Background
Historically UK CGT has always had a territorial limit and with certain recent exceptions (relevant to residential property) non-UK residents have been outside the scope of UK CGT on their real estate investments. This helped to make the UK an attractive jurisdiction for inward investment, and gave foreign investors in the UK an advantage not available in most other jurisdictions, which have long taxed foreigners on their real estate gains. The territorial limit to CGT also enabled a great degree of flexibility in creating tax neutral co-investment and fund structures. The absence of CGT allowed investors with CGT exemptions (pension funds, sovereign wealth funds, charities) to co-invest in real estate alongside those without exemptions without any tax leakage, and this flexibility was key to facilitating joint ventures between those with management expertise and cash-rich institutions.

Basic rules
With effect from 6 April 2019 non-UK residents will be subject to tax on all gains realised on their UK real estate assets.

The new regime taxes both direct disposals by non-UK residents of UK real estate, whether residential or commercial, as well as indirect disposals. Indirect disposals are the sale of interests in “property rich” vehicles.

A vehicle is “property rich” for these purposes if it derives at least 75% of its value from UK real estate. Investors who hold under 25% of the vehicle will in limited circumstances be taken outside the scope of the charge. Interests are aggregated with those held by related parties, and the 25% threshold does not apply in most circumstances where the vehicle is some sort of fund (including a REIT). The 25% threshold will still apply to investors in funds that are marketed on the basis that no more than 40% of their investments are expected to be in UK real estate. This ensures that investors with small stakes in funds that were not marketed as UK real estate funds, but which happen to be UK property rich at the time the investor disposes of their interest, will not be subject to UK CGT on their gain.

There is an optional rebasing for commercial property as of 5 April 2019, so investors will only be subject to CGT on gains arising after that date.

Trading exemption, the SSE and qualifying institutional investors
The rules include a trading exemption which applies to sales of companies with real-estate heavy trades. This exemption will be particularly valuable to private equity funds investing in retail, restaurants or hotel chains. The disposal of a trading company that has some land used for non-trading purposes can still benefit from the trading exemption, provided the company’s non-trading land accounts for no more than 10% of the value of all its property.

The UK’s existing “substantial shareholdings exemption” (SSE) for trading companies continues to be available and can be more generous, on the basis that the non-trading activities test uses a 20% threshold to determine whether or not the trading requirement is met.

Further, where a property rich company is owned by an appropriate proportion (80%) of “qualifying institutional investors” (including pension funds, charities and sovereign wealth funds) for SSE purposes the trading requirement is dropped altogether.

The main benefit of the new trading exemption is that, unlike the SSE, it is available to non-corporate shareholders such as individuals and unit trusts. Where the SSE or the trading exemption is claimed on the sale of a property rich company, the target does not, however, benefit from the same rebasing of its real estate assets as entities sold by funds under the new exemption regime (see below).
 
Double tax treaties
The UK can only tax a non-resident investor if the terms of any double tax treaty between the UK and the jurisdiction of the non-resident allow it. Most double tax treaties to which the UK is a party allow the UK to tax non-residents on direct disposals of UK real estate as well as disposals of vehicles that are UK “property rich”.

One important exception is the Luxembourg/UK treaty, which prevents the UK from taxing gains on disposals by Luxembourg residents of interests in UK “property rich” vehicles. Many real estate funds and joint ventures use Luxembourg vehicles, and this treaty protection will effectively preserve the current CGT treatment for these vehicles.

The UK is in the process of renegotiating this provision in the Luxembourg treaty, so the protection may not be available for much longer (although the process of renegotiating a double tax treaty can take several years). Further the new rules contain rules preventing new structures being established in Luxembourg in order to take advantage of the treaty protection from CGT.

Application to funds
One of the main concerns that arose when the new regime was first announced was around the treatment of funds and other collective investment vehicles that commonly use non-UK holding vehicles for their real estate investments. UK pension funds and other institutional investors hold a large proportion of their UK real estate investments through these structures and without special rules these vehicles would all have become subject to tax, leading to these investors suffering tax at fund level where they would not have done if they held assets directly. Similarly they would have suffered from sale prices being discounted by buyers for “latent” gains in the structure. In addition, funds with “master” holding vehicles could have suffered from multiple tax charges on a single gain.

Following engagement between HMRC and the industry, in which this firm participated, this issue has largely been addressed. Fund and joint venture vehicles can enter into elections which have the effect of shifting gains in the holding structure up to the level of investors. This allows pension funds and other exempt entities to benefit from their exempt status and receive their share of gains free of tax.
 
These elections should ensure that tax leakage at fund level can be prevented in most cases, and exempt investors can continue to invest in UK real estate via funds and joint ventures without suffering more tax than they would on their direct investments. The downside for funds electing into the exemption regime is that they will be subject to additional reporting obligations. Further, non-UK investors will have UK tax filing obligations. The government is considering the introduction of rules that would allow funds to file returns and pay tax on behalf of their investors, which would alleviate this, however any such rules are unlikely to be introduced for a while. In the meantime it should be possible to use “blocker” vehicles to shift the compliance burden from investors to the fund, where investors are unwilling to file UK returns.

The transparency election
Any collective investment vehicle which is transparent for income tax purposes - most obviously the Jersey property unit trust (JPUT), a very common vehicle for real estate investment - can elect to be transparent for CGT purposes. Where this election is made, it will be as if the investor held the property directly (or, technically, in partnership with the other investors). When the property or the JPUT is sold, the investor is treated as selling the underlying property.

This means that investors who are exempt will not be taxed on disposals by the vehicle, and taxable investors should be subject to tax only once. As the vehicle is transparent, there will be no latent gain in the vehicle leading buyers to discount price. Given these benefits, it is likely that in almost all cases investors who hold real estate assets through JPUTs will elect for transparency. It is also likely that JPUTs will continue to be the holding vehicle of choice for a wide range of investors, offering CGT and income tax transparency as well as potential SDLT savings on transfer, without the regulatory requirements that apply to onshore vehicles offering the same tax treatment such as REITs.

Transparency elections are irrevocable and must be made within one year of the vehicle acquiring UK property. JPUTs already in existence have until April 2020 to make a transparency election. The consent of all unitholders is required for a transparency election.
 
The exemption election
Real estate funds and joint ventures with non-UK vehicles which meet certain conditions can elect to be exempt for CGT. The rules are complicated but in broad terms a fund must either meet a widely marketed test, or be non-close and have fewer than 25% treaty protected investors. For these purposes a structure is close if it is controlled by five or fewer participants, but certain qualifying investors (in particular pension funds, sovereign wealth funds, other qualifying funds and REITs) are disregarded for these purposes. Many joint ventures involving these investors should be able to benefit from the exemption election despite not having been marketed.

Where this election is made, the fund vehicle itself will be tax exempt, and so will all of its subsidiary vehicles. Gains realised by any joint venture vehicle in which the exempt fund holds at least a 40% interest will also benefit from proportionate exemption. The exemption applies to UK as well as non-UK subsidiaries. Therefore, this election ensures that, however many holding vehicles there are within a structure, there will be no CGT charges at fund level, enabling exempt investors to extract their share of proceeds free of tax. In addition, when a property-holding vehicle leaves an exempt fund, its real estate assets are rebased, ensuring that a buyer will not assume any latent gains, leading to price discounting.

Funds must provide information relating to their investors and fund disposals for each accounting period in which they wish the exemption to apply, in addition to the two years prior to the election. The rules give HMRC power to prescribe the information they require.

The items they expect include details of the fund’s investors, in particular name and address, their tax status and the value of any disposals the investors have made in the period. HMRC recognises that fund managers of some funds may not hold the relevant information required under the new rules and in some cases will not be permitted by the terms of their fund constitution to disclose details of their investors to HMRC.
 
Often a fund’s constitution will permit this where disclosure is required by law, however disclosure under the exempt regime will not strictly be required by law, as a fund is not obliged to claim the exemption. HMRC has acknowledged that funds, particularly those established before the new regime was announced, may be constrained in what they can provide and will not disqualify existing funds from exemption where there is a “reasonable excuse” for failure to provide information.

Where a fund structure involves partnership vehicles the rules can present difficulties. For example, the rules provide that a partnership fund holding property companies can only qualify for exemption if it meets the “widely marketed test”. HMRC has made clear that this is not the intention and that where the partnership is non-close (disregarding the general partner for these purposes) it can also qualify. Where a property holding company is held by parallel partnerships (for example a joint venture between two partnership funds), the company will not be eligible for exemption, as the exemption can only apply in partnership scenarios where the company is wholly owned by a single partnership. This provision will also cause problems for groups with minority investors. In these cases, restructuring will be required to enable the vehicles to benefit from the exemption.

Conclusion
The new regime will go a long way to achieving the government’s stated intention of levelling the playing field between domestic and overseas investors in UK real estate, with CGT a new reality for many non-UK investors. The extension of the CGT net could have made indirect investment in real estate prohibitively inefficient for exempt investors such as pension funds and charities. However, the transparency and exemption options for co-investment vehicles should ensure that in most cases these investors are not worse off as a result of the changes.