UK Consultation on Sovereign Immunity from UK Direct Tax — Implications for Real Estate Investments

HM Treasury and HM Revenue and Customs (HMRC) are consulting on proposed changes to the U.K.’s existing approach to sovereign immunity from U.K. direct taxation. The proposed changes would be a major step change in the taxation of sovereign investors in the U.K., particularly in relation to real estate. The first stage of the consultation closed on 12 September 2022. As the next stage, the U.K. government will publish a response to the consultation and draft legislation for technical consultation. 

Although this is billed as a consultation, it seems clear that HM Treasury/HMRC intend to proceed with substantive changes, and the general view in the market is that it is unlikely that the status quo will be preserved. This would impact not only sovereigns themselves but also real estate fund managers and sovereigns’ joint venture partners, given the potential implications for sovereign investors’ structuring preferences for real estate investments. 

At present, foreign governments (and heads of state acting in their official capacity, etc.) are granted blanket immunity from U.K. direct taxation. Depending on the particular circumstances, certain other emanations of a foreign government (e.g. states in a federal system, government departments, government pension schemes, central banks, etc.) can also benefit from this sovereign immunity, though this is assessed on a case-by-case basis on the facts and subject to HMRC confirming that sovereign immunity applies on the facts. Companies that are wholly-owned by a foreign government may not benefit from sovereign immunity from U.K. tax in their own right, but in some circumstances HMRC may agree that sovereign immunity can apply to such structures.

In a real estate context, this means that sovereign immune investors are exempt from U.K. tax on:

1. Rental income (whether received directly or via a structure that is transparent for U.K. income tax purposes — e.g. a Jersey property unit trust/JPUT);
2. Property income distributions (PIDs) from U.K. REITs and U.K. PAIFs (the latter being, broadly, an open-ended equivalent to a U.K. REIT);
3. Trading income from U.K. real estate;
4. Capital gains on a ‘direct’ sale of U.K. real estate; and
5. Capital gains on an ‘indirect’ sale of U.K. real estate (i.e. a sale of a corporate entity that is UK real estate rich —  broadly, where 75% of gross asset value is derived from U.K. real estate).

As a result, at present, sovereigns often have a preference for U.K. tax transparent structures where possible in order to benefit from their tax exemption to the fullest extent; although fully U.K. tax transparent structures are not always possible in widely-held private funds. 

Under the proposed changes, sovereigns would become taxable on all of these categories of income and gains with effect from April 2024 (with grandfathering proposed for income and gains attributable to the period prior to implementation). This would be a major step change and we expect that many sovereign investors will need to reassess the structures through which they make direct and indirect investments in U.K. real estate.

In addition, currently investors with sovereign immunity are also ‘good’ investors for various U.K. regimes that confer tax advantages. For example, a sovereign immune investor is:

1. An “institutional investor” for the purposes of the U.K. REIT regime, which (in very broad terms) requires a minimum threshold of interests in the REIT to be held by “institutional investors” as a condition of being a U.K. REIT;
2. A “relevant qualifying investor” for the purposes of the U.K.’s new qualifying asset holding company (QAHC) regime, which (in very broad terms) requires a minimum threshold of interests in the company to be held by “relevant qualifying investors” in order for it to qualify as a QAHC;
3. A “qualifying investor” for the purposes of the U.K. exemption election regime for collective investment vehicles, which (in very broad terms) requires a minimum threshold of interests in the relevant entity making the exemption election to be held by “qualifying investors”; and
4. A “qualifying institutional investor” (QII) for the purposes of the U.K.’s substantial shareholding exemption for companies that are directly or indirectly owned by QIIs (QII SSE), which grants relief from the U.K. capital gains tax for a company selling shares in another company if certain conditions are met, including that at least 25% of the seller company is owned (directly or indirectly) by QIIs — partial relief (in proportion to ownership by QIIs) is granted if the company is at least 25% but less than 80% owned by QIIs and full relief is granted if the QII ownership is 80% or more.

The current proposal notes that the interaction with various other regimes (including those above) will need to be considered carefully. It states, however, that sovereigns are likely to remain ‘good’ investors for the QAHC regime, broadly because the ‘good’ investor category for that regime is aiming to catch institutional-type investors, rather than those that are exempt from U.K. tax. It seems fairly clear, therefore, that sovereigns are likely to remain ‘good’ investors for the U.K. REIT regime and the exemption election regime for the same reasons as they should for the QAHC regime. 

By contrast, it is less clear that sovereigns would retain QII status (at least as regards real estate investments) because that category of ‘good’ investor does generally comprise only categories of investor that are U.K. tax exempt for relevant purposes. Similar logic would appear to apply to other U.K. tax regimes where the ‘good’ investor categories are linked to U.K. tax exempt status (e.g. eligibility to invest in a U.K. exempt unauthorised unit trust).

As the consultation alludes to, the knock-on implications of any changes to whether (or the extent to which) sovereigns fall within these definitions will need to be considered carefully. For example, though not specifically referenced in the consultation document, the U.K. hybrid rules utilise the QII definition in helpful provisions which (in very broad terms) can treat income received by QIIs as if it were taxable when it is not (which might otherwise cause a hybrid mismatch).

For the reasons outlined above, if implemented as proposed, these changes to sovereign immunity are likely to fundamentally change the analysis when assessing preferred structuring options for sovereigns investing in U.K. real estate (whether directly or indirectly). Consequently, structures that have historically been suitable, or even advantageous, for sovereigns investing in U.K. real estate may become less attractive. By the same token, sovereigns, real estate fund managers and sovereigns’ joint venture partners might start exploring alternative options for structuring future investments and for restructuring of existing investments.