DLA Piper's Full Sovereign Immunity Consultation Response

The consultation

1. On 4 July, HM Treasury published a consultation on the UK's sovereign immunity from direct taxation (the Consultation), which proposes to limit the existing sovereign immunity regime, as it applies to sovereign investors. The proposal, if adopted, would mean that sovereign immunity would be limited to providing exemption from UK withholding tax (WHT) on receipt of passive UK sourced interest income. Sovereign immunity on all other income and gains which under current rules provides an exemption on direct tax, would be disapplied.

DLA Piper's response

UK real estate

2. It is important to acknowledge that it is the elected UK government's sole right to choose the level of taxation. This is ultimately a political question.

3. As the Consultation points out, sovereign investors favour acquiring and developing UK real estate. It is important to recognise that sovereigns play a vital role in providing much needed investment into the UK economy, in particular in the UK real estate sector. Such investment provides good quality housing and commercial property across a range of sectors boosting the country's infrastructure in important areas such as logistics, student housing and life sciences which boosts both the local and national economy. In addition, acquisition and development of new property and refurbishment of existing property creates jobs across many sectors of the UK economy.

4. In addition, the level of taxation is only one of the factors that a sovereign will consider when looking at investing into a jurisdiction. In the post-Brexit era, and at present with one of the highest rates of inflation across the developed world, the UK faces significant economic and geo-political challenges. Some of our US clients in particular have also mentioned to us that doing business in the UK is often more a cumbersome process than in other jurisdictions, such as the US. In addition, numerous changes to UK tax legislation over recent years has led to one of the most complex tax regimes in the world, in particular with respect to UK real estate. Removing sovereign immunity, with respect to all aspects of UK real estate profits, will be another drawback to investment into UK real estate.

5. Sovereign investment affects direct investment (ie whereby sovereigns wholly own UK real estate directly / indirectly) but also investment through third parties such as Fund managers (otherwise known as Sponsors).

6. A number of our sovereign and Fund manager (with sovereign investors) clients have confirmed that if the Consultation proposals are adopted in the form proposed in the consultation document, it would almost certainly affect underlying returns on UK investments, and this would therefore lead to a reduction of future inbound investment into UK real estate.

Other jurisdictions

7. As the Consultation highlights, it is important to consider how other jurisdictions tax sovereigns. The Consultation sets out (at p.8) the benefits provided to sovereigns in other jurisdictions. We have carried out our own review in conjunction with our colleagues in the relevant jurisdictions.

8. As the Consultation notes, in France sovereigns are eligible for exemption on WHT on dividends and on capital gains tax if a ruling is approved by the French Tax Authorities.

9. Furthermore, other jurisdictions provide sovereigns with exemptions to tax to the extent that they hold a minority (passive) interest in the target entity. Most notably, in the US there is an exemption from WHT on interest and dividend payments, and exemption from capital gains tax, to the extent that the sovereign holds less than 50% in the entity. In Italy the minority shareholding in the entity must be below 20% to obtain capital gains exemption, and in Australia the minority shareholding must be below 10% to obtain full exemption. Although these jurisdictions do not provide a comparable sovereign immunity regime to the UK, there are exemptions for sovereigns holding a minority, passive interest in the relevant entity.

10. Finally, some jurisdictions, such as the Netherlands, rely on extensive provisions in Double Tax Treaties (DTT) to provide sovereigns with exemptions to WHT.

Sovereign immunity under current law

11 In a real estate context, there are a number of activities that a sovereign can carry on:

(a) Operating and development activity (ie at the Manco / Operator level)

(b) Trading eg dealing / developing land (ie the entity acquiring and disposing of the land)

(c) Rental income

(d) Gain on exit

The list above sets out (in descending order) a range of activities that a sovereign can carry out. The activities that most resemble commercial activities are operating and development profits (eg where a group entity is paid a fee for activities by the managers of managing a portfolio and / or development of the land) and trading profits (such as development and / or refurbishment of UK real estate itself). On the other end of the spectrum, activities that least resemble commercial activities is the passive holding of real estate as an investment and receipt of rental income, with the possibility of a capital gain on exit. Under current rules, sovereigns are immune from all UK tax on such profits.

Approach to the Consultation proposals

12. Trading vs investment: to the extent that HM Treasury is looking to limit the extent of sovereign immunity (whilst noting our comments above), in a UK real estate context there is greater rationale for retaining sovereign immunity relating to passive investment (rental income and capital gain) as compared to commercial activities (operating and development profits, and trading profits). Furthermore, the Consultation sets out that the extent of sovereign immunity should, under the proposals set out therein, be limited to WHT exemption on UK source interest, as this represents a pure passive investment. It is less clear why passive holding of commercial real estate and receiving rental income and capital gain on exit (for example receiving dividends from a REIT), or receiving returns from investment in a real estate Fund (and therefore relying on the SSE QI I test, see below) is materially different.

13. Minority interests: should HM Treasury also look to reduce sovereign immunity with respect to property investment (rental income and capital gains), as well as commercial activity, instead of completely eliminating sovereign immunity in the real estate context, consideration should instead be given to adopting the US model, whereby a sovereign holding a less than 50% shares has the benefit of sovereign immunity (known as a s.892 exemption) from WHT on interest, dividends and an exemption from capital gains tax.

14. Grandfathering: to the extent that the Consultation proposals are adopted, grandfathering provisions should be put in place to ensure that sovereigns can retain the benefit of sovereign immunity with respect to existing structures in which they hold real estate investments. As an alternative, and to help prevent sovereigns from disposing of their existing investments in the short term, sovereigns should be provided an exemption or relief from indirect taxes (SDLT and VAT) to allow them to restructure their investments UK real estate investments, particularly where the tax treatment of a holding structure is adversely impacted as a result of the proposed changes (we are thinking here of the potential impact on structures such as REITs which may have been created in reliance on, for example, Institutional investor status).

15. UK REITs: under current rules, sovereigns have two separate benefits when investing in UK REITs:

WHT on distributions: Investors in UK REITs are subject to WHT on dividends at the rate of 20%, subject to applicable domestic exemptions to certain investors and reduction under applicable DTT. Under current rules, sovereigns are entitled to a refund from HMRC of all WHT. Please see above our proposals on the priority order of changes that should be made to sovereign immunity (investing in a REIT which in turn holds property as an investment should, in our view, be treated more like a passive investment in securities, rather than a commercial activity).

Furthermore, and if pursuant to the Consultation, sovereign immunity would no longer apply to WHT on REIT distributions, consideration should be given to providing a reduced WHT rate (eg to 15%) on the basis that sovereigns will in many jurisdictions not fall within the requisite DTT definitions. This reflects the position that DTT were not negotiated to provide favourable terms to sovereigns as the expectation had been that sovereigns were fully exempt from UK tax. The 15% WHT rate is the tax rate that the vast majority of overseas tax paying investors are subject to.

Eligibility criteria: as part of their eligibility criteria, a REIT must not be a close company, unless, broadly, at least 50% of shareholding in a REIT is held by 'institutional investors' (Condition D). Under current REIT rules, a sovereign is treated as an 'institutional investor'. If, as an outcome of the Consultation, sovereigns lose 'institutional investor' status, this would cause a number of REITs to fail their Condition D eligibility criteria. Further to conversations with HM Treasury and HMRC we understand that the concern with allowing sovereigns to retain 'institutional investor' status is that this would permit sovereigns to 'roll up gains' in REIT structures without paying tax on such ongoing disposals (until profits are finally extracted by way of a distribution and subject to WHT). This is because under current REIT rules, there is no requirement to distribute capital gains (unlike rental profits).

Whilst we agree that this provides sovereigns with a tax advantage, it would still mean that sovereigns would pay tax when capital gains are eventually distributed to sovereigns (assuming that sovereigns would be subject to WHT, see above). If this is not acceptable to H M Treasury, and as an outcome of the Consultation sovereigns are subject to WHT on dividends from a REIT, our proposals below set out a number of suggestions to counter the concern of sovereigns 'rolling up' capital gains:

• no change to existing REIT structures - as mentioned above, so that any changes should only apply to future REIT structures,
• REITs with a sovereign holding less than a 50% shareholding should allow that sovereign shareholder to be considered an 'institutional investor' (in line with the approach sovereigns holding less than a 50% shareholding should not be subject to tax), and / or
• REIT structures that elect to distribute a percentage of their capital gains within an agreed time period (and any such proposal should take into account legitimate concerns with respect to how the REIT invests proceeds), should benefit from sovereigns having 'institutional investor' status and remove the concern around long term roll up of gains.

16. SSE QII: with respect to the substantial shareholding exemption (SSE) as it applies to qualifying institutional investors (QII), under current rules sovereigns benefit from QII status. Although there is undoubtedly a correlation between how sovereigns are taxed on their own capital gains and whether sovereigns have QII status, even if sovereigns are subject to tax on capital gains on disposals of UK real estate, consideration should be given to providing exemption pursuant to the SSE QII test on minority shareholding interests in the disposing entity (ie less than 50% shareholding).

Who is a sovereign?

17. We welcome the amended definition of a sovereign to include constituent territories of a federated State to be eligible for immunity from tax. As the consultation explains, this would remove the need for the current case-by-case consideration. It would therefore have the benefit of being simple to apply, easily understood by those affected, and, in addition, in line with the approach currently taken for Crown immunity. In addition, the current approach to granting sovereign immunity status is in some respects contradictory - it is difficult to understand why under the current regime, in some jurisdictions constituent states are each entitled to benefit from sovereign immunity whereas in other jurisdictions (such as the USA and Australia) the constituent states cannot benefit from sovereign immunity. This would also align the UK with many other jurisdictions which extends sovereign immunity to constituent territories of a federated State.

At the same time, the benefit of extending the scope of sovereign immunity to constituent territories of a federated State, should not come at the expense of losing the benefit of the current immunity benefits. The Consultation's proposal to limit sovereign immunity to WHT on UK sourced interest provides only a marginal benefit.