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Click here to download the full client alert with footnotes.
The UK Government recently launched a comprehensive and commercially significant consultation on the taxation of sovereign wealth investors (broadly, foreign governments, sovereign wealth funds and overseas public pension schemes) in the UK.
Under the existing tax regime applicable to sovereign wealth investors, all UK source income and gains, including income from commercial trading activities, are exempt from direct UK tax (i.e., income tax, capital gains tax and corporation tax, including related withholding taxes). Eligibility for the current exemption is based on a combination of common law – specifically, the principle of international law known as sovereign immunity whereby one sovereign state does not impose its domestic laws over another - and HM Revenue and Customs (“HMRC”) practice. Sovereign immunity status is in practice granted by HMRC on a case-by-case basis.
The consultation sets out a comprehensive reform of the UK tax exemption on the basis that the UK’s current approach to sovereign immunity from tax is not transparent or well-understood.
The proposal contains three principal changes:
The last point is likely to present the most important change for sovereign wealth investors and almost certainly the core aim of the consultation given the significant sums of money invested by foreign sovereign wealth investors in UK real estate - both directly and via investment funds operated by UK fund managers.
Two justifications are given for this change of policy:
First, HMRC published a survey of 11 other leading investee jurisdictions, concluding that no other jurisdiction offered a similarly wide sovereign tax immunity for real estate investment and active trading income (the latter could be generated by UK offices of the sovereign operating a UK property business, for example). The consultation proposes to limit the immunity to passive investment income – principally, UK interest and dividends, which in each case are not derived from UK real estate investments. This new limitation – a material restriction on the current regime - is in line with sovereign immunity exemptions which the UK Government considers are offered by other, comparable investee jurisdictions.
Second, and perhaps more importantly, over the last few years the UK Government has changed the UK’s tax laws to the effect that essentially all foreign investors in UK real estate, including those who had previously been excluded from UK taxation, are now taxable on the profits derived from their UK real estate investments, regardless of whether the investment is direct or indirect, or through real estate investment funds. Currently many sovereign wealth funds are sophisticated commercial investors and major players in UK real estate. This change is aimed to place non-sovereign investors at an equal footing with sovereign investors.
Conversely, the change to the eligibility criteria is likely to be less of a concern for sovereign wealth funds in practice. One proposal is to widen the exemption by not just including sovereign states, but also federal states within a sovereign jurisdiction (e.g., California and Florida could qualify, in addition to U.S. governmental institutions). It is unclear how impactful this extension would be. Further, while HMRC and HM Treasury (“HMT”) have stated during industry consultations that no grandfathering will be available for existing entities benefitting from sovereign immunity status, it is unlikely that sovereign wealth funds currently benefitting from sovereign status would lose their immunity.
In terms of practicalities, HMRC consider following the U.S. model of the “892” exemption. Section 892 generally provides an exemption from income taxation for foreign governments on passive activity investments and carves out from the exemption income that is derived from the conduct of “commercial activities” or a “controlled commercial entity.” It would appear that the UK consultation on the taxation of sovereign wealth funds would be broader in its scope of taxation of income derived from real estate, since in the UK proposal there is no distinction between passive and commercial activity as it relates to the ownership of real estate.
While HMRC and HMT have stated in discussion that no decision has been taken, it seems highly unlikely that the changes to the taxation of sovereign wealth investors will not be enacted, particularly in the current economic climate. The consultation is closing on 12 September 2022 and expected to proceed regardless of the outcome of the current leadership contest within the UK Government. The changes are scheduled to take effect from April 2024. To prevent retrospective effect, the new legislation is expected to allow for rebasing (i.e., only gains and profits attributable to periods starting from April 2024 would be taxable).
Sovereign wealth investors which are currently relying on the existing sovereign tax exemption for their UK real estate investments, or that are carrying on active trading activities through their London establishments, will need to carefully monitor progress of the consultation and review their investment and operating structures to ensure that other exemptions will be available to them.
Attorney advertising. The material contained in this Client Alert is only a general review of the subjects covered and does not constitute legal advice. No legal or business decision should be based on its contents.
Marco A. Blanco
Olga R. Beloded
+1 212 696 6000
+41 22 718 3500
+33 1 42 68 72 00
+49 69 247 576 0
+44 20 7710 9800
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