Sovereign immunity from direct taxation: Consultation on policy design

The UK Government has issued a consultation which sets out a revised approach to sovereign immunity from direct tax.

The UK Government has issued a consultation which sets out a revised approach to sovereign

The UK Government has issued a consultation on 4 July 2022 which sets out a revised approach to sovereign immunity from direct tax. The consultation could result in sovereign persons’ income and gains from UK immovable property and income from UK trading activities being brought within the scope of UK tax. This would have a wide-ranging impact on natural persons and non-natural persons claiming sovereign immunity, for example government departments and agencies, central banks, government funds such as sovereign wealth funds and social security funds and government pension schemes. The stated aims are to introduce legislation which will provide transparency and clarity on the principle of and conditions for sovereign immunity and to strike a balance between supporting investment in the UK and delivering fairness between different participants in the UK market.

The consultation process and timing

The consultation process closes on 12 September 2022. The Government will be consulting relevant stakeholders and interested parties on the proposals through meetings during the consultation period. Parties who would like to be included in a consultative meeting are being asked to request this via the email address before 25 July 2022.

In line with the UK’s tax policy making process, the Government would seek to publish draft legislation for technical consultation ahead of the inclusion of the legislation in a future Finance Bill.

It has been proposed that the new rules will apply from 1 April 2024 to income recognised in accounting periods ending on or after that date for entities chargeable to Corporation Tax, and from 6 April 2024 to sovereign natural persons. Apportionment rules would apply where a sovereign entity’s accounting period straddles 1 or 6 April 2024.

Key considerations

Eligibility and scope

The consultation document (Condoc) acknowledges that a more targeted approach to exemption goes hand in hand with a broader approach to eligibility. A clearer view on who qualifies for sovereign immunity is a likely outcome of the consultation, for example the Condoc proposes that all constituent territories of a federated State will be eligible for immunity but not municipal authorities.

Potential impact on Direct Investment returns

Sovereign investors have long enjoyed exemption from UK taxation on rental income and gains derived from direct investments in UK real estate and investments made through transparent vehicles such as partnerships. The transparency and exemption elections included within the Non-Resident Capital Gains Tax rules also made it possible for sovereign investors to achieve the same result through investment via a Jersey or Guernsey property unit trust. The proposals would result in sovereigns no longer benefitting from exemption from UK tax and would arguably make investment in UK real estate less attractive.

Direct Private Equity & Infrastructure investments, commonly, take the form of equity and debt investments in UK companies. Therefore, investment returns are typically in the form of dividends, interest income and, on exit, capital gains on the disposal of equity. There is no domestic withholding tax (WHT) on UK dividends, so this position will not be impacted. The Condoc indicates that the UK Government is looking to retain sovereign immunity on UK source interest income. In respect of capital gains on exit, the Condoc outlines the desire to retain the broader Substantial Shareholding Exemption (SSE) introduced in 2017, for companies owned by Qualifying Institutional Investors. Finally, the UK Government does not wish to undermine the attractiveness of the new Qualifying Asset Holding Company regime (which provides for further relaxations on existing interest WHT and capital gains exemptions) by removing sovereign immune persons from the list of qualifying investors.

Potential impact on Public investment returns

No WHT applies to UK sourced dividends so distributions from ordinary listed shares will not be affected.

Interest is subject to a 20 percent WHT rate, but the Condoc indicates that the UK Government is looking to retain sovereign immunity on UK source interest from passive investments such as listed bonds. The domestic quoted Eurobond exemption would continue to apply, in any case.

Real Estate Investment Trusts (REITs), however, make property income distributions (PIDs) which are taxed at 20 percent under UK domestic law. Sovereigns are currently able to reclaim the WHT on PIDs but in the absence of sovereign immunity it would be necessary to look to tax treaties to reduce or eliminate the rate of WHT applied.

Potential impact on UK office/branch activities

Sovereign immunity has largely kept UK office/branch activities out of the scope of UK direct tax. However, if a Foreign Government has a UK nexus, additional tax implications will need to be considered such as the permanent establishment rules and the complexities around transfer pricing and how to attribute profits for the purposes of UK corporation tax.

There will be extra emphasis on whether the activities of investment managers and other agents could create a taxable presence in the UK, to the extent a strategy is trading, and whether the Investment Manager Exemption applies.

Tax privileged investment structures and regimes

Careful consideration will be given to the status of sovereign immune investors investing via tax privileged structures or making use of regimes which have thresholds for qualifying investors. The examples given are REITs, the SSE, the Qualifying Asset Holding Company Regime, Long Term Asset Fund, Exempt Unauthorised Unit Trusts and Collective Investment Vehicles holding real estate.

How KPMG can help

We will be actively engaging in the consultation. Please let us or your usual contacts know if you have any questions on the potential impact of any of the proposed changes.