Real Estate Focus: March 2020

Introduction

In this edition we take a look at COVID-19 FAQs for landlords and tenants; key Budget announcements for real estate; imminent changes to minimum energy efficiency standards for landlords in the private rented sector; and restrictions on use in leases.

COVID-19: Will it change the balance between landlords and tenants?

Coronavirus (COVID-19) has spread with startling rapidity. In response, government advice and policies are being revised at an unsettling pace and are increasingly draconian.

At the time of writing the government has told cafes, pubs, theatres and restaurants to close and further such announcements may well follow. Many businesses are limiting access to their office and other locations or closing them entirely. On March 19, 2020, a Coronavirus Bill had its first reading, its purpose being to give the government powers to contain the spread of COVID-19, including powers to issue directions in relation to events, gatherings and premises.

In the commercial leasing sector, the balance between landlord and tenant from a risk and cost perspective has developed over decades. An “institutional” lease (also referred to as triple net/full repairing and insuring (FRI) lease) will typically place risk and cost on the tenant for the majority of scenarios. Does this mean that tenants will bear the brunt of COVID-19?

Regardless of the legal position, landlords will wish to be mindful of the long term negative impact on the tenant that inflexibility could potentially bring. A flexible approach will therefore be a key factor.

No landlord wants an insolvent tenant and therefore we expect to see commercial negotiations playing an important role in agreeing a path for the next few months and beyond. However, landlords will need to ensure that any temporary (or longer term) agreement or concession does not have unintended consequences. Such consequences could include:

• Tax liability – for example, certain lease variations trigger a surrender and re-grant, which would have SDLT consequences. VAT could also be a consideration in some situations.
• Prejudicing the landlords’ position on insolvency – any concession given to a tenant must be carefully worded to ensure that the total claim that a landlord may have against a tenant is not limited in the event that the tenant does not survive.
• Prejudicing the landlord’s position with its lenders. Many loan agreements will have covenants requiring lender consent to vary or waive lease terms. Even if the landlord wants to assist its tenants, it may only be able to do so if its lender takes a similar position.

Landlords also need to be mindful of the position that the UK government is taking in relation to particular businesses. Landlords of small business tenants in some sectors will have noted the government’s waivers of business rates. A landlord might prefer that a tenant continues in occupation paying no rent whilst no rates are payable, rather than potentially taking on rates and other liabilities for outgoings themselves by taking back premises.

Against this background, here are our top ten questions and answers for landlords and for tenants.

Budget 2020: Real estate tax and key announcements

Recent years have seen a global trend towards increased real estate taxation for non-residents, be that in the form of taxation on capital gains realised on direct or indirect disposals by such sellers, or local transfer taxes. The March 2020 Budget continued that trend, confirming a number of already- announced policies, such as the extension of corporation tax to non-resident corporate landlords and an additional SDLT surcharge for non-resident purchasers of residential property.

However, unlike previous years (which saw key changes to the way in which offshore developers and non-resident property investors are taxed), there were no big surprises in this year’s Budget from a real estate perspective beyond the announcements made as part of the package to assist businesses impacted by the coronavirus.

Non-resident corporate landlords: Move to corporation tax on property rental income

With effect from April 6, 2020, non-UK resident corporate landlords (NRCLs) will become subject to UK corporation tax, rather than income tax, on their property rental income. This is the second key legislative change to the taxation of UK real estate for NRCLs to come into effect recently and follows the introduction of corporation tax on gains on UK property-related investment assets held by NRLs (NRCGT) last year.

These changes together have a significant impact on both new and existing UK property holding structures. While the implementation of NRCGT generally crystallises a tax charge at the point of disposal (which could be some time away), the NRCL transition to corporation tax will have an immediate impact on post-tax net rental returns.

HMRC published guidance on this transition to UK corporation tax in January 2020. Amendments to the operation of the Non-Resident Landlord Scheme allow an irrevocable election for finance costs to be limited to a fixed allowance of 30 per cent of the UK rental income (net of expenses other than finance costs), and deducted as an expense when calculating the amount to be withheld.

2 per cent SDLT surcharge on purchases of residential property in England and Northern Ireland by non-UK residents from April 2021

Budget 2018 announced a consultation on applying an SDLT surcharge for non-UK resident purchasers of residential property. The consultation considered a 1 per cent surcharge and the Conservative manifesto indicated that a 3 per cent surcharge would be introduced.

Budget 2020 confirmed that for companies (either non-resident, or UK resident but owned by non-residents) acquiring residential property, the rate of tax will, with effect from April 2021, be a flat 17 per cent. For non-resident individuals, the rate of SDLT on an acquisition of property in England and Northern Ireland is subject to two potential surcharges – a surcharge of 3 per cent for additional dwellings, and a surcharge of 2 per cent by virtue of the purchaser being non-UK resident. Responses to the consultation will be published shortly, with draft legislation expected in summer 2020.

Coronavirus

The Budget included a raft of measures designed to alleviate the impacts of the coronavirus on businesses. In particular, the business rates retail discount will be increased to 100 per cent for 2020-21 with an expansion to the leisure and hospitality sectors and further relief for pubs.

Rate of UK corporation tax

Retention of the current 19 per cent corporation tax rate. This had been expected to fall to 17 per cent, in accordance with legislation currently in place, but this will now be reversed and the rate of corporation tax will remain at 19 per cent. While the rate of corporation tax is marginally lower than the 20 per cent rate of income tax currently applicable to NRCLs, the restriction on the ability to claim deductions under the corporation tax regime may mean that there is a higher effective rate of tax for such NRCLs from April 2020.

Increase in structures and buildings allowance

The rate of capital allowances for structures and buildings, announced at Budget 2018 and relating to the costs incurred in the construction or renovation of commercial property, will be increased from 2 per cent to 3 per cent per annum with effect from April 2020.

VAT exemption on fund management fees for certain real estate funds from April 1, 2020

Following a CJEU decision in Fiscale Einheid X, which confirmed that supplies of management services to certain closed-ended collective undertakings (including those holding real estate) could fall within the VAT exemption, the UK will give effect to this decision through legislation. Up until now, taxpayers had a choice as to whether or not to rely on the direct effect of the CJEU case law. With effect from April 1, 2020, supplies of management to certain real estate funds that meet the following conditions will be exempt from VAT (there is no longer a choice):

• The sole object of the fund is the investment of capital, raised from the public.
• It manages its assets on the principle of spreading investment risk.
• All of its ordinary shares are included in the official list.
• All of its ordinary shares are admitted to trading on a regulated market situated or operating in the United Kingdom.

This change could affect supplies to certain UK Real Estate Investment Trusts, and their fund managers (who themselves would suffer irrecoverable VAT as a result of making exempt supplies of management).

Reverse charge for VAT on certain construction services

A reverse charge for VAT on certain construction services was announced in the Autumn 2017 Budget, and a Statutory Instrument provided that a reverse charge, which shifts the responsibility for accounting for the VAT to the recipient of the supply, would apply to business to business supplies of construction services (subject to certain exceptions) with effect from October 1, 2019.

In September 2019, an order was made to defer the commencement date of the VAT reverse charge from October 1, 2019 to October 1, 2020.

Construction Industry Scheme (CIS) consultation

Legislation will be introduced in Finance Bill 2020-2021 to prevent non-compliant businesses from using the CIS to claim tax refunds to which they are not entitled.

The measure will also simplify the rules covering “deemed contractors” and expand the penalties for supplying false information when registering for CIS. A consultation has been launched to look at ways to counter perceived avoidance, and this will also pick up amendments to the “deemed contractor” rules, which will be of interest to certain landlords.

Fund consultation

There will be a review of the UK’s alternative funds regime with a view to seeing whether there are certain amendments that could be made to the UK tax code to facilitate more investment via UK asset holding companies. This would be welcomed by the UK fund industry (including real estate funds) who will undoubtedly support the removal of barriers to fund entities and activities being located here.

For further information, please contact Julia Lloyd, Counsel, or another member of our Real Estate Tax Team.

Energy efficiency: Raising the bar in the private rented sector

Minimum energy efficiency standards (MEES) for landlords in the private rented sector have been in force since April 1, 2018. These provide that, with some exclusions and exemptions, a landlord cannot grant a new – or renew an existing – tenancy of a “sub-standard” property. A property is sub-standard if it does not have an Energy Efficiency Certificate (EPC) rating of E or higher.

These requirements do not currently apply to tenancies granted before April 2018, but that is about to change.

From April 1, 2020, private sector residential landlords will not be able to continue to let a sub-standard property. Commercial landlords with existing tenancies have a little longer to comply, until April 1, 2023.

On a related note, one of the exemptions for residential premises used to be that energy efficiency improvements were only required if they were at “no cost to the landlord”, for example because of the availability of government or local authority funding.

This changed on April 1, 2019, when the “no cost” exemption was removed and replaced with a landlord financial contribution capped at £3500 (inclusive of VAT) per property. Landlords should note that any “no cost” exemptions already claimed will end on April 1, 2020.

How watertight are restrictions on use in leases?

In our September 2019 Focus, we reported on a case in which the Upper Tribunal modified a restriction on use in a lease, citing it as a “rare example of that jurisdiction being exercised”. We spoke too soon.

Numerous cases have publicised the power of the Upper Tribunal under section 84 Law of Property Act 1925 to discharge or modify a restriction on the use of freehold land provided one of the grounds in that section is made out. That power also extends to covenants in leases restricting use, once 25 years of a lease term of more than 40 years have expired. Cases on this limb of the Upper Tribunal’s jurisdiction have been few and far between but that appears to be changing.

Berkeley Square Investments Ltd v Berkeley Square Holdings Ltd [2019] UKUT 0384 (LC) involved a long lease of a Grade I listed townhouse in Berkeley Square. The lease was granted in 1978 for a term of 92 years and contained a covenant restricting the use of the premises to that of an office with a small residential element. The lessee wanted to implement a planning consent to convert the premises into a private members’ club. The freeholder as landlord opposed the idea and refused consent to the change of use, so the lessee applied to the Upper Tribunal under section 84 for a modification of the user covenant.

The application succeeded on two of the grounds set out in section 84. The first was that the proposed use was a reasonable one and that the restriction on use did not secure any practical benefits of substantial value or advantage to the landlord. The second was that the proposed modification would not injure the landlord. An order was therefore made to permit use as a private members’ club subject to including additional clauses in the lease to protect the landlord’s position (one being a prohibition on lap-dancing!).

While such cases are heavily fact-dependant, they nevertheless highlight a useful tactic to help release the development potential of properties subject to long leases.