Benjamin Franklin famously cited death and taxes as the only two certainties in life. Rather than dwell on the former, Hogan Lovells’ tax partner Elliot Weston considers the impact of recent UK and US tax changes on the structuring of real estate investments
1. New UK interest restriction rules
From April this year, new rules will limit corporation tax deductions for UK corporate borrowers. The ceiling for allowable UK interest expense will generally be 30% of UK EBITDA, subject to a higher limit under a group ratio test. There is to be a limited exemption in relation to third party debt for UK infrastructure companies and for UK property companies holding only UK real estate let for 50 years or less. Problems with this exemption could arise where the real estate is held as partnership property or a parent guarantee is given.
2. Non-UK residents to become subject to UK corporation tax
Non-UK resident landlords, which constitute a substantial part of the UK property investment market, are unaffected by the new interest restriction rules. However, the UK government has announced a consultation on extending the scope of UK corporation tax to include the taxable income of non-UK resident companies. It is likely that one of the consequences of this change in law will be that non-UK resident landlords will also be subject to the UK interest restriction rules, possibly from April 2018.
3. Exempt institutional investors will be advantaged
The new interest restriction rules will not affect institutional investors that are exempt from UK tax on investment income, such as a UK registered pension schemes or sovereign investors. Such institutional investors will be in an advantageous position in pricing property acquisitions as compared with a taxable corporate investor which is subject to interest restrictions. This is because the after-tax return on property income for a taxable corporate investor would be reduced by the corporation tax liability on the disallowed interest, but the return for an exempt institutional investor with the same level of gearing would be unaffected.
4. Encourage equity investment
As a result of the tax differences between equity and excessive debt being removed, we would expect borrowers to look more closely at the availability of equity funding. Once a UK resident borrower has reached the interest restriction ceiling under its existing financing, there would be no difference in tax terms in further financing itself through equity (with dividend payments) rather than debt (with non-deductible interest expense). There has already been a trend since the financial crisis of 2008 away from bank lending and towards more “club” joint ventures (where real estate investment and development is funded by investors). This trend can only be accelerated by the change in tax law to limit the deductibility of UK interest expense.
5. FATCA’s impact on non-US funds investing in real property
The Foreign Account Tax Compliance Act is a set of US rules targeting US taxpayers using foreign accounts. FATCA imposes a 30% withholding tax on recipients of certain “US source payments” unless the recipient is FATCA-compliant. Steps to become FATCA-compliant depend on whether the recipient is a foreign financial institution or non-financial foreign entity, and can involve reporting obligations for FFIs (similar to the requirements under the OECD’s Common Reporting Standards). This is particularly relevant for non-US funds investing in real property (whether or not in the US) using investment-type entities and holding company structures (such funds are often considered FFIs because they invest in “financial assets” rather than directly in real estate). Real estate investment fund structures should be reviewed to determine the impact of FATCA (and the CRS).
