Sovereign Tax Status: UK Government Consults on Modernising the UK Taxation of Investments by Foreign Sovereigns

Under current rules, sovereign investors are generally exempt from UK taxes on income and capital gains on their investments.

The UK government is consulting on extensive changes to the existing rules, expected to take effect from 1 January 2029. HM Treasury has published a consultation document, “Modernising Taxation of Foreign Sovereign Investments” (the "Consultation"), setting out how the government intends to replace the existing rules with a new “sovereign tax status” ("STS") legislative regime from 1 January 2029. The government will also legislate for a special tax status for a sub-category of sovereign investor referred to as "State-operated Overseas Pension Funds" ("SOPFs").

This is a consultation on proposed new legislation, not a final announcement of the law. The government has announced the policy direction and its start date, but the detail is still open for comment and may change. Any resulting legislation is expected to take effect from 1 January 2029, with final legislation to be introduced in Finance Bill 2027-28. Nonetheless sovereign investors and SOPFs together with general partners and managers of funds whose investors include sovereign investors and SOPFs should review the impact of these proposals in advance.

The comments in this note are based on the Consultation and are subject to final legislation being enacted.

Who will be affected?

The following are most likely to be affected by the changes proposed in the Consultation:

• The Consultation lists the types of entity to which STS will apply ("Sovereigns"). This includes foreign sovereign states and their constituent territories, heads of state acting in their sovereign capacity, certain wholly-owned state entities and sovereign wealth funds;
• SOPFs; and
• Funds whose investors include Sovereigns and SOPFs.

The most significant impact is likely to be in relation to UK real estate. In general, we do not anticipate that the changes are likely to significantly impact other asset classes provided that Sovereigns avail themselves of the new rules, which will require an application to HM Revenue & Customs ("HMRC") even if they qualify for immunity from UK taxation under the existing rules.

What is changing?

A legislative regime

STS will be codified in legislation for the first time in the United Kingdom, and Sovereign investors will need to apply to HMRC to obtain STS. This contrasts with the current rules, which rest on general, uncodified principles of international law. The separate Crown immunity from taxation currently extended to Australia, Canada and their states and provinces will be replaced by STS.

Restrictions to tax immunity

Sovereign investors will generally be taxed in the same way as other non-UK resident investors on income from UK real estate and on capital gains from UK real estate and interests in certain UK property rich vehicles. Sovereigns will also become taxable on income from UK trading activities, but it is unusual for Sovereigns to receive UK trading income directly meaning that the impact of this change is likely to be less significant than the changes in relation to UK real estate.

Exemptions retained

Interest income will continue to be exempt, and dividends will generally remain untaxed (as for other non-residents). State property situated in the United Kingdom will be exempt from UK inheritance tax.

New exemptions

SOPFs will be exempt from UK tax on chargeable gains. UK investment management activities carried on by investment offices of Sovereign investors specifically for the purpose of managing (and for the benefit of) the investment portfolio of that investor will be exempt from UK corporation tax on profits that might otherwise be attributable to such activities.

Investment funds and substantial shareholdings exemption ("SSE")

Sovereign investors will be qualifying institutional investors (“QIIs”) for the purposes of most fund tax regimes. However, they will generally cease to be QIIs for the purposes of the SSE on disposals of interests in UK property rich vehicles. SOPFs will keep their status as QIIs for the purposes of the SSE even for those disposals.

REITS

Sovereign investors will be able to own substantial interests in UK Real Estate Investment Trusts ("REITs") through UK holding companies qualifying for a new tax status (a "Sovereign REIT HoldCo"). This new tax status for Sovereign REIT HoldCos is designed to achieve an effective UK tax rate of 15% on income and gains from UK real estate that are distributed, while undistributed capital gains ought to remain exempt from corporation tax within the REIT.

Capital gains rebasing

Assets that become chargeable to UK tax on capital gains will be "rebased" to market value at 1 January 2029. The effect of this will generally be that Sovereign investors will only be chargeable to tax on capital gains representing increases in market value of investments from 1 January 2029 even for assets that were acquired before that date (as noted, SOPFs will be exempt from UK tax on capital gains).

Transitional reliefs

There will be tax reliefs to help restructure existing real estate holdings, including a time-limited SDLT relief.

What does this mean in practice?

The principal impact of these changes is likely to be to affect the relative tax efficiency of investment in UK real estate for Sovereign investors, including SOPFs, whether they invest directly in UK real estate or indirectly through funds or other vehicles.

Sovereign REIT HoldCos

For Sovereign investors in UK real estate, it is likely to be attractive to hold assets in a REIT with the Sovereign investor holding its shares in the REIT through a Sovereign REIT HoldCo. Income and gains from property investments within the REIT would be exempt from corporation tax. A REIT is not required to distribute capital gains, and whilst REITs' ability to hold significant amounts of uninvested cash without incurring adverse tax consequences is limited, the effect is that capital gains can be realised free of tax and reinvested in other real estate assets on a gross basis.

A REIT is required to distribute the bulk of its income from property investments, and distributions of both income and capital gains from a REIT to a Sovereign REIT HoldCo as property income distributions will be subject to corporation tax at 15%. This ought to result in an effective corporation tax rate of 15% on distributed income and gains. Whilst much more attractive than the standard corporation tax rate of 25%, at which income and gains would otherwise be taxed from 1 January 2029, this is a significant increase in the effective tax rate that can be achieved under current rules for Sovereign investors.

Unfortunately, the Consultation contains no detail regarding the treatment of SOPFs investing in REITs.

Consider reorganising existing holdings

Three changes are likely to make many existing investment structures less efficient. Firstly, the withdrawal of immunity from UK tax on income and gains from UK real estate will mean that, in principle, income and gains will be taxed at normal rates. Second, Sovereign investors will no longer be QIIs for the purposes of the SSE so far as it concerns UK real estate investments. Third, the application of the "Holder of Excessive Rights" rules will be tightened regarding Sovereigns investing in REITs, in particular where a Sovereign has disaggregated its holding in a REIT between a number of connected entities so that no single entity holds 10% or more of the REIT. Although certain exclusions and defences may be available, these rules can give rise to a tax charge on the REIT where a distribution is paid to a "Holder of Excessive Rights."

The Consultation offers some mitigation to these changes through the creation of a further new tax regime for Sovereign REIT HoldCos. Sovereign investors with existing UK real estate holdings should consider reorganising into a Sovereign REIT HoldCo structure, where the UK real estate assets are held by a REIT with the Sovereign investor holding its shares in the REIT through a Sovereign REIT HoldCo. By reorganising in this manner, it ought to be possible to reduce the effective rate of corporation tax from UK real estate investments to 15%. Any decision as to whether to reorganise will need to be based on an assessment of the relative costs and benefits (tax and otherwise) of continuing with the existing structure, implementing a reorganisation and confirmation of the likely effective tax rate under a new structure. In particular, real estate investments will be "rebased" for tax purposes to their market values on 1 January 2029 so any assessment of whether to reorganise will need to take into account the likely realisation strategy and the prospects of an increase in value after that date. The interests of any joint venture partners or other investors where investments are held in funds will also need to be considered. In general terms however, we expect that it will be attractive for Sovereign investors to implement Sovereign REIT HoldCo structures.

So far as tax costs of implementation of a reorganisation are concerned, timing will matter. For assets that stand at a gain relative to their tax base cost it will likely be advantageous to restructure before 1 January 2029, while capital gains remain exempt. If that is not possible, then doing so as soon as possible after 1 January 2029 will be desirable. Other strategies to tax efficient implementation may be available, particularly for indirect holdings, but these will be fact-dependent and will turn on legislative detail not yet published. For example, it is not yet clear whether the various corporation tax reliefs for company reorganisations and reconstructions will apply on a reorganisation designed to avail of the new rules for Sovereign REIT HoldCos. So far as SDLT is concerned, the government has announced that a temporary relief will apply from 2028 until at least 31 December 2030 for restructuring residential and commercial real estate held directly or indirectly by Sovereigns. Whilst this is helpful for properties in England and Northern Ireland, no mention is made of relief from the Scottish and Welsh devolved analogs of SDLT, respectively Land and Buildings Transaction Tax ("LBTT") and Land Transaction Tax ("LTT"). Any reliefs from LBTT and LTT will be a decision for the governments of Scotland and of Wales.

Reorganisation plans should be developed well in advance of 1 January 2029. In particular, any third party consents that may be needed should be identified long enough in advance that consent can be sought where necessary, e.g. from lenders or, for leasehold properties, from landlords. Similarly, equity documents will need to be reviewed to determine any restrictions that may apply and sufficient time allowed to negotiate amendments where necessary.

Mixed funds and joint ventures

It is not yet clear how these proposals will work for funds and joint ventures that combine Sovereigns with other tax-exempt investors. The Sovereign REIT HoldCo regime, as currently proposed, is not available to non-Sovereign investors. Funds and joint ventures with a mixture of investors (i.e. where not all investors are Sovereigns) will need to consider their approach carefully having regard to likely outcomes for different constituencies of investor. This may involve, for instance, the creation of parallel funds or co-investment arrangements so that differing tax requirements of investors can be accommodated.

SOPFs

SOPFs will be exempt from UK tax on chargeable gains, including on direct and indirect disposals of UK land. They will also remain QIIs for the purposes of the SSE as it applies to sales of interests in companies that are "UK property rich." On the other hand, the Consultation does not make clear how SOPFs will be treated under the REIT regime. It is not therefore yet clear whether investment through a REIT will be attractive as compared with simpler structures that rely on the SSE to generate capital gains free of UK corporation tax, or indeed of tax transparent structures such as offshore property unit trusts (typically, "JPUTs" or "GPUTs") that have elected for tax transparency on capital gains. SOPFs may also wish to consider establishing Exempt Unauthorised Unit Trusts because SOPFs (but not other categories of Sovereign) will be eligible investors in these vehicles, which are exempt from UK tax on capital gains. Potentially, depending on what legislation is introduced, investment through a REIT could produce a higher effective tax rate on capital gains that are distributed to the SOPF.

Next Steps

The deadline to respond to the Consultation is 20 January 2027. A technical consultation will follow on draft legislation ahead of final legislation being introduced in Finance Bill 2027-28. Legislation is expected to take effect on 1 January 2029.

How can Mayer Brown help?

We can assist with:

• Making representations in response to the Consultation;
• Reviewing existing investment structures to determine what changes may be necessary and the relative merits of different approaches, both as regards tax and as regards other matters. This might include delivery of a strategy paper so that key stakeholders can reach an informed decision;
• If a decision to reorganise existing holdings is made, we can produce detailed tax structuring memoranda and step plans to support implementation, assist with the identification and obtaining of third party consents (e.g., from lenders), and implement the legal steps required including drafting and negotiating legal documents;
• Applications to HMRC for Sovereign tax status;
• Advice as to whether SOPF tax status is available; and
• General advice in relation to the proposed legislation as it progresses through a technical consultation to draft legislation, and then to final legislation.