Investing in UK residential property: navigating the tax maze
The UK residential real estate market remains attractive to overseas investors. However, navigating the UK taxation of making such an investment requires careful investigation and advance planning.
Recent years have seen significant increases in the taxation of residential property, in particular higher rates of stamp duty land tax (“SDLT”) for overseas buyers, greater exposure to capital gains tax and inheritance tax and of course the Annual Tax on Enveloped Dwellings (“ATED”), which affected many existing companies holding residential property.
The introduction of HMRC’s Trust Registration Service in 2017 has resulted in the registration of trusts holding UK real estate and this has been expanded as a result of the 5th Anti-Money Laundering Directive to bring more trusts within the scope of registration.
Following Russia’s invasion of Ukraine earlier this year, the government swiftly introduced the Register of Overseas Entities (brought into force by the Economic Crime (Transparency and Enforcement) Act 2022), which requires the registration of overseas entities holding UK real estate (residential, commercial or otherwise) and their beneficial owners.
This has all resulted in the taxation and compliance burden of owning residential property becoming so much more complicated and harder to navigate than it has ever been before.
Different ownership options for UK residential property
There are several different options for structuring the ownership of UK residential property and the most preferable option will depend on the circumstances of each case and how the property will be used.
Due to the introduction of ATED and changes to the inheritance tax rules in 2017, purchasing residential property through an offshore company is no longer as attractive as it once was.
If the property is rented out to third parties on a commercial basis, relief from ATED will be available (section 133 Finance Act 2013), but a return must still be filed and the relief claimed every year. Since 6 April 2020 non-UK resident companies have been liable to corporation tax on rental income (currently 19%), which can be a more complex computation than for the income tax charge that previously applied.
Under paragraph 2, Schedule A1 Inheritance Tax Act 1984 (“IHTA”), the value of the company will be within the scope of inheritance tax as its value will derive from UK residential property.
A 15% flat rate of SDLT applies to acquisitions of high value residential property by companies where the property is intended to be occupied for personal use (there are some exceptions, e.g. where the property is acquired to form part of a commercial rental business). Where the property is acquired by an offshore company, or, in certain circumstances, a UK company which is under the direct or indirect control of non-resident persons, a 2% surcharge will be added, so that the rate becomes 17%.
Corporation tax will be due in respect of any gain arising on a future disposal of the property, but capital gains tax can apply instead if there is a disposal of the company and it is “property rich” (broadly at least 75% of its value derives from UK land – Schedule 1A Taxation of Chargeable Gains Act 1992).
This is now a simple option for many overseas buyers and ATED will not apply. Inheritance tax will apply to the value of the property at 40% over the owner’s available nil rate band of £325,000, but this tax exposure can be mitigated through the use of loans and/or life insurance.
With borrowing, it is generally advisable for the lending to be put in place at purchase to ensure that there is a deduction for inheritance tax purposes. If the borrowing is put in place at a later stage there can be problems with deductibility under the provisions disallowing liabilities attributable to financing excluded property under s.162A IHTA. However, if there are plans to undertake development of the property, financing put in place at a later date to pay for these improvements may be deductible.
An English Will is required to deal with the property devolution on death. Joint ownership can often assist with inheritance tax planning. For some families a viable option is to have several members purchase the property so that the inheritance tax exposure can be spread across several people and generations, although care must be taken to avoid falling foul of anti-avoidance rules relating to gifts and reserved use.
If the property is rented out, the owner(s) will be liable to income tax on the rental income at their marginal tax rates of 20% to 45%.
The usual SDLT rates currently payable on an acquisition of residential property by an individual owner are set out in the table below:
|Purchase price (£)||Rate of tax (%)|
|Up to 250,000||0|
|250,001 to 925,000||5|
|925,001 to 1,500,000||10|
An additional 2% surcharge applies to each of the above rates to non-UK resident buyers who purchase property over £40,000 and a further additional 3% surcharge is levied (again to each rate of tax above) where the purchaser owns existing residential property in the UK or elsewhere in the world (or is married to someone who does). This takes the top rate of SDLT, on the part of any purchase price that exceeds £1.5m, to 17%. Where several buyers are purchasing the property, the 2% and 3% surcharges will apply if any one of them meets the relevant criteria.
It should be noted that the UK resident test for SDLT purposes is slightly different to the Statutory Residence Test. An individual will be UK resident if they are present in the UK on at least 183 days in a continuous 365 days period beginning with the date that is 364 days before the effective date of the transaction (generally this is the date of completion) and ending with the day that is 365 days after the effective date (paragraph 4, Schedule 9A Finance Act 2003). There is a favourable rule for spouses where only one spouse is non-UK resident. If one spouse meets the 183 day requirement and is UK resident at the date of completion of the purchase, the non-UK resident spouse will also be treated as UK resident provided they purchase the property jointly.
Relief from the 3% surcharge may be available where the purchaser is replacing their only or main residence. If the purchaser has not yet sold their existing main residence at the time of purchasing the new property, the 3% surcharge will be payable, but can be claimed back provided the following broad conditions are met:
- when the new property is bought, the purchaser intends it to be their only or main residence;
- the purchaser sells their existing main residence within 3 years of purchasing the new property; and
- within the 3 year period ending with the purchase of the new property, the existing property has been their only or main residence.
Non-Resident Capital Gains Tax (“NRCGT”) at 18% to 28% will be due on any gain realised on a future disposal of the property, subject to the availability of principal private residence relief.
Instead of personal or corporate ownership, an offshore trust could be used to purchase the UK property. As with personal ownership, ATED will not be applicable.
Inheritance tax charges would apply at a maximum rate of 6% on each 10 year anniversary of the trust (with periodic charges potentially applying if non-excluded property leaves the trust between 10 year anniversaries). However, the inheritance tax exposure can be mitigated through borrowing. As with personal ownership, it is advisable for this borrowing to be in place at the outset of the purchase in order to ensure a deduction is available and to avoid the application of s.162A IHTA.
Unless the settlor is irrevocably excluded from benefit and pays commercial rent for occupying the property (or uses it only very occasionally – up to 2 to 4 weeks a year according to HMRC’s guidance at IHTM14333), the gift with reservation of benefit rules will apply and the value of the property would be included in the settlor’s estate for inheritance tax purposes. Being excluded from the trust means that this may not be an attractive option for purchasers unless they are buying real estate for family members to use or real estate that is going to be rented out on a commercial basis.
If the property is rented out, the trustees will be liable to income tax on the rental income, typically at 45%, although the settlor may become liable to income tax if they are already or become UK tax resident.
Trustees of discretionary trusts will always pay SDLT at the additional 3% rates and non-UK resident trustees will also be liable to the 2% surcharge. However, these surcharges may not apply if a UK resident beneficiary has a life interest in the trust. Depending on the circumstances, planning could therefore involve giving a beneficiary who plans to occupy the property a life interest under the trust in order to achieve an SDLT saving.
In the low interest rate environment we have enjoyed for many years, funding UK property purchases and offshore structures with bank debt has traditionally been considered an attractive option. Provided they are structured correctly, the borrowing will reduce the value of the property for inheritance tax purposes. Where properties are owned by companies and have been rented out, the interest payments are an allowable deduction against profits for corporation tax purposes.
However, the increasing cost of borrowing means that now may be an appropriate time for exploring other options, particularly where settlors (in the case of offshore trusts) or shareholders (where there are offshore companies) have offshore funds that they can use to fund the structures.
It is important to weigh up the annual interest charges under bank loans against the inheritance tax saving. For trusts this will involve considering the 10 year charge and how much it would increase if the trust were funded with cash rather than debt. Surprisingly, it may now be cheaper to pay an increased inheritance tax charge every 10 years than to fund potentially significant annual interest payments. However, where the bank borrowing has been taken out by an underlying company, there is scope for planning around the 10 year anniversary charge by increasing the borrowing before then.
Other options can include funding a company with shareholder loans and considering charging interest on these in order to secure a deduction from rental income. The risk of the interest being UK source and therefore liable to 20% withholding tax would need to be considered carefully in light of the particular circumstances. This is in addition to ensuring the Non-Resident Landlord Rules are complied with and the company does not fall foul of profit shifting rules given the OECD’s focus in this area.
However, care needs to be taken with regard to loans made to individuals, trustees and partners that are used to purchase or improve UK residential property (defined as “relevant loans” in Schedule A1 IHTA). The receivables in respect of such loans will be treated as UK situated assets in the lender’s estate for inheritance tax purposes both while the loan is outstanding and for 2 years afterwards (paragraphs 4 and 5, Schedule A1 IHTA).
NRCGT at 28% will be due on any gain realised on a future disposal of the property, subject to the availability of principal private residence relief if a beneficiary has been occupying the property as their only or main residence.
The Collateral trap
It is not uncommon for lenders to require borrowers to provide offshore assets as security or collateral for loans. However, this can expose non-UK resident borrowers and UK resident remittance basis users to potentially significant UK taxes.
Under Schedule A1 IHTA assets offered as security, collateral or guarantee for a relevant loan will be treated as non-excluded property. It is extremely important to review carefully the documentation for a bank loan to ascertain the extent of any security required from the borrower and therefore the extent of their inheritance tax exposure. The exposure to inheritance tax of the assets offered as security will be capped to the value of the loan.
There was a change in HMRC’s guidance in 2021 that can catch remittance basis users in the UK, who have provided foreign income and gains as collateral for offshore borrowing. HMRC used to take the view that, provided the foreign income and gains given as collateral were not used to repay or service the debt, they were not remitted.
However, this view changed in 2014 when HMRC announced that foreign income and gains used as security would be treated as remitted. The deemed remittance was capped up to the amount of the borrowing or, if less, the amount of the borrowing brought into the UK. Between 17 December 2020 and 21 July 2021 HMRC expanded their position in the Residence, Domicile and Remittance Basis Manual. They now state that (at RDRM35050 and 37050) , if the entire borrowed funds are brought into the UK, all the foreign income and gains used as collateral will be treated as remitted, even if these far exceed the amount of the loan. A cap only applies if not all of the loan is brought into the UK and in this case the remitted funds are limited to that amount (s.809P(10) ITA 2007).
The Trust Registration Service
Trustees of trusts holding UK real estate will need to consider their reporting obligations under HMRC’s Trust Registration Service, which now applies to a wider variety of trusts following changes introduced by the Fifth Anti-Money Laundering Directive. Non-taxable trusts are now caught if they acquire a direct interest in UK land.
Information about the trust and its beneficial owners must be provided and must be kept up to date. Information on the Register is generally only available to HMRC and law enforcement bodies, but certain requests for information can be made by others, including those investigating money laundering/terrorist financing or where trusts have registered a controlling interest in a third-country entity.
The Register of Overseas Entities
Overseas entities that hold UK land must register on the Register of Overseas Entities by 31 January 2023. In addition, overseas entities that acquire UK land after 5 September 2022 will not be able to register the legal title at the Land Registry or otherwise deal with the property unless they are registered.
Information to be disclosed includes details of certain beneficial owners, generally if they own more than 25% of the shares/voting rights, but interests of co-shareholders can be amalgamated in certain circumstances. Other beneficial owners can be required to register if they are able to exercise significant control or influence over the entity or have the right to appoint or remove a majority of the board of directors. Certain information on the Register will be publicly available. Detailed guidance about the extent of disclosure for trust beneficiaries as ultimate registrable owners is awaited.
The acquisition of UK residential property is a complicated area, as this article has shown. Before purchasing such property, it is highly recommended that buyers obtain professional advice to ensure that they do not inadvertently expose themselves to unexpected UK tax charges.
This article first appeared in The Tax Journal in January 2023.