The Government has published legislation on how the new capital gains tax (CGT) regime for non-resident real estate investors will apply to funds and joint ventures. In broad terms the new regime will mean that many investment structures - particularly those using Jersey unit trusts - can continue to be tax efficient for a range of investors, but the detailed provisions may present challenges to certain structures.

The extension of UK CGT to non-resident investors in real estate was announced at the end of 2017. The Government's intention is to level the playing field between offshore and domestic investors, and while the timing is unfortunate (the new tax is effective from April 2019, the month after Brexit), this measure does align the UK with most other jurisdictions which have long taxed foreigners on their real estate gains. Under the new regime both direct sales of property by non-residents, and indirect sales, namely sales of interests in "property rich" vehicles, will be subject to CGT.

At the time the extension was announced major concerns were raised by the funds industry. These arose from the widespread use of non-resident entities in fund and joint ventures to enable tax exempt investors such as pension funds and charities to invest in real estate alongside taxable investors without suffering more tax than they would if they held assets directly. The use of non-resident holding vehicles such as Luxembourg Sarls and Jersey unit trusts essentially facilitated tax neutral co-investment by exempt investors. The new CGT charge, without any special treatment for these structures, would have meant that exempt investors in fund structures could suffer tax charges, and structures involving multiple layers of holding vehicles could result in a single gain being taxed multiple times as the proceeds were repatriated through the structure to investors.

The new funds regime addresses both of these concerns. First, by offering property unit trusts (mainly based in Jersey although there are many in Guernsey and the Isle of Man too) the option to be transparent for CGT purposes, and second by providing a CGT exemption to funds meeting certain conditions.

1. Transparency

Unit trusts are particularly popular vehicles for exempt investors in UK real estate, as they are transparent for income tax purposes, can be transferred without an SDLT charge, and are not subject to onerous regulatory requirements. With so much UK commercial real estate held via these structures it was critical that a solution was found for these vehicles and the transparency option achieves this. Any unit trust opting for transparency will effectively be ignored for CGT purposes so that a disposal of its real estate assets is treated as made by the unitholders, and will not be taxed where those unitholders are tax exempt. This transparency option will ensure that unit trusts continue to be efficient for most exempt investors. The conditions for transparency will be met by the majority of property unit trusts, although there are some potential problems:

• first, the transparency election can only be made with the consent of all investors. For widely held funds this will be difficult to achieve in practice; and
• second, an impact of transparency is that investors in these structures who are not exempt will suffer tax charges on disposals by the unit trust, regardless of whether the proceeds are distributed to them. So for unit trust funds that reinvest gains this could lead to dry tax charges. For these funds, the second of the government's options in the new funds regime, the fund exemption, will be more valuable.

2. Fund exemption

Where real estate funds meet certain conditions the fund can opt to be exempt from CGT. The exemption applies to the fund vehicle and all its subsidiaries, and has the effect of shifting the tax charge on any gains from fund to investor level. In this way, investors that are exempt will not suffer tax leakage on their share of gains, and gains realised by funds with multiple layers of holding vehicles should not be taxed more than once. Another benefit of the funds exemption is that if a vehicle within a fund structure leaves the fund, in most cases its real estate assets will be rebased, so that a buyer will not inherit a latent tax gain and should not seek to discount the sale price to reflect this.

The rules for the fund exemption are complex compared to the transparency option. The Government are keen to ensure that private groups and families cannot benefit from this regime and also that gains cannot escape tax altogether, including as a result of investors claiming the benefit of the UK's many double tax treaties.

Key points to note

• The exemption is open to a broad range of non-UK vehicles, including property unit trusts, partnerships, certain companies and Authorised Investment Funds. 
• The vehicle in question must either meet a widely marketed test or be "non-close". Both tests are designed to ensure that private groups and families cannot benefit from the regime. An entity is "close" for these purposes if it is controlled by five or fewer participators, unless one or more of its investors is an institutional entity (this category includes pension funds, charities, sovereign wealth fund and REITs). Many funds and joint venture arrangements will meet these conditions. However the draft legislation published last week suggests the bar is set higher for partnership funds, and that some partnerships that have not been widely marketed may not benefit from the exemption. We understand that is not the Government's intention and hopefully this will be clarified.
• The exemption is only open to "property rich" funds. This covers funds that derive at least 75 per cent of their value from real estate, and this condition means pan-European funds will be excluded from the exemption, although it may be possible for sub-groups within such funds to benefit.
• Funds that are not widely marketed must meet a further condition, namely that no more than 25 per cent of their investors are protected from UK CGT under a double tax treaty. Few treaties protect investors from CGT on real estate gains, with Luxembourg being the main exception (although the UK have commenced renegotiation of this treaty to remove this benefit). The impact of this condition is that funds with significant numbers of investors using Luxembourg vehicles will not be able to benefit from the exemption, and this could create tension in joint ventures between treaty protected investors and other investors looking to benefit from the fund exemption to mitigate tax leakage. 
• As noted above, the conditions for partnerships to qualify for exemption are more restrictive. For example, whereas an entity that is only partly owned by a non-partnership fund will benefit from the exemption on a proportionate share of its gains, entities that are not wholly owned by a partnership fund cannot benefit at all. This will present problems for certain structures, for example property companies that are owned 50:50 by partnership funds, and ones using parallel partnerships to accommodate investors. Further, a property company that is owned by a partnership and does qualify for the exemption will not be entitled to a rebasing of its assets on a disposal by the partnership, in the same way that a vehicle leaving a non-partnership exempt fund would. It is not clear whether the exclusion of certain partnership structures from the benefits of the regime is deliberate, or reflects the short time period the Government had to devise the rules.
• Any fund that qualifies for exemption must report information to HMRC, designed to give HMRC visibility of the gains realised at fund level (and to ensure that these gains are ultimately taxed at investor level). In some cases it will not be possible for existing funds to obtain this information (which includes details of investors' tax status) or to pass it on to HMRC, however the intention is not to disqualify funds that are constrained by their constitutions from disclosing the relevant information.
• Investors in an exempt fund will be taxable on disposals of their interests in the fund and on any capital distributions they receive. There are also various circumstances in which investors are deemed to have disposed of their fund interest, crystallising any gains at that point. This will apply in particular where a fund ceases to be property rich, for example when it is in wind down mode. Importantly the tax on this deemed disposal will not be payable until the investors actually receive their share of proceeds, provided this is within three years. There are other circumstances in which a deemed disposal will arise, triggering a tax charge. These include where a dividend that includes capital proceeds is paid by the fund. It appears that in this case an investor will be deemed to dispose of the entirety of their interest in the fund, which could lead to the taxable gain being a different amount from their actual economic gain.

The rules published last week contain other important changes for investors. First, the Government has removed the 25 per cent ownership exemption for the charge to tax on disposals of indirect interests. Under the rules as originally published an investor holding less than 25 per cent of a property rich vehicle would not be subject to CGT on a sale of their interest in the vehicle. Now, investors in a wide range of property rich entities will be subject to CGT on a disposal of their interests, however small their stake. This would apply for example to a non-UK shareholder in a UK REIT who holds a small stake. The 25 per cent exemption remains in place for investors in funds that were not marketed as being predominantly UK real estate funds.

The regime for REITs has also been changed, so that REITs are now exempt from CGT on indirect disposals of land (namely sales of property owning subsidiaries) as well as direct sales of real estate assets. This ensures that offshore funds claiming the new funds exemption are not in a better position than onshore REITs.

The rules contain some surprising results for certain partnership structures, which may not be able to benefit from the regime, but in other respects the rules will be welcome to the industry and ensure that real estate investment can still be structured to be tax neutral for exempt investors.  Fund managers will need to get to grips with the new conditions for fund exemption and transparency and ensure that both existing and future funds deliver investors the best tax outcome.