UK: What Does the Proposed UK Company Tax Reform Mean for the Real Estate Sector?

Last Updated: 1 October 2002

Over the summer the UK financial press gave considerable coverage to the proposals published by the Inland Revenue in August for major reform of the UK corporate tax regime. In this briefing we look at the implications of the measures for different entities active in the UK real estate sector.

What is proposed?

The changes will only apply to companies. The key proposals are:

  • All profits from the sale of land, buildings, equipment and shares in property investment companies to be taxed as income in line with the accounting treatment, rather than under the current capital gains tax regime. This means, in particular that the allowance for inflation (known as indexation allowance) would be abolished.
  • All other profits and costs associated with land and buildings will also be taxed or relieved as income in accordance with the accounts. This will mean that, from 2005, when UK listed companies will be obliged to adopt international accounting standards, revaluations of real estate assets may become taxable.
  • Tax relief for depreciation to be given in accordance with the amounts and rate at which the expenditure is written down in the accounts, rather than under the existing system of capital allowances.
  • Streamlining the categorisation of income and expenses for tax purposes, which may accelerate the use of tax losses.
  • Closer alignment of the tax treatment of property investment companies and their shareholders with the more favourable tax regime which applies to trading companies and their shareholders. This may include, for example, extending the new exemption for corporate disposals of substantial shareholdings, currently limited to trading companies, to property investment companies. It could also include extending more favourable capital gains tax taper relief treatment to individual shareholders in property investment companies. However, the document does indicate that the favourable rules are unlikely to be extended to "passive" investment companies or their shareholders.

How will the changes affect exempt funds?
The changes will have no effect on exempt funds because exempt funds are not taxed on their return from real estate investments.

Life companies?
The consultation document recognises that life companies need special consideration by virtue of the special tax regime which applies to them. Very little detail is given at this stage. However, the document does expressly state that the proposed tax treatment of gains might be inappropriate for life companies or may at least require modification.

Property investment companies?
Property investment companies are potentially the worst affected entities in the real estate sector:

  • The loss of indexation allowance may significantly increase the taxable profit on the sale of an interest in real estate, particularly where the land has been held for a long period. This may be tempered to some extent by the introduction of a “rollover” relief, which would allow the tax on a sale to be deferred, provided the sale proceeds are re-invested in land and buildings or plant and machinery.
  • A system of depreciation allowances based on the accounts rather than the specific tax rules giving capital allowances for the cost of fittings is likely to have the effect of reducing the allowances which a company can claim in computing its tax liability. Currently, property investment companies claim capital allowances for expenditure on plant and machinery, which includes much of the fit-out cost of a development. However, for accounting purposes, fit-out costs are not generally separated from the land itself. As a result, the cost of fittings is not separately depreciated in the accounts.
  • Where accounting rules require revaluations to be taken to the profit and loss account, revaluations will be taxable at this point. Current UK accounting rules do not require revaluations by property investment companies but international accounting standards do. From 2005, all UK listed companies will be required to comply with international accounting standards. This means that listed property companies may be taxed on increases in value of investment properties, regardless of whether the property has been sold.

On a slightly more positive note:

  • The proposal to streamline the categorisation of income for tax purposes may permit earlier use of tax losses for the following: UK companies with both UK and overseas property interests and UK companies which carry on both a property investment business and a separate trade, whether or not property related. It is possible that this change may also accelerate the use of capital losses made on the sale of real estate.
  • The closer alignment of the tax treatment of investment companies and trading companies may also be beneficial to property investment companies and their shareholders as it may extend the availability of certain reliefs. See final bullet point under “What is proposed?” above.
Property dealing companies?
The impact of the proposals on property dealing companies is likely to be minimal, given that their returns on real estate dealings are already taxed as income rather than capital. As a result, the changes to capital gains indexation allowances and depreciation allowances should have no effect. The relaxation of the loss relief rules may allow property dealers who also carry on another activity (e.g. property investment) to access tax losses earlier.

Non-UK residents?
The consultation document makes no explicit reference to non-residents and this makes it difficult to be definitive in this area. However, the proposals could potentially have a serious impact on non-residents investing in the UK. Currently most non-residents are not subject to UK tax on the sale of UK investment land and buildings. By contrast, non-residents are generally taxed on UK source income. The proposal to tax gains as income could therefore for the first time expose non-residents to a UK tax charge on the sale of UK land and buildings.

What is the timing of these changes?

A transitional regime for the move to an accounts-based system of taxing capital assets is clearly contemplated. The document suggests that companies which acquire assets on or after the commencement date for the new regime would be taxed under the new rules in respect of those assets. Assets already held on the commencement date would continue to be taxed under the existing capital gains regime, unless the company marks the asset to market. This means that companies with long-term interests in land and buildings may be subject to a long transitional period, with compliance cost implications.

The Inland Revenue has indicated that major changes will not be introduced until 2004 at the earliest. Currently it appears that priority is being given, first, to the rationalisation of the categorisation of income, second, to taxing capital assets as income and third, to aligning the treatment of trading and investment companies.

Overall, the document is short on detail in many places, particularly on the implications for life companies and for non-residents. Consultation with business and other interested parties is likely to continue into 2003 and the proposals will almost certainly be refined as a result.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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