Taxation of UK development profits – The new world
Sheltering under the eaves of the Finance Bill 2016 are various changes to the way in which profits from trading in UK land are taxed. This bumper edition (I’m feeling generous) will summarise the law to-date and the effect of these changes.
Capital vs. income
Key to understanding this issue is to recognise the difference between capital and income. If you acquire property (or any asset, for that matter) with the intention of long-term investment – the classic being a ‘buy-to-let’ scenario - then, when you eventually sell, the profit will be treated as a capital gain. Until April 2015, non-resident investors could generally avoid CGT on gains on UK land and property. Now we have ‘non-resident CGT’, but this only applies to residential property – for some reason commercial property gains are still tax-free for non-residents. However, if you acquire property with the intention of selling it quickly at a profit, or if you buy land, develop it and then sell the resulting properties then you are trading and your profit will be treated as income. The problem is that, as you will see below, there has never been an exemption from income tax for non-residents.
If you trade in UK property then you are liable to income tax, whoever you are. This includes non-resident companies that trade in the UK, which confuses a lot of people as they think companies are only liable to corporation tax, but they can be liable to income tax too. This is exactly the kind of fascinating factoid that tax lawyers like to bore people with at parties, which is why we rarely get invited to parties (or at least, invited back).
The only way to shake off this income tax liability is through the protection of a double tax treaty. So read on and I will tell you all about these little beauties.
Double tax treaties
Tax lawyers love tax treaties as much as they love parties, but since we never get invited to the latter we spend an unhealthy amount of attention on the former. As noted above, in order to avoid the income tax charge on UK trading profits you need a treaty. For curious and somewhat anachronistic reasons, the UK has treaties with the Isle of Man, Jersey and Guernsey. I say curious because we have no treaties with any other ‘tax havens’ for the obvious reason that the UK would have nothing to gain and everything to lose. Nonetheless, these treaties exist and have been widely exploited over the last few decades to completely avoid income and corporation tax on development profits from UK property.
The trick was to set up a company in a treaty jurisdiction, like Guernsey, and that company would acquire land in the UK to be developed. Provided the company avoided creating a ‘permanent establishment’ in the UK – which was achieved by the creative use of contracts with connected parties in the UK – then the profits would be ‘taxed’ in Guernsey. Of course, there is no tax in Guernsey, which means that the developer avoids all taxation. Quite understandably, this greatly antagonised our friends at HMRC – so much so that they planned a highly secret and audacious mission to redress the balance, the fruits of which were revealed on 16th March 2016.
The 16th March bombshell
It turns out that HMRC sent senior officials in ‘plain clothes’ to the islands in order to secretly re-negotiate the offending treaties. Normally treaty re-negotiations are messy, long drawn-out and rather public affairs. Quite how HMRC managed to do all this in complete secrecy is one of life's great mysteries.
On 16th March the Chancellor announced that the three treaties with IOM, Jersey and Guernsey had all been renegotiated and the amendments would take effect from that day! This caught us all by surprise, which I’m sure was the intention. The amended treaties reserved taxing rights over UK property to the UK, meaning that the fun and games with non-resident companies would come to an end. Or so they thought…
The Chancellor also announced a raft of new legislative measures both to forestall the Finance Act and to prevent ‘abuse’ in the future. Intriguingly, one measure, with immediate effect, was to prevent developers from unloading property before the new Finance Act came into effect. However, HMRC did not publish the rule in question, leaving us to stare at the tea leaves left over from the Budget press releases in an attempt to divine some meaning from them. Whether this lack of clarity was deliberate on the part of HMRC is anyone’s guess, but the effect was to make people think twice about any connected party transaction between 16th March and 5th July (which is when the new legislation came into effect).
The 5th July legislation
The new measures are in three parts: (a) the territorial scope of corporation tax is widened, (b) ditto for income tax and (c) we have new ‘transactions in securities’ (TIS) rules.
The first two of these are essentially treaty overrides, intended to ‘switch off’ Section 6 TIOPA 2010 (which gives domestic effect to treaties), but only for arrangements entered into after 16th March 2016. Therefore existing structures will not be affected, although if they are situated in the IOM or the Channel Islands then because of the amended treaties, which take immediate effect from 16th March, you will find that when your existing structure makes a profit you will not be able to get any treaty protection.
Finally, the TIS rules have been amended to catch shares in companies that deal in or develop UK land.
What does this all mean
If your existing structure is in the IOM or Channel Islands then it looks like you will be caught by UK tax on your profits when they are realised. However, if your structure is in another treaty jurisdiction (and there are a few) then you will be relieved to know that the treaty override should not apply to you. Of course, any new structures will be caught by the override.
So, what will future structures look like?
They will look very domestic indeed: the brace of new legislation is probably good enough to prevent most non-resident traders/developers from using offshore structures to avoid UK income tax. I would expect, instead, for UK companies to be used, bearing in mind that the main rate of UK corporation tax is due to be reduced to 17% by 2020. Bear in mind that in Northern Ireland the rate will drop to 12.5% by 2018 and that because NI is still part of the UK the anti-avoidance measures described above will not apply.
Non-residents still need to consider other tax considerations, as non-resident companies were also used for IHT protection and, given that we are likely to see an IHT ‘look through’ (see Issue 16) from 2017, this has got much harder. I suspect that we will see more inventive use of intra-group lending in order to reduce the equity in the new UK vehicles, thereby reducing the IHT exposure.
If you are attached to the idea of using treaties to avoid UK tax on UK property trading then I suggest you get unattached pretty soon. It looks like that particular fox has finally been shot. That is not to say that your opportunity for tax planning has ended but, as always, it’s getting more difficult. There could be some mileage in the Northern Ireland route – HMRC has just issued a guidance note on how the ‘NI rate’ will be applied and, if you are lucky, I will examine this in a future issue.
In the wake of Brexit, the UK has to get more competitive, so perhaps repatriating structures isn’t so bad if the tax rates continue to plunge.
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