Government announces fundamental reform of UK tax treatment of foreign sovereign investors

• From 1 January 2029, foreign sovereigns will be taxed in the same way as other non-residents. Accordingly, they will be subject to tax on income profits from UK land, and, in limited circumstances, UK trades. They will also fall within the scope of non-resident capital gains tax (NRCGT), which applies to direct and indirect disposals of UK land.
  
  
• Exemptions will apply to persons who fall within the new concept of a person with "sovereign tax status" (an STS). In particular, a sub-category of STS, the state-operated overseas pension funds (SOPF), will be exempt from capital gains tax. In addition, STSs will be able to benefit from reduced taxation on investments in UK REITs.
  
  
• STS will, subject to some exceptions, continue to be treated as qualifying (i.e. "good") institutional investors (QIIs) for the purposes of the key fund tax regimes that confer tax privileges on certain entities that have a sufficient proportion of investors who are QIIs (such as that for qualifying asset holding companies (QAHCs)). This should limit the impact of the changes on investors who co-invest alongside sovereigns.
  
  
• Limited transitional provisions will apply, including rebasing assets for gains tax purposes and a time limited SDLT relief for restructurings.
  
  
• The design of the new regime is now being consulted on, and this will be followed by a technical consultation on draft legislation ahead of final rules being introduced in the Finance Bill 2027-28.

Although the new regime will be disappointing for many in the private capital sector, and may require sovereigns to restructure certain investments, it will bring the UK into line with many other major jurisdictions.

• Sovereign investors with UK real estate exposure should undertake a comprehensive review of their holdings to identify assets that will be brought into the UK tax net and to quantify the prospective tax cost, with a particular focus on assets currently held directly or through transparent structures.
  
  
• Many sovereign investors are likely to want to explore restructuring directly held UK property into UK corporate vehicles or REIT structures to access the more favourable tax treatment available under the new regime, in particular, the 15% rate on PIDs available through the "sovereign REIT holding company route".
  
  
• The time-limited SDLT relief and the rebasing of assets to market value on 1 January 2029 create a defined window for restructuring on favourable terms, but taking advantage of these reliefs will require early planning and coordination, including across multiple jurisdictions. The three-year clawback on the SDLT relief for changes of control will also need to be factored in.
  
  
• State-operated pension funds should review the proposed SOPF definition carefully to determine whether they qualify, given the significant capital gains benefit, that flows from SOPF status.

Currently, the UK provides a generous, if slightly shadowy, tax regime for foreign sovereigns. Generous, because it provides a complete exemption from tax on UK source income and gains, and shadowy because it is based on non-statutory principles of international law that have been interpreted by HMRC, with uncertainty as to the exact parameters as to who can benefit.

The generosity makes the UK something of an outlier in international terms, with many other jurisdictions giving sovereigns more restricted relief from direct tax. In particular, it is common for jurisdictions to tax sovereigns on profits from domestic real estate and trades. That being said, until 2019 the UK generally did not tax any non-residents on their UK real estate profits, and so the position of sovereigns was not, in that regard, anomalous.

With "normal" non-residents now within the UK tax net for their UK real estate profits, and foreign sovereigns taking an increasing share of inward investment into UK real estate, it is unsurprising that back in 2022 the last Conservative government considered similar proposals to the current ones. Indeed, many had expected it to plough ahead with them, but in the March 2023 Budget the then Chancellor Jeremy Hunt said that the proposal would not be taken forward.  Although no reason was given, presumably the government was concerned that the policy would undermine the level of inbound investment the country is able to attract.  Clearly, from the Treasury's perspective, the calculus has now changed.

Overview

The taxation of sovereigns will be put onto a statutory footing, with the existing principle of complete sovereign tax immunity being abolished (along with the similar concept of Crown immunity for Australia (and its states) and Canada (and its provinces)).

Under the new rules, foreign sovereigns will be treated in the same way as other non-resident investors, unless a specific exemption applies.  To be able to benefit from an exemption, a non-resident will have to have "sovereign tax status".

In practice, the main impact of the new regime is likely to be on investment in domestic real estate.  This is because returns from other asset classes located in the UK are generally not (or can be structured so as not to be) taxed in the hands of non-residents. Where sovereigns already invest through UK companies, those companies are already subject to corporate tax and so there will be no change.

The regime will have effect from 1 January 2029, but some helpful transitional provisions apply. The design of the new regime is now being consulted on (until 20 January next year), and this will be followed by a technical consultation on draft legislation ahead of final rules being introduced in the Finance Bill 2027-28.

Who is an STS?

The following will be an STS :

• foreign sovereign states (as recognised by the UK government) and constituent territories of federal states – but not municipal authorities;
  
  
• heads of state when acting in a sovereign (and not private or personal) capacity;
  
  
• governments, integral parts of governments, government export credit agencies that are 100% government-owned and organisations fulfilling a government function on behalf of, and which are subject to direction by, a government;
  
  
• sovereign wealth funds;
  
  
• SOPFs – see discussion below;
  
  
• the central bank or currency or monetary authority of a sovereign state; and
  
  
• separate entities incorporated and resident in the foreign sovereign's home country in which the state owns 100% of the shares. 

Sovereign tax status will only be available through a formal application process.  Sovereigns who currently benefit from tax immunity will need to use this process.  HMRC expects to begin accepting applications no later than six months before new rules take effect.

It is welcome that wholly owned entities and constituent territories of a federal state will now be expressly eligible for STS status, rather than needing to rely on the current case-by-case approach adopted by HMRC.

What is an SOPF?

A SOPF will be a new sub-category of STS, with its own standalone definition, that is intended to put state-operated pension schemes in a similar tax position to other overseas pension funds.

Broadly, to qualify as a SOPF, the fund will need to be established abroad under the law of a foreign state or constituent territory of a federal state, and will need to be established and operated exclusively (or almost exclusively) to administer or provide retirement benefits to individuals employed exclusively (or almost exclusively) in the provision of government, public or social services to the relevant state or constituent entity. The "almost exclusively" language will be key for many state-operated pension schemes, and it is hoped that additional clarity can be obtained through the formal consultation process.

The definition, will extend to certain other entities such as national insurance/social security funds and state pension funds for the general population. Helpfully, it will also cover entities or arrangements operated exclusively (or almost exclusively) to invest funds for the benefit of a SOPF e.g. wholly owned subsidiaries.

What is the scope of UK tax charges on STSs?

Non-residents that are not individuals will be subject to tax in the same way as a non-resident company, and subject to UK corporation tax unless an exemption applies.

The treatment of key categories of income and of capital gains is discussed below.

UK source interest

In principle non-residents are subject to withholding tax on UK source interest. However, STSs will benefit from a special tax exemption for UK source interest, with payers relieved from the obligation to withhold tax once HMRC gives authorisation.

Given that it is fairly straightforward to structure financing arrangements to ensure that no tax charge arises, the proposed exemption for STSs from tax on UK source interest is of limited significance.  In many cases, the requirement to obtain authorisation from HMRC for payers to pay gross, is likely to mean existing structural solutions remain attractive.

What is more, the Government does not currently intend to extend the Double Tax Treaty Passport Scheme to STSs, potentially making the process for obtaining authorisation to pay gross cumbersome and possibly requiring separate authorisation in relation to every lending arrangement. Borrowers who have entered into financing arrangements with foreign sovereign lenders will therefore want to review existing finance documents closely to assess the likely impact on their obligations for interest payments and withholding. 

UK source distributions

Non-residents are not subject to UK tax on distributions received from shares held as investments. The exception to this is property income distributions (PIDs) received from UK REITs or property authorised investment funds, which are taxed as UK property (rather than dividend) income.  STSs will be in the same position as other non-residents, subject to a discounted tax rate potentially applying to PIDs they receive from REITs. (For more detail please see "How will the new REIT regime rules work?" below).

UK property income

STSs will be subject to tax on income arising from UK land.  A corollary of this is that they will potentially be subject to the non-resident landlord scheme, which, broadly, requires letting agents or tenants to withhold income tax from rental payments unless the landlord receives HMRC permission to directly account for their UK tax liabilities.

UK trading income

STSs will potentially be subject to tax on their UK source trading income. In practice, this is likely to only arise in limited circumstance – essentially where the STS carries out a UK trade through a UK permanent establishment (or other taxable presence).

One practical example would be where the STS holds a direct interest in a trading UK LLPs, for example, as a result of a "GP stake" deal (an area of the market where we have seen significant uptick in investment from sovereign wealth funds in recent years).

Foreign sovereigns may also need to start thinking more carefully about the dividing line between trading and investment activity, in particular, in the context of lending into the UK. HMRC guidance on the circumstances in which loan origination and other lending activity by investment funds would be treated as an investment activity (published in the context of the UK's QAHC rules) may prove valuable in getting STS investors comfortable here. Similarly, HMRC guidance on the circumstances in which other ancillary activity undertaken by investment funds – such as acquiring and disposing of derivative contracts or crypto assets – that has proved useful for UK pension fund investors, may also be helpful in this regard. For managers, it is prudent to expect additional due diligence in these areas from STSs, and possibly additional side letter comfort will be requested, where there is particular sensitivity.

On a related point, there could also be an issue where, as is not unusual, an STS has a UK based in-house investment management team. In that situation, absent relief, two concerns arise:

1. the UK team could be considered to be a UK permanent establishment (or other taxable presence) of the sovereign, such that any trading profits of the sovereign attributable to the team's activities would be subject to UK tax; and
   
   
2. the UK team is likely to be subject to tax on its own fees for managing the affairs of the non-resident. It is likely that transfer pricing would apply, such that it would be deemed to receive an arm's length fee if one were not actually payable.

The Budget materials are not entirely clear, but appear to address the first of these issues and, possibly, the second one as well.

In relation to the first point, the documents indicate that some form of relief will be available to prevent the presence of an in-house UK management team bringing an STS within the charge to tax.  The UK's existing investment managers exemption may well not apply to an in-house team, so a bespoke provision for STSs would be helpful, albeit it appears to be limited to management of assets located abroad.  

In relation to the second point, the documents are (even) less clear. However, they could be read as saying that there will be an exemption from corporation tax for profits of in-house teams themselves deriving from activities carried on specifically for managing, and for the benefit of, an STS's investment portfolio.

Other UK source income

This is not specifically discussed in the Budget materials, but, in typically fairly limited circumstances, non-residents can be subject to UK tax charges on types of UK source income not discussed above.  This will also apply to STSs.

A possible concern here could be receipt by STSs of management fee rebates, as in certain circumstances these can constitute taxable "annual payments".  Depending on the final scope of the rules, we could conceivably see some sovereign investors looking to opt out of certain management fee waivers, in a similar manner to 892 sensitive investors in the US.

Capital gains

STSs, other than SOPFs, will, like other non-residents, be subject to tax on gains deriving from disposals of UK land or UK property rich vehicles. In addition, if, broadly, they carry on a trade in the UK through a UK permanent establishment, they will be subject to tax on gains arising from that trade or permanent establishment. However, all other capital gains (for example on the disposal of shares in a (non-UK property rich) UK company) will be outside the scope of UK tax.

In order to ensure that SOPFs are put on a level playing field with other overseas pension scheme, SOPFs will benefit from a special exemption from tax on capital gains. This will sit alongside the existing capital gains exemption for "overseas pension schemes". This is an important change from the original 2022 Conservative proposals (given that many state-backed pension schemes may have struggled to meet the UK's overseas pension scheme definition) and it is therefore welcome that the government appears to have taken on board industry feedback in this regard. State pension funds will want to examine the proposed SOPF definition closely to confirm whether they will meet it.

In what circumstances will sovereigns retain QII status?

Recognising the important role that sovereigns play in UK investment markets, and the potential impact that a change in status for sovereigns could have on those that co-invest alongside them, the government has confirmed that STSs will be treated as QIIs for the purposes of most fund tax regimes, including those relating to QAHCs and long-term asset funds (LTAFs), as well as the non-resident capital gains tax rules for non-UK collective investment vehicles.

However, there are two important exceptions:

1. The government is not intending to make any changes to the eligibility criteria for investors in exempt unauthorised unit trusts (EUUT).  This means that investors will remain limited to those who are exempt from tax on chargeable gains (other than because they are non-resident). Therefore, the only STS eligible to invest in an EUUT will be an SOPF.  Clearly, this has the potential to have adverse implications for existing EUUT structures that have STS investors – something which is not addressed by the consultation.
   
   
2. Under the UK's substantial shareholdings exemption (SSE), companies owned by QIIs can benefit from the exemption in a wider range of circumstances than other UK companies.  Under the Budget measures, STSs will remain QIIs for the purposes of the SSE rules but not where the disposing company is disposing of interest in a UK property rich vehicle.  In that circumstance, the STS will only have QII status if it is a SOPF.  This makes sense, otherwise a non-SOPF STS could hold interests in UK property rich vehicles via holding companies which benefit from the SSE - thereby side-stepping the capital gains charge that would have arisen if the STS itself had made the disposal.

Outside of the regimes noted in the consultation, QII status is also relevant under the UK's anti-hybrids mismatch – broadly speaking a hybrid mismatch does not arise if income would have been brought into account by a QII for the purposes of calculating taxable profits but for the fact that the person is a QII. It is currently unclear how the Government intends to treat STS investors for the purposes of the hybrids rules, but our view is that STS should continue to be treated as QIIs.

How will the new REIT regime rules work?

A REIT is a UK corporate fund structure which benefits from an exemption from tax on income and capital profits from its property rental business. However, broadly, it is required to annually distribute, as PIDs, at least 90% of its profits from that business.  PIDs are treated as property income in the hands of investors and are subject to withholding tax – currently at 20% but rising to 24% from next year.

In an effort to balance effective taxation of returns from UK real estate with support for sovereign capital in the UK real estate market, and in a significant improvement to the original 2022 proposals, the government is planning to introduce "bespoke access to a REIT structure which will enable them to hold a controlling interest in a REIT through a UK company while benefiting from a 15% tax rate on property income distributions."

Under the government's plans, STSs will be treated as QIIs for the purposes of the REIT regime, such that substantial holdings by them will not prevent the REIT failing the statutory requirements for having a wide investor base.  However, STSs will effectively be treated as "bad" investors for the purposes of the "holders of excessive rights" (HoER) rules - which, broadly, impose corporation tax charges (at 25%) on REITs that make distributions to certain corporate investors with at least a 10% stake.

Importantly, if the STS does not want an HoER tax charge to arise in the REIT, it can, effectively, choose to bear a 15% corporation tax charge on REIT PIDs.  The proposals here are somewhat complex. To access the discounted rate, the STS must hold a substantial interest in the REIT through a new special form of UK-tax resident company - the "sovereign REIT holding company" (SRHC) – which will be the entity on which the charge actually falls. Distributions from the SRHC to the STS will be treated in the same way as normal distributions, and so should not be subject to tax.

To be a SRHC, a company will need to be wholly-owned by an STS, used only to invest in REITs and notified to HMRC. Its only permitted income will be distributions from REITs (PID and non-PID), together with gains or losses on disposals of interests in REIT shares. The 15% charge will be on the gross amount of PIDs received from REITs with no deductions allowed. The effect of these proposals is that a sovereign will be able to control or wholly own a UK REIT whilst obtaining the 15% rate on property income distributions that is commonly available under the UK's double tax treaty network to other non-resident investors. Sponsors and co-investors with sovereign shareholders in REIT structures will want to assess carefully how these changes could affect their existing structures and to what extent a restructuring of the sovereign shareholder's interest might be required.

Are there transitional provisions?

Two types of transitional provisions will apply. The first type provides reliefs for future tax liabilities by reference to the position before the new regime comes into effect, whereas the second type provides relief for restructurings undertaken by sovereigns to prepare for the new regime.

Capital gains rebasing falls into the first category. There will be a general capital gains rebasing to market value on 1 January 2029 for assets held by STSs newly brought within the charge to UK tax on capital gains. The Budget documents do not discuss whether this general rebasing will be mandatory, or whether sovereigns whose property is currently sitting at a loss will be able to elect out of this, and it appears that there may be slightly different rules where the asset held by the STS is an interest in a UK property rich vehicle. In that case, it appears that it may be possible to elect out of rebasing but, if that occurs and the property is eventually disposed of at a loss, it will not be possible to use that loss to offset other gains. 

As regards the second type, whilst holdings of UK land through UK companies will be unaffected by these proposals, many sovereign investors currently hold UK real estate directly or indirectly through transparent structures so that income and gains accrue to them and fall within the UK's existing sovereign immunity rules. As a result of those returns now becoming taxable, it is likely that many sovereigns will want to restructure their portfolios – for example by inserting a UK corporate holding vehicle or a REIT structure.  To facilitate this, there are two transitional provisions which will provide relief for restructurings. 

1. The first is a time-limited stamp duty land tax (SDLT) relief, which is currently proposed to last "from 2028" to "at least 31 December 2030". 
   
   Helpfully, the relief will apply to real estate held both directly by sovereigns and indirectly, including where the sovereign only holds a partial share of the real estate.  The document also confirms that the relief will apply to acquisitions by qualifying companies and collective investment vehicles (including, UK REITs) held directly or indirectly by STSs.
   
   However, the relief will be clawed back if the purchasing entity is subject to a change of control within three years of the initial transaction. In addition, as SDLT only applies in England and Northern Ireland, it will be up to the Scottish and Welsh governments to decide if they wish to introduce equivalent reliefs for land and buildings transaction tax and land transaction tax.
   
   
2. The second restructuring relief provides protection from the "application of the UK's debt and derivatives anti-avoidance rules in relation to the restructuring of existing UK real estate holdings by those qualifying for sovereign tax status". However, the government intends to include rules to prevent losses on derivatives referable to pre-commencement periods being used in the new regime.

Comment

In these fiscally constrained times, it is unsurprising that the UK is planning to replace the current blanket sovereign immunity for tax on income and gains with a pared-back suite of reliefs, in line with many competitor jurisdictions. 

Although the key planks of the new regime seem fixed, the government appears to be in listening mode as to the best way to design the regime and these proposals appear to be more refined than those consulted on in 2022, with the Government taking on board many of the concerns raised by industry at that time (notably in relation to QII fund status, SOPF gains exemption, REITs and specific transitional rules to facilitate restructurings).  This is good news, as is the fact that the ultimate legislation will be subject to a further consultation. That being said, despite the implementation date (1 January 2029) being some way off, it will important that the new regime is finalised in good time before then, giving sovereigns an adequate lead time to restructure investments and put in place appropriate systems to address any new UK tax compliance obligations.

The main impact of the new regime is likely to be on investment in domestic real estate; however, sovereigns receiving, or potentially receiving, UK trading income (e.g. some GP stake investors)[ER2]  will be impacted too. Affected sovereign investors will therefore want to review their existing investment arrangements and consider what if any restructuring may be required.

The fact that sovereign investors will remain outside the scope of UK tax on capital gains (other than those relating to UK land), interest and dividends and the fact that sovereigns will continue to be treated as QIIs for the purposes of the key fund tax regimes, means that other asset classes in the UK (e.g. private equity, venture and credit assets) are likely to be less directly affected by these proposals, although investors and sponsors of these asset classes will still need to work through some of the second order consequences (for example, in relation to interest withholding, the investment/trading distinction and investor due diligence and side letter requests).  

It will be interesting to see what impact the measure has on inbound investment.  In this regard, the Office for Budget Responsibility, in estimating the yield from the changes (£0.7 billion by 2029-30) takes into account an unspecified "attrition adjustment" which may indicate concerns that the level of sovereign investment in the UK will drop. As the cost of capital for real estate sponsors targeting sovereigns increases, it will also be interesting to see whether enhanced terms (e.g. reduced management fees, favourable carried interest structures etc) are implemented to compensate sovereigns for reduced UK risk-adjusted returns.