On 4 July 2022, the UK government surprised tax practitioners and taxpayers alike by releasing a consultation document on the reform of the UK’s rules for sovereign immunity from direct taxation.
Given the extent of UK investment from those benefitting from sovereign immunity – in particular, Sovereign Wealth Funds – the impact of the proposed changes on the UK tax burden on such investors should not be underestimated.
In summary, the consultation considers the following:
- Narrowing the types of income that can benefit from the sovereign immune exemption to UK interest only. In particular, this mean property income, property income distributions (known as “PIDs”) from REITs, capital gains tax on the sale of real estate (including real estate rich SPVs) and trading profits would all become subject to UK tax.
- Bringing sovereign entities within the scope of UK corporation tax, and inpiduals within the scope of income tax and capital gains tax on those types of income and gains above, along with all the accompanying UK filing obligations.
- Broadening the eligibility for sovereign immunity to potentially include entities wholly-owned by states or governments.
- Considering whether government pension schemes would continue to be included in the reformed sovereign immunity regime or whether other exemptions would be appropriate (such as registering as an overseas pension scheme).
- Considering whether sovereign immune investors would still be “qualifying investors” for the purposes of various regimes and exemptions (such as the REIT regime, substantial shareholding exemption, qualifying asset holding company (“QAHC”) regime and non-resident CGT exemption (“NRCGT”) elections).
- Significantly limiting the scope of sovereign immunity from inheritance tax. In order to view our commentary on specific considerations for inpiduals, please see the subheading "Inpiduals" beneath “Implications for specific types of investor”.
The consultation anticipates any reforms to take place from 1 April 2024 (6 April 2024 for inpidual investors), providing investors with significant lead-in time.
However, the consultation itself will close in just over two months, on 12th September 2022. CMS will be engaging with HMRC during the consultation process, putting our views forward as a firm with our client’s interests in mind, as well as working with industry bodies such as the British Property Federation on the same.
Should you wish us to feed anything back on your behalf, or generally discuss the impact of the proposed changes, please get in touch with the contacts listed in this article.
The purpose behind the consultation
In brief, sovereign immunity is a common law principle that one sovereign state should not seek to apply its law to another sovereign state. With respect to tax, this principle has been interpreted as meaning that foreign sovereigns, governments and certain extensions of the state are exempt from liability to direct taxes (corporation tax, income tax and capital gains tax).
Until now, the UK has never opted to codify the doctrine into legislation. Amongst other things, this has meant that the immunity extends to exempt more types of receipt from taxation than in many overseas jurisdictions (a point which is made in the consultation). The government now proposes to narrow that eligibility to passive investment income only. In practice, this will mean narrowing the immunity to interest income, given that the UK does not in general levy withholding tax on pidends.
It is important to note that, while generous overall, the current regime also has its drawbacks.
For example, it is currently accepted that SPVs wholly-owned by overseas states or sovereigns do not benefit from sovereign immunity. This has meant that structures preferential from a commercial point of view are disregarded in favour of transparent structures which allow access to the immunity. In a sign that this position may be reversed, the government welcomes views on granting eligibility for sovereign immunity to corporate entities wholly-owned by states or governments.
Additionally, the lack of clearly defined statutory concepts has led to great uncertainty for taxpayers in this area, who traditionally have had to rely on confirmation from HMRC’s Sovereign Immunity Team on a case-by-case basis.
While the publication of the consultation is a surprise, it undeniably follows the direction of travel towards taxation parity between resident and non-resident investors. As such, while the suggestions are only at consultation stage, the tone and clarity of the proposals strongly indicates that the government is keen to press ahead with the outlined changes.
Reducing the scope of sovereign immunity
While not wishing to downplay the other changes indicated in the consultation, the reduction in the types of receipts benefitting from sovereign immunity is likely to have the greatest impact on sovereign investors.
Should the reforms envisaged by the consultation go ahead, a currently immune non-inpidual sovereign may need to radically reconsider their UK investment strategy, to take into account a 25% (from 1 April 2023) corporation tax rate on the following receipts:
- UK trading income;
- UK property income;
- capital gains tax on UK real estate and UK-property rich companies;
- PIDs from REITs.
In addition to the tax burden, non-inpidual investors will also need to shoulder the administrative burden of corporation tax reporting and filing. It is not yet clear how such practical obligations will be adapted to reflect the difference between a corporate entity and a sovereign person, state, or government. There will be similar administrative requirements for inpiduals in relation to capital gains tax and income tax assessment.
In better news for those currently benefitting from sovereign immunity, the consultation proposes for a rebasing of assets newly within the scope of UK corporation tax to occur on the day the new regime comes into force. Gains which have accrued in such assets prior to 1 April 2024 should therefore not be taxed on disposal, reducing the retrospective impact on sovereign investors.
Increasing the scope of sovereign immunity
As noted above, a positive proposal for sovereign investors is to formally increase the types of entity that can benefit from sovereign immunity, to include controlled entities wholly owned and controlled by the State. This will provide a greater degree of flexibility when choosing investment holding structures.
Further, the government proposes to formally extend immunity to (i) all constituent territories of a federated state and (ii) sovereigns or heads of such constituent territories.
Implications for specific types of investor
Government pension schemes
Perhaps ominously for overseas government pension schemes, the consultation questions whether they should benefit from a reformed sovereign immunity regime.
The rationale given for this is that they may be able to benefit from exemptions via other routes (such as registering as a recognised overseas pension scheme). This is a route that many overseas pension schemes have avoided in the past but may have to reconsider now.
Those benefitting from tax-advantaged or -exempt regimes as (qualifying) institutional investors
It is common for UK tax-advantaged regimes (such as the REIT regime and the newly-introduced QAHC regime) and exemptions (such as the substantial shareholding exemption and NRCGT exemption elections) to remove barriers for access – or loosen burdens associated with obtaining such benefits – for certain types of investor.
These types of investor are generally either defined as “Institutional Investors” or “Qualifying Institutional Investors”. While entities and persons that fall within these definitions change slightly depending on the regime or exemption in question, there are commonalties –pension schemes, insurance companies, charities and certain widely-held collective investment schemes commonly appear. Importantly, those benefitting from sovereign immunity tend to fall within these definitions – and the consultation proposes reconsidering whether this should continue to be the case.
The tone of the consultation suggests that where the definition is used to cater for entities which are widely-held (such as in relation to the REIT regime), then the benefits for those with sovereign immunity should remain. However, where inclusion is related to an investor’s tax-exempt status, the definition is likely to no longer include those with sovereign immunity. This would be the case with, for example, the broader application of the substantial shareholding exemption.
UK inheritance tax is chargeable on the UK situated assets of inpiduals who are not domiciled in the UK. Therefore, a major benefit of the current sovereign immunity regime is that the UK assets of overseas domiciled inpiduals who have sovereign immune status are exempt from UK inheritance tax.
It is therefore significant that the government’s current proposal is to limit sovereign immunity from inheritance tax to UK assets which:
- pass to the successor (as Sovereign or Head of State) of a foreign Sovereign or Head of State; or
- otherwise remain state property.
This will have a particular impact for those who have invested in UK residential property, given that, even where such property is held within foreign SPVs, its value may be caught in the UK inheritance tax net.
It is undeniable that the proposed changes will have a huge impact on the long term investment strategies of Sovereign Wealth Funds – as well as inpidual Sovereigns, royal families and Heads of State.
However, the proposed entry-into-force date of 1 April 2024 does provide impacted investors an opportunity to consider the full repercussions of the changes and what investment structures should be used going forward.
In particular, the UK:
- has a wide range of tax-advantaged regimes such as REITs and QAHCs. With careful planning, it may be possible to restructure investments in order to access the benefits of these regimes, so as to reduce the impact of the proposed changes; and
- has a well-established and wide ranging treaty network. It is anticipated that overseas governments will be able to take advantage of treaty benefits on a wider range of income, where the changed rules cause such income to be subject to tax.
In the meantime, please get in touch if you would like to discuss the impact of the proposals on your investments, or feed into CMS’ consultation response.