20 August 2022
The Government issued a consultation document on 4 July 2022 regarding broad reform of the UK’s approach to sovereign immunity from direct taxation.
The principle underlying sovereign immunity is that a sovereign state should not seek to apply its laws to another sovereign state. Under this principle, the existing UK sovereign immunity regime provides, broadly, that trading income, rental income, interest, dividends and chargeable gains are all exempt from UK tax in the hands of sovereign immune persons.
The consultation is prompted by the Government’s concern that the current regime is outdated, on the basis that:
- it is significantly more generous than those of many other major economies;
- the quantum of income and gains that benefit from exemption has increased materially in recent years; and
- it has not kept pace with the changing nature of the investments made in the UK by sovereign investors.
Scope of reform
To demonstrate its generosity, the consultation compares the scope of the UK sovereign immunity regime with the exemptions available in jurisdictions such as the USA, France, Germany, Italy, and Japan. Whereas the UK provides for income from a broad range of sources to be exempt for sovereign investors, as mentioned above the consultation highlights that most of the other jurisdictions identified provide for relief in significantly more limited circumstances.
This is cited as evidence that the UK regime is anomalous amongst comparable economies and that more limited sovereign immunity would better align the UK with its competitors, whilst bringing a significant amount of additional income within the charge to UK tax.
Proposals and impacts
The consultation therefore proposes that the exemption for sovereign natural and non-natural persons should be limited to UK sourced interest income that does not relate to trading activities undertaken in the UK. This would, the Government argues, bring the UK regime in line with those operated by the likes of the USA and Australia. It is important to note, however, that the UK does not generally impose withholding taxes on dividends, so sovereign investors would continue to receive dividends from UK companies without suffering UK tax charges.
The proposed reform has also been prompted, in part, by what the Government sees as a change in the focus of sovereign investments, with increasing commercial activities, particularly in property markets. The proposed reforms would therefore remove any disparity in the tax treatment between taxable and sovereign immune persons investing, in particular, in UK real estate.
There is extensive discussion in the consultation document on introducing legislation to codify the principle of sovereign immunity and the conditions that must be met to benefit from the regime. The Government considers that this should provide for increased transparency and greater certainty for potential investors. This issue occupies a significant part of the consultation document and reflects the fact that establishing definitions for tax purposes that are practical and can be readily applied is often fraught with complexity. Great care will, therefore, be needed to ensure that attempts to create transparency do not result in confusion.
The consultation proposes that the new rules would be effective for periods starting on or after 1 April 2024 for corporation tax and 6 April 2024 for income tax and capital gains tax. Apportionment would apply for accounting periods that straddle these dates.
To mitigate tax liabilities on capital disposals made under the new regime, the consultation suggests that, for those affected, the historic cost of assets may be rebased to market value as at the date the new rules come into effect. A mechanism to allow sovereign investors that realise a capital loss under the new regime to use acquisition cost rather than market value is also under consideration.
The consultation closes on 12 September 2022. Interested parties should submit their comments in advance of that date to ensure their views are taken into account by the Government.
Is this the right time for reform?
The Government’s aim of operating a sovereign immunity regime that is ‘transparent, appropriately targeted, applied consistently and in line with the international mainstream’ is to be supported. The proposed changes may generate significant additional tax revenues for the Exchequer; however, it is also important not to lose sight of the contribution made by sovereign persons as a source of long-term investment for the UK economy in a period of increased economic uncertainty.