical hallmarks that would indicate that further consideration of the hybrid analysis is necessary would be the existence of hybrid financial instruments, hybrid entities or both within the structure. It is important to consider the entire ownership chain due to the ‘imported mismatch’ rules that can result in disallowed expenditure in the UK where a mismatch has taken place further up the chain. A common example might be the use of preferred equity certificates treated as equity in some jurisdictions but debt in others. Even though UK borrowings may have been advanced as vanilla loans, there may be a disallowance where these loans have been financed with hybrid instruments the effect of which have not been counteracted further up the chain.
New Loss Rules
Whilst not a direct outcome of BEPs, it is worth mentioning for completeness that the UK government is also implementing new loss rules for corporation tax payers effective from 1 April 2017. One of the key changes is that each year a company will now only be able to shelter 50 percent of its current year profits with brought forward tax losses. There is however an annual de minimis amount whereby, on a group basis, the first £5 million of profits can be relieved in full. This restriction is therefore likely to only adversely impact the very largest companies or those real estate SPVs that are members of groups utilising UK losses elsewhere in the structure.
For non-resident real estate investors that are funded entirely with equity and third party debt the resultant reduction in tax rate on moving into the corporation tax regime will be welcome news. However, the reality is that a large number of non-resident structures rely on the tax shield from related party financing to help enhance investor returns and the corporate interest restriction will be to the detriment of this in many instances.
The hybrid mismatch rules may give rise to additional restrictions on financing costs. Many non-resident investors will be exploring new structures that achieve a tax advantage that does not rely on hybrid features to achieve the desired effect.
It is important to remember though that prior to embarking on such an exercise the impact of the interest restriction rules needs to be understood. There will be little point implementing an alternative financing structure that falls outside the hybrid rules if the expense would get disallowed in any event.