Schedule A income taxation
Foreign companies with property in the UK are treated as carrying on a Schedule A business from 5 April 1995. This means that the profits or losses are calculated in the same way as that of a trade, with income and expenditure dealt with on an accruals basis.
Interest payable, incurred wholly and exclusively for the purposes of the Schedule A business, is treated like any other expense whether it was paid for the acquisition, or for the improvement of property, or for any other reason relating to the trade. It is now no longer relevant whether payment is made to a lender resident in the UK or not.
Thus if the borrower is not a UK resident company, and the loan is not secured on a UK asset (it may be secured, for example, on other non UK assets), and provided that the interest is payable outside of the UK, the loan will not have a UK source. Interest thereon will be deductible from the Schedule A business profits, but no UK withholding tax will be levied on the interest even if the borrower and lender are both nonresident entities. This is the case even if the money was utilised to purchase the UK property.
Creating non-UK source interest payments
In order to ensure the non-UK source of the interest, yet try and obtain tax deductibility against rental income on the grounds that the interest expense is wholly and exclusively incurred for the UK property, the following guidelines may be adopted by one offshore company (say BVI 1) borrowing funds from another offshore company (BVI 2):-
- A loan agreement between the two companies should be signed outside of the UK simultaneously with the purchase of the property, preferably in the jurisdiction where the companies are incorporated or administered and governed by such law, and should be retained at the registered offices of the two companies
- The share capital of BVI 1 should be adequate for the Inland Revenue provisions concerning thin capitalisation (see B1.8.1), and certainly sufficient to provide interest cover for a short period in the event of non-receipt of rental income for whatever reason
- The bank accounts of the two companies should be outside of the UK
Withholding tax requirements
Non resident owners will be given permission to self-assess from FICO (Financial Intermediaries and Claims Office [Non-Residents], St John’s House, Merton Road, Bootle, Merseyside, L69 9BB) by completing NRL1 for non resident individuals, NRL2 for companies and NRL3 for trusts.
It will generally be more preferable to self-assess to prevent withholding tax being levied in the first place by agents involved, with subsequent reclaims required by way of filing a refund returns claim. Withholding tax on rental income will generally be far higher than the UK tax on the net profits, primarily because interest may be payable by the non resident rather than the agent so it cannot be taken into account for the purposes of calculating withholding tax. Moreover, accrued interest cannot be taken into account when calculating withholding tax on rental income, only the interest that has actually been paid by the agent, and furthermore the agent may not wish to reduce the rental income by certain expenses which he may not consider to be fully deductible.
Profits from sale
If the transaction is trading in nature and the properties that are bought by the foreign company are subsequently sold at a profit there are three ways in which the transaction may be treated for UK tax purposes.
a) Trading in the UK but with no UK branch or agent
If the transaction is trading in nature, any profit realised on the sale of the property will represent trading income. Under normal Income Tax principles non-residents are liable for tax on UK source income and the foreign company will be liable to UK Income Tax at the basic rate, i.e. 22%, on the profits realised from the sale of the UK property (see (c) below).
b) Trading in the UK through a UK branch or agent
If the Inland Revenue can show that the offshore company is trading in the UK through a branch or an agency then any trading profit will be liable to UK Corporation Tax under the normal principles. The rate of tax could therefore be as high as 30% but this would depend on the level of income received by the company from its trading activities.
c) Protection under a Double Tax Treaty
A further alternative is that the company may be resident in a country which has concluded a double tax treaty with the United Kingdom, and that the trading profits are protected from UK under the terms of that particular treaty. For example, if the company owning the property was, say, a Cyprus
or Dutch company, there would be no liability to UK tax provided the profits of the company are protected under the treaty, and this would be the case as long as no permanent establishment existed in the United Kingdom. A permanent establishment would include a place of management of the foreign company in the UK or where the property was held by the foreign company for say more than 12 months during which time the property was being developed by the foreign company. In this latter situation, it would be advisable for the foreign company to have a third party company renovate the property and carry out all the necessary works to avoid this eventuality.
Distinction between trading and investment
Where a foreign company purchases UK real estate and subsequently sells it, the treatment of the transaction, for UK tax purposes, depends on whether the transaction is an “investment” or a “trade”. Defining into which category a transaction falls can be quite difficult and depends on a large number of factors; however, the following are guidelines which will help determine the nature of a particular transaction:
a) What is the motive of the acquisition of the property?
If it was to generate income, the transaction is likely to be an investment, however if it is to generate a profit on sale it is likely to be dealing in UK property and thus trading.
b) What is the evidence available to substantiate the claim to motive?
Do board minutes exist which evidence the intentions of the directors to acquire property for investment or trading?
c) What is the method of finance?
If the funds are short term in nature this is indicative of an intention to quickly dispose of the property and therefore indicative of an intention to deal/trade in UK property.
d) Is the property income producing?
If a property produces no income it is difficult to show that it was bought as an investment.
e) What is the period of ownership?
Property investments are normally held for a period of several years whereas a trading transaction would normally be one where the property is acquired, possibly renovated and then sold at a profit within a relatively short period of time.
f) What is the expertise of the owner?
The Inland Revenue generally contends that a property developer is more likely to acquire a property or dealing then as an investment.
g) Application for planning consent.
If planning consent is required, to what extent is the property to be developed. In addition it should be noted that it is important for the offshore company to be represented properly in its dealings with the UK vendor.
Bearing the above in mind it would appear that the acquisition of UK properties could best be made using individual overseas companies. The benefits this would give rise to can be summarised as follows:
- any potential liabilities stemming from the ownership of the property are ring-fenced
- capital gains arising from the sale of investment properties is made free from UK tax (subject
- of course to the current laws on non-residents achieving UK capital gains remaining the same) and
- the most suitable vehicle for each transaction/acquisition can be identified and used
Section 776 TA 1998
Although this section is entitled “Artificial Transactions in Land”, it applies to any dealings which have the effect of realising a “gain of a capital nature” from a disposal of an interest in land. The effect of the section is to assess the whole of any gain as income rather than accepting the transaction as an investment as described above. Due to the differing scope of income tax and capital gains tax, the result may be that a foreign company which realises a gain from the disposal of UK property is subject to tax in the UK which it would otherwise be exempt from if the property were accepted as an investment property. For example, if a BVI company is used to acquire a new property in London, it would not normally be subject to capital gains tax in the UK on a subsequent sale but is subject to income tax on any UK source income. If section 776 is invoked the gain from the sale of the property is treated as income and will be subject to UK tax accordingly. Section 776 can be invoked wherever:
a) land, or any property deriving its value from land, is acquired with the sole or main object of realising a gain from disposing of the land; or
b) land is held as trading stock; or
c) land is developed with the sole or main object of realising a gain from disposing of the land when developed
Inheritance tax consequences
Another major tax to consider is inheritance tax. It is levied on the diminution in value of an individual’s estate following a transfer of assets on death at a flat rate of 40% with an exemption for the first £234,000. Gifts made to certain trusts during an individual’s lifetime will continue to be taxed at half the rates applicable for transfers on death ie 20%, whilst gifts to individuals may be potentially exempt transfers (PETs) if the donor survives the gift for 7 years. There may also be deductions available for agricultural or business property of 50% to 100%, the latter also applying to shares in UK privately controlled companies. Thus the ownership of property through a UK company may reduce the impact of inheritance tax, especially when one considers that the first £234,000 is exempt and there is also a £3,000 annual exemption available, which may be carried forward for one year.
Nevertheless, for non-domiciled individuals, it is generally more advantageous to hold UK property through a foreign, non-UK company. The assets brought into charge are world-wide assets for UK domiciled individuals, but are restricted to UK assets for non-UK domiciled individuals. It follows then that a non-domiciled individual may be better off holding UK real estate through a non-resident company so that on his death only the shares in the non-resident company would be transferred; since these are assets outside the UK, no inheritance tax is applicable. Of course, this depends on the value of the real estate; if the value (net of loans) is not materially in excess of the exemption figure, then insurance may be a less expensive route depending upon age.
For virtually all property acquisitions in the UK, it is generally more advantageous to structure the acquisition through single purpose offshore companies. If there is a requirement to obtain treaty protection against a s776 assessment on the basis of property being held in the nature of a trade rather than an investment, Dutch companies have often been successfully used for such acquisitions. Otherwise, Jersey companies may be the preferred entity for UK property acquisitions where finance, perhaps from the investor’s own resources, is considered non-UK source by being channelled through a separate offshore lending vehicle.