On 4 July 2022, the government published a consultation document calling for engagement in relation to proposed reforms to clarify who is entitled to benefit from sovereign immunity and also to restrict the availability of sovereign immunity from UK direct tax as it applies to sovereign entities and investors: Sovereign immunity from direct taxation: consultation on policy design.
In summary, if the reform proposals are enacted sovereign immunity will only apply to passive interest or dividend income,1 which is a major change from current policy. In particular, income and gains arising to a sovereign entity from UK immovable property (including the sale of shares in UK property-rich companies) and income from UK trading activities will be brought within the scope of UK tax for the first time.
Current Position
Sovereign immunity is the principle in international law that one sovereign state should not seek to impose its law on another sovereign state. In the UK, sovereign immunity has been implemented in a tax context by granting foreign sovereigns (including extensions of the state such as funds or bodies corporate) exemption from liability to direct taxes no matter the activity undertaken by the sovereign entity (whether the activities are associated with their sovereign functions or are more commercial in nature).
Proposed Reforms
The UK position is different to how sovereign immunity operates internationally where most countries usually limit any tax exemptions to certain government investments. The main factor driving the proposed reforms to the UK sovereign immunity rules is that changes to other tax rules in recent years (primarily expanding the scope of UK tax to non-residents on UK property) have increased the impact of sovereign immunity on UK tax revenues. The government also wishes to align the UK with the international mainstream on the treatment of sovereign immunity.
In overview, the consultation proposes the following:
1. Codification of the principles of, and conditions underpinning entitlement to, sovereign immunity into legislation in order to provide greater clarity and certainty. At present, the principle of sovereign immunity in UK tax law is a creature of case law and HMRC practice.
2. Limitations upon the type of income which benefits from sovereign immunity from direct tax to income that:
a. arises from investment as opposed to trading activity;
b. arises in respect of investments that are of a more passive nature and that are more commonly held as part of an exercise of sovereign functions; or
c. arises in respect of investments for which exempting it from direct taxation creates the appropriate balance between supporting investment in the UK and delivering fairness between different participants in the UK market.
Accordingly, income and gains arising to a sovereign entity from UK immovable property (and the sale of shares in UK property-rich companies) and income from UK trading activities would be brought within the scope of UK tax. However, similar to the introduction of the original non-resident capital gains tax rules, transitional rules are likely to be introduced to ensure that capital gains tax will only accrue once the new rules come into effect, i.e. assets will be rebased to the effective date of the legislative change (with an option for any gain to be recalculated on original acquisition cost to the extent that the rebased value leads to an unfair outcome).
3. Investors benefiting from sovereign immunity are currently treated as qualifying institutional investors with beneficial tax treatment for the purposes of various tax provisions in UK tax legislation. These concepts were introduced to encourage the use of UK structures by large institutional investors (such as sovereign wealth funds). The concept is used in the Real Estate Investment Trust (REIT) legislation, the UK substantial shareholding exemption (SSE), the new qualifying asset holding company (QAHC) regime, the long term asset fund (LTAF) regime, the exempt unauthorised unit trust regime and the UK property rich CIV rules for non-resident capital gains tax. At this point in time the government acknowledges that the operation of these regimes alongside a reformed sovereign immunity regime will need to be considered, but they have noted that allowing sovereign persons to remain as qualifying investors within individual regimes of the existing tax legislation could undermine the intended tax collection motive behind the proposed reform.
4. Sovereign immunity will only be available following approval of a formal application made to HMRC, and the status will be retained unless there is a change in circumstances.
5. The existing reporting requirements in the Taxes Acts will apply to sovereign persons with an obligation to file income and corporation tax returns to the extent they are within the scope of UK tax. In addition, the non-resident landlord scheme will apply to sovereign persons. Concomitant with this change, legislation will be enacted to ensure that a state is not immune from the jurisdiction of the UK courts in respect of proceedings relating to its liability for direct taxes.
Expected Timeline and Next Steps
Please note that the consultation closes on 12 September 2022, with a view to HMRC/HM Treasury publishing a summary of responses in due course. Subject to any changes in government policy or priorities, the current intention is that any new legislation enacting these policies will come into effect from 1 April 2024.
Interested parties are encouraged to take this opportunity to provide their views.
Footnotes
1) The UK does not currently tax non-residents on UK source dividend income.
