Are tax administrations just greedy, needy, or is there a fundamental shift in the way taxpayers should be declaring their income? Has the BEPS initiative signalled a wake-up call to individuals and corporates? Are the ‘Google assessments’ the beginning of the end of artifice, or as Churchill would have said, merely the end of the beginning? What is the fundamental shift?
One can look at the technical aspects of the source rules, such as the ‘Nexus approach’ for the taxation of intellectual property in accordance with Action point 5 of the BEPS initiative. But in essence, governments and tax administrations are looking beneath the surface and attempting to assess substantive elements of a taxpayer’s income. Should Amazon avoid local taxation merely because it does not meet the technical definition of a permanent establishment? Should Google avoid local taxation where a fundamental part of its business emanates from local activities? Should Vodafone avoid local taxation on the sale of a local business merely because the legal ownership resides in a foreign enterprise?
Tax authorities are no longer restricting themselves to where legal ownership of assets and income actually resides, but are able to extend source rules beyond superficial appearances. Thus an offshore entity may own valuable intellectual property rights, having registered such rights in its name, yet the work in creating such rights has been undertaken by personnel based elsewhere. Transfer pricing analyses will assist tax administrations in understanding these issues, and will lead to companies reviewing historical approaches to international tax planning. Yet there remain many opportunities to mitigate tax costs which are actually encouraged by national legislation, and the function of an international tax consultant is to be aware of these incentives whilst understanding the need to substantiate activities within an appropriate structure.
IFS has held annual conferences for many years every November at the Landmark hotel, London, now under the IBSA banner (IFS created the International Business Structuring Association in 2014). We will be identifying such incentives in this year’s conference, which is based on a fascinating case study of how a small company develops its business globally, and the range of advice obtained throughout all its growth stages. From research and development planning to intellectual property identification and exploitation, to financing its expansion, dealing with VAT issues and maximising after-tax profits – and even developing a brand manifesto and digital strategy for its products, we are covering the major issues the entrepreneur experiences. We have a great programme of experts in various fields working through the case study and I know it will be an invaluable day’s experience for all delegates. For more information, please look at the IBSA website at (click here).
As a further reflection of the extension of the source rules as they apply to real estate in the UK, this month’s article has been written by Dmitry Zapol and considers some of his recent experiences with IFS clients who have acquired UK properties either for their own use or as investments.
With kind regards
Developments in Real Estate Taxation in Recent Years by Dmitry Zapol
For decades, the UK has welcomed overseas investors with interests in residential and commercial properties with its benign tax regime. Admittedly there had been a few mildly irritating snags: an increasingly high stamp duty land tax (SDLT), unavoidable taxation of rental income, and inheritance tax issues. These may have been mitigated with the help of foreign property owning companies and various debt instruments, whose costs were dwarfed by the ensuing benefits. However, the main advantage lay in the absence of taxation associated with ownership and disposal of UK real estate by non-residents.
Finance Act 2012 shook up the existing tax planning framework, with later legislation causing further dismay to new entrants to the property market. Readers may find useful a short rundown on how the residential taxation rules have been tightened over the last few years.
In 2012 we saw the introduction of a higher 7 percent SDLT on acquisition of residential properties with a purchase price of over £2 million (USD2.65m). The same property bought by a “non-natural” person (typically, a company) would now attract a 15 percent tax. The changes were introduced almost overnight, giving no time to prospective purchasers to restructure their transactions.
In an effort to discourage inheritance tax avoidance through personal ownership of UK situs assets, Finance Act 2013 introduced the annual tax on enveloped dwellings (ATED). Its purpose has been to discourage corporate ownership of UK residential properties by making the owner pay an annual charge, with the amount dependent on the property’s value. Also for the first time, non-UK resident owners became liable to tax on capital gains arising on disposals of UK properties in respect of which the ATED was due.
Finance Act 2014 brought in a significant limitation of the scope of liabilities that could be used to reduce a UK inheritance tax charge, while Finance Act 2015 made non-UK residents liable to UK tax on capital gains arising in connection with disposals of all UK residential properties.
In an attempt to cool down the buy-to-let market, Finance Bill 2016 has introduced an additional 3 percent SDLT rate on purchases of second residential properties in the UK. In 2017, this measure will be complemented by a restriction on the deduction of financing costs by individual landlords. Also in 2017, individuals will no longer be able to “hide” properties behind non-UK companies to avoid inheritance tax.
Alongside these major changes, the UK Parliament created a continuing narrowing of the thresholds at which the new charges would apply, causing more properties to come within the ambit of the legislation. The increasingly complex rules have been mostly aimed at shaping personal exploitation of UK residential properties — where a residential property is rented out commercially, the owner receives SDLT and ATED reliefs.
Curiously, the tax rules associated with commercial properties have not undergone such dramatic changes. This is despite the fact that much larger direct tax revenues can still escape taxation. The most significant development lies in the restriction of the use of double tax agreements with the Crown Constituencies when creating investment structures. Also, the scope of the transaction in land rules has been significantly narrowed, although these have always formed part of the legislative network.
We are now in a situation where before the legendary Englishman (or property owner of any nationality) can call his home his castle, he has to face numerous obstacles and traps set by the Exchequer for the unwary.
There is a bewildering mix of SDLT, inheritance tax, capital gains tax and occasionally income tax that is rarely imposed in a combination likely to satisfy the homeowner. Instead, as with communicating vessels, a reduction in liability in one area often leads to increased liability elsewhere. However, laws of physics do not apply to taxation, and the converse is not always true.
Let’s illustrate the above by considering the situation of a wealthy family who are looking to buy a mix of residential properties in the UK, which in the author’s view forms a fascinating tax management puzzle.
Non-Resident Property Investment in the UK: A Case Study
In the situation under examination, Michael is the father who normally lives and works outside the UK and visits his family occasionally to avoid UK tax residence. Marta is Michael’s 18-year-old daughter, who has lived and studied at Brighton College for four years and is now moving to London to attend the London School of Economics (LSE). Marina is their wife and mother, who had lived with Marta in a rented apartment while she was a schoolchild and is now looking to move closer to the capital.
The family already have a number of residential properties outside the UK, which belong to the three of them in various proportions. Now Michael and Marina are looking to buy a £7 million family home in Surrey. Also, to ease Marta’s transition into the adult life, they want to buy her a £1.2 million apartment in London.
Michael is worried that anyone can pull their names as home owners from the Land Register. He has heard that the family can remain anonymous if they buy the properties through offshore companies. Michael is concerned to hear about a flat 15 percent SDLT that the company will pay if it purchases the house in Surrey and Marta’s London apartment. Additionally, every year the company will be liable to file an ATED return and pay the ATED charge at the rate published at HMRC’s website (Note 1). Conversely, there are no such consequences where an investment property is bought by a corporate body. Thanks to the property business relief, (Note 2) the 15 percent SDLT rate and ATED are avoided, provided that the apartment is rented out on commercial terms for at least three years to persons not connected with the family.
He wonders whether a nominee holding company may provide a solution to Michael’s concerns. The corporate owner would typically be registered in a low-tax jurisdiction where it falls outside the scope of the UK’s PSC (persons with significant control) register rules (Note 3). The company acquires the legal title to the properties, which is reflected in the Land Register, whereas the beneficial title remains with the family under a bare trust agreement.
As a result, from HMRC’s point of view, the structure remains tax transparent while at the same time the anonymity requirement is achieved. Although in March 2016 it was announced that beneficial ownership information relating to UK land may become available to the public, at least for now the nominee corporate ownership achieves its purpose. In the end, the family agree to pay the annual fees to maintain the nominee company with a view to liquidating it should the proposals on the beneficial ownership disclosure become law.
The next step is to decide on the financing. Michael has enough capital to pay for the properties outright, although he has access to finance, and Marina together with Marta can take out low-interest UK mortgages guaranteed by the father. With everything else being equal, the mortgage option is recommended – if the mortgage is on market terms, it constitutes a liability that reduces the value of the family’s estate for the family’s inheritance tax liability. If the mortgage is interest only, the liability remains for its entire term. Alternatively, as repayments are made, Michael and Marina may think about taking inheritance tax insurance to cover the shortfall.
The three family members are happy to own the Surrey home as joint tenants where each person has equal rights to the whole property. If one of the parents dies, their share of the property automatically passes to the other parent and to Marta. In the former case, the spousal exemption applies, (Note 4) resulting in no inheritance tax liability. In the latter case, the liability can be managed by insurance, as discussed above. Later, the surviving parent can gift his or her share of the home to Marta, although this could be considered a gift with reservation of benefit (Note 5). Unless the parent moves out of the home, starts paying Marta market rent, or occupies the property under Section 102B of the 1984 Inheritance Tax Act, paying their proportion of the running expenses, the property will remain in the parent’s estate on death.
It is decided that Marta will be the sole owner of her London apartment.
Before the family exchange the contracts with the sellers, the question of SDLT comes up again. Marina and Michael already own homes in their country and as a result they are liable to pay the extra 3 percent tax on the purchase of the UK property (Note 6). Because they are married, even if Marina sells her share, the charge will not be avoided.
Michael cheekily suggests a divorce, but faces the wrath of Marina and an explanation that the separation must be absolute and not just on paper! Still looking for ways around paying the tax, Michael wants to know how the tax is administered. The conveyancing solicitor tells Michael that he is under an obligation to disclose ownership of his homes worldwide and that Michael faces substantial interest on unpaid tax and penalties for non-disclosure, with HMRC being able to contact foreign tax authorities using the tax information exchange agreements.
Grudgingly, Michael comes to terms with the inevitable tax liability. However, it occurs to them that Marta will also face the 3 percent charge when she purchases her London apartment due to her share in the family’s property outside the UK. There is still time for Marta to gift that share to her parents without adverse foreign tax consequences. But a gift of the foreign property constitutes a chargeable disposal from the point of view of UK capital gains tax, leading to a 28 percent liability. Luckily, Marta has been in the UK for less than seven years. As a non-domiciled person, she can claim the remittance basis of taxation without paying the £30,000 remittance basis charge and avoid the tax completely.
Even if Marta parts with her offshore property, the fact that she co-owns the Surrey home keeps her within the ambit of the 3 percent charge. In the end, the family have to decide whether avoiding the extended SDLT expense is more beneficial than the hassle of getting rid of the foreign real estate and facing a potential future inheritance tax liability when passing the family home to Marta. HMRC have a useful SDLT calculator that helps them with making the choice (Note 7).
In the end, it is agreed that Marta will be one of the joint tenants of the family home and will own the flat on her own. It is decided that Michael will pay for the property outright. To avoid a potentially exempt transfer that could lead to his inheritance tax liability, Michael transfers the required funds to Marta’s non-UK bank account from which she pays the solicitors in the UK.
In the future, when the parents or Marta decide to sell the properties, they can claim the principal private residence relief and avoid capital gains tax on disposal, although Marta may have to choose which property constitutes her home and make an election within two years of the acquisition.
Soon the parents decide to acquire a £3 million apartment, also in London, that they plan to keep as an investment property and rent out through a letting agency for at least five years. Considering that neither the 15 percent SDLT nor ATED will be an issue, they can acquire the property both directly or through a company. Unfortunately, since they already own homes, the extra 3 percent SDLT will apply if they own the property personally, whereas the company will be charged at the regular progressive rate.
In reaching his final decision, Michael should consider taxation of the rental income. Whether it is Michael or the company letting the apartment, they have to register as a non-resident landlord (Note 8). Although rental profits can be received net of income tax from the tenants or from the managing company, it is normally more efficient to receive them gross and pay tax directly to HMRC by filing an annual tax return.
As an individual, Michael is liable to UK income tax on the net rental income at his marginal rate; however, only his UK source income affects the effective rate. Additionally, as a resident of a country with which the UK has concluded a double tax agreement (DTA) with a non-discrimination article, he can benefit from the annual income tax allowance, which is currently £11,000.
Notably, not all DTAs provide for the exemption, and HMRC have published useful notes explaining this (Note 9). In most cases, UK income tax can be credited against Michael’s tax liability in the country of his residence. Conversely, the company pays a flat 20 percent income tax on UK rental profits. Absent further corporate taxation in the offshore jurisdiction, it can distribute taxed income as dividends elsewhere. Unless Michael meets the terms of the controlled foreign company rules in the country of his residence, such income will not be taxed further.
In both situations, the rental income can be reduced by the amount of financing expense, such as loan interest. However, as an individual, Michael is limited in his ability to reduce the rental income by the finance cost up to his basic rate of tax (Note 10). There are no such strict restrictions imposed on corporate landlords at the moment, although legislation is expected to this effect in the near future (Note 11).
When the time comes to sell the apartment, Michael will be liable to UK 28 percent capital gains tax on the disposal gains, despite being non-UK resident. Conversely, the company will pay 20 percent tax on capital gains. In principle, Michael may be able to sell the company’s shares and pay no tax whatsoever; however, under the new anti-avoidance rules, HMRC may see this as a disguised trading transaction and impose tax.
In conclusion, it is worth noting that the government has also announced that in 2017 it will legislate so that inheritance tax is charged on all UK residential property, including property held indirectly by non-domiciled individuals through a structure such as an offshore company (Note 12). It is probable that the rules will include residential property that has been rented out.
Despite the mammoth efforts of the Office for Tax Simplification, legislation keeps growing in size and complexity. Readers must appreciate that a concise case-study cannot avoid the oversimplification of certain matters and the author has left outside the picture many permutations that the real-life clients throw at him. In the end, however, the UK still remains an attractive destination for property investments provided of course that competent tax advice is sought!
Note 1 (click here)
Note 2 (click here)
Note 3 (click here)
Note 4 (click here)
Note 5 (click here)
Note 6 (click here)
Note 7 (click here)
Note 8 (click here)
Note 9(a) (click here)
Note 9(b) (click here)
Note 10 (click here)
Note 11 (click here)
Note 12 (click here)