Tax and UK commercial property deals – corporate due diligence
Many commercial buildings in the UK held as investments are often owned through special purpose corporate vehicles (SPVs). These can be UK companies or, quite often, offshore incorporated and perhaps ultimately owned by a fund. Holding investment property through SPVs is commercially attractive, as it allows for risks to be ringfenced and asset-specific debt packages to be negotiated and easily secured.
When it comes to transactions, it is quite often the SPV itself that is sold rather than the underlying asset. Commercially, this can be easier as it does not require transfer of leases or service contracts and there is also a saving in transfer taxes – UK commercial property is subject to SDLT (or its devolved equivalent) at rates of up to 5%, whereas the sale of shares only incurs a stamp duty levy of 0.5% (or potentially 0% where the SPV is not a UK company).
Structure of UK real estate investment SPV deals
It is common for corporate transactions in this space to be priced on a net asset valuation model, with the carrying cost of the property asset replaced with current market value. Financial due diligence on these deals, whilst important, can often be relatively straightforward. The property valuation used is a matter for advising surveyors/property consultants and, depending on the number and complexity of leases, the modelling of future cash flows is relatively formulaic. Based on our experience, if there are any issues arising on these deals (away from the property asset itself) it is often the case that these reflect tax risks.
Tax issues and opportunities
Comprehensive tax due diligence is a must on any property investment SPV deal. Issues vary depending on the exact nature of the deal, the structure and tax status of buyers/sellers etc, but there are recurring themes that are critical to review and address.
These include:
Tax base cost
If a property is standing at significant gain in an SPV, the inherent tax liability this gives rise to needs to be quantified. Historic expenditure needs to be reviewed and, if the asset has been held for a number of years, market value as at April 2019 (the date UK commercial property held by non-resident entities came within the scope of UK capital gains) may be relevant.
It is common for any inherent tax liability to be used in price setting for the deal. The well-advised buyer is in a position to have these discussions early on and potentially secure a commercial advantage.
Trading vs investment
How does the special purpose corporate vehicle being bought hold the asset? Is it an investment asset or could it be held, or potentially held, on trading account, i.e. as stock or inventory? The distinction is not always obvious and can be very important for tax purposes. For example, a buyer wishing to acquire an SPV that has held its property asset on trading account, and hold it as an investment may face a significant tax cost if the asset is ‘appropriated’ from stock to fixed assets on acquisition. Again, early identification of this type of issue can provide a commercial advantage.
Tax residence
Many property SPVs holding UK real estate are established in non-UK jurisdictions. Whilst the tax benefits of offshore holdings have been eroded recently, there are still significant potential benefits. A buyer needs to be sure that an SPV purportedly resident in say Jersey, is actually tax-resident there. Tax residence can be a highly subjective point and does not necessarily follow the jurisdiction of incorporation. An early and comprehensive review is essential.
VAT
UK VAT on non-residential commercial properties is reasonably straightforward, although there are of course nuances and things to get right. Property as an asset class is generally exempt from UK VAT unless it has specifically been brought within the UK VAT regime by the current or previous owner. However, historic VAT matters can be extremely important and complex where the underlying asset is perhaps a build-to-rent asset or purpose-built student accommodation that has been constructed by the seller.
It is possible to structure property builds in this space to benefit from a VAT zero rating thus enabling significant VAT recovery, but the planning is not straightforward. We have seen this go wrong in several areas and an ill-advised buyer can inherit significant exposure unless the historic position is checked thoroughly.
Deductions for interest on debt
Many property SPVs are financed by interest-bearing debt. This can be external bank finance, shareholder debt or commonly a mixture of the two. The UK rules around the tax deductibility of interest have increased in complexity exponentially in recent years with the introduction of the corporate interest restriction, anti-hybrid rules and enhanced transfer pricing compliance, etc.
A comprehensive review of prior interest deductions and factoring future debts costs into pricing models is essential. Another important aspect to consider regarding interest is withholding tax. Depending on a variety of factors, property SPVs may be required to withhold UK income tax at 20% on payments of interest. If this has not been done historically or compliance obligations have been missed, potentially significant liabilities can arise.
CIS compliance
The construction industry scheme (CIS) is a regime requiring businesses engaging in significant construction work to assess their contractors and potentially withhold tax from payments. The rules, and more importantly when they do or do not apply, are complex. Errors can be made in CIS compliance, particularly where the target SPV has constructed or spent significant sums on its property asset.
How can Moore Kingston Smith help?
Our real estate and M&A tax teams have extensive experience in structuring and due diligence of property special purpose corporate vehicle deals both on the buy and sell side. We have been involved in transactions as varied as the acquisition of a portfolio of purpose-built student accommodation assets and flagship London office blocks, all held through corporate special purpose corporate vehicles.
We know the critical areas that need to be reviewed and present our work quickly and concisely in a way that helps buyers secure the most from acquisition negotiations. For sellers, we can provide commercial advice on the basis that we know exactly what a buyer will be looking at.
We also know that larger deals are routinely insured using warranty and indemnity insurance. We are experts in making sure that maximum insurance coverage can be provided regarding historic tax matters.
If you are a buyer looking for a cost-effective and expert due diligence provider or a seller looking for an expert adviser, please get in touch.