Introduction
As the momentum towards the global market gathers pace, cross-border acquisitions of real estate are becoming more commonplace. However, perhaps no other area of international business is as complex as the tax considerations related thereto, and this tax briefing, therefore, focuses on the main principles to be considered when approaching such investments.
The first point that must be made is that no two investments are exactly alike, and therefore one may plan differently for investments, which produce high net income from those that are held for their potential capital gain. Similarly, some real estate acquisitions may be classified as pure investment situations, whilst others would be considered speculative and therefore subject to a different tax regime. In every case, the effect of financing the acquisition must be of paramount importance to ensure deductibility of interest against rental income, absence or mitigation of local withholding taxes together with low taxation on the net interest income derived if internal financing has been used. Carry forward of excess interest and management charges may be important with low income-producing properties where any resultant capital gain will be subject to local tax, and the determination of whether to create a permanent establishment by virtue of the ownership of the real estate may play an important role in the over-all tax treatment of real estate profits. There are many other indirect tax considerations to take into account, such as transfer and registration taxes, gift and inheritance taxes, value added tax, intermittent taxes at say 10-year intervals on the increase in value of the real estate, special annual taxes on the ownership of real estate by non-tax treaty protected entities and wealth taxes.
Rental income
Net rental income has a source where the real estate is located, and double tax treaty provisions will not restrict the rights of that particular country to impose corporate or personal income tax on net income from that source. To this extent, therefore, a foreign acquirer may directly invest personally or through a foreign entity, or indirectly through a local company, without affecting the rights of the particular country to impose tax on net rental income. The main strategy for reducing local taxation on rental income therefore rests with reducing the taxable base by way of interest charges, which is discussed below.
Holding real estate indirectly through a locally formed company will subject the net rental income to local corporate tax, although interest expense will normally be allowed. Moreover, distribution of post-tax income will then be subject to a dividend withholding tax. Alternatively, a direct investment from abroad will either attract the same local corporate/personal taxation, but usually without the dividend withholding tax (unless the branch tax is applicable as in the US and France amongst several other countries); but withholding taxes on net rental income may often be levied at lower rates and accepted as final tax liabilities in connection with such income, which may result in a considerably lower over-all rate of tax than indirect ownership via a local company.
Deductibility of interest
This is perhaps the single most important aspect of real estate investment tax planning. Substantial tax savings may be achieved if interest is deductible against both rental income and, if the interest exceeds the net rental income, against subsequent capital gains by virtue of carrying forward excess interest charges. However, the laws relating to the deductibility of interest against rental income are so diverse in various countries that one must be certain that the choice of entity chosen to acquire real estate permits the full deductibility of all interest charges.
Where a foreign investor is borrowing funds to acquire the real estate but, for reasons given above, the investor decides to acquire the real estate indirectly through a domestic company, then it would generally be preferable for such company to borrow the funds direct rather than these funds being loaned to the foreign investor. This will, of course, not always be the case if the deductibility of interest cannot be assured at local level.
In many cases, however, the foreign investor will wish to utilise his own funds for real estate acquisitions, in which case it may be advisable to create a financing structure to which such funds are advanced for onlending to the acquiring entity. However, most interest attracts a local withholding tax at rates of between 20% and 25% (although the US rate is 30%), which will only be reduced if the interest is payable to an entity in a tax treaty jurisdiction, in which case the withholding tax is normally reduced to nil, or if the interest is exempt under unilateral law if paid to certain investors eg the portfolio interest exemption in the US. The choice of entity used for internal financing arrangements must therefore take into account relevant double tax treaties, and for this reason, Luxembourg and Holland are often used as ideal finance intermediaries, subject to limitation of benefits provisions in the relevant double tax treaties.
Capital Gains
Most countries levy capital gains tax on the realisation of gains made by non-residents from the acquisition of real estate investments. Even if there is a double tax treaty in existence with the investor’s country of residence, there would normally be provision enabling the capital gains still to be taxed locally. Thus Article 13 of the Model OECD Treaty states that gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State.
There are countries such as the UK which do not extend their capital gains tax legislation to non-residents on the profits derived from real estate investments, in which case there is a material difference whether the property is held direct by the non-resident investor, or through a local company which will be subject to capital gains tax under the ordinary domestic rules. However, in most countries, the ownership of property direct by the foreign investor or indirectly via a local company will create the same capital gains tax liability if the underlying real estate is sold.
For this reason, investors may often consider selling shares in the real estate investment company, rather than the underlying real estate itself. To combat this, many countries include both in their domestic tax provisions (the US under FIRPTA regulations), and also their bilateral tax treaty arrangements, a provision extending capital gains tax to the sale of shares in a company whose business property is composed mainly of immovable property; in this context, a holding of more than 50% of total assets in local real estate would normally result in the company being classified as a local real estate holding company. If the company is itself located in the same jurisdiction as the real estate, then the transfer of shares may be a reportable transaction, in which case it will be difficult to avoid assessment to this (extended) capital gains tax legislation. However, where the real estate company is a foreign company, then it may not be required to report the transfer of shares, and even this extended capital gains tax may therefore be avoided.
Where accumulated losses are brought forward in the form of excess depreciation or loan interest to be offset against capital gains, then it may be preferable to restrict tax liability to the local jurisdiction in which the real estate is situated. Under the relevant article of an appropriate double tax treaty, if the local jurisdiction maintains the right to impose capital gains tax on the sale of immovable property, then normally such gains will be tax exempt in the investor’s country of residence. If the investor tries to avoid local capital gains tax by the formation of a foreign company with the intention of selling the shares in that company, then any available losses will be unrelieved and the sale of the shares in the foreign company may create a taxable event in the investor’s country of residence.
Consideration must also be given to potential capital gains tax liabilities on dispositions in the course of internal reorganisations or inter-family or inter-corporate transfers, as well as transfers subsequent to the death of an individual investor.
Inheritance tax, gift tax and wealth tax
Foreign investors would not normally be subject to local inheritance tax, gift tax or wealth tax if the assets owned by them are situated outside of the particular country. For this reason, therefore, the relevant assets owned by individual investors may need to be shares in a foreign company, which itself then owns the local real estate, so that transfers of the shares in the foreign company may be made free of local tax on death or by way of gift. However, such indirect holdings via a corporate entity may itself create problems such as benefits in kind or a notional rental charge where individuals occupy the premises rent free.
Direct investments by foreign individuals in local real estate could create a local tax liability for inheritance tax, gift tax and wealth tax purposes, as could indeed shares in a local company used indirectly to acquire the real estate. However, such taxes would only be relevant to the foreign investor if they are donor-based taxes, as is the case for UK inheritance tax. For most countries in continental Europe, inheritance tax and gift tax are both donee-based taxes, so that they are only applicable if the recipient is resident in the particular country, regardless of how the donor made the real estate investment, or indeed where the assets transferred are situated.
Particular attention must be paid to the forced heirship rules common in continental Europe which require a certain proportion of a donor’s assets, if located in a European country, to be transferred to the donor’s children, another percentage available for the donor’s wife, and any further percentage available for fee transfer; these rules may be relevant regardless of the country of residence of the donor.
Where an individual donor is subject to inheritance or gift tax by virtue of his domicile, whilst foreign-based donees are similarly subject to inheritance and gift taxes by virtue of their domicile, then an inheritance tax double tax treaty may determine which country has the right to impose such taxation on gifts or testamentary dispositions. Unfortunately there are far fewer inheritance tax treaties than income tax treaties, and therefore the possibility of dual imposition of inheritance and gift tax must be considered.
Wealth tax is also an important annual tax to consider and although companies may often be free of this (net worth) tax, individuals are often subject to wealth tax in many European countries. As for inheritance tax and gift tax, the ownership of shares in a foreign company which invests in local real estate may avoid a significant local wealth tax liability.
Miscellaneous taxes
There are then major taxes of a miscellaneous nature which must be considered. Although many real estate transactions are outside the scope of Value Added Taxation, some transactions may incur an additional VAT charge especially in relation to new properties.
Transfer taxes are generally higher in Europe than in the UK and US at rates of, for example, 6% or more of acquisition costs. Municipal property taxes may be additionally charged on transfer of real estate based on a deemed increase in the capital value since the preceding transfer.
A Special Tax’ is imposed in France and Spain at 3% on the value of real estate owned by a corporate entity located in a non-tax treaty jurisdiction, payable annually at this level. This is due even if the real estate is owned by tax treaty based companies unless disclosure of beneficial ownership is made.
Summary
The effect of all these taxes is to create a myriad of sometimes conflicting taxation requirements. To enable investors to decide on the relevant suitable structure, it is vital to understand the differing tax systems and how they may interact between the countries in which the real estate may be situated, the investors may reside, and their funds be located.
The final decision can only be taken when all factors are considered, and investors should be wary of accepting ‘packaged’ advice which does not completely investigate the aspects mentioned in this article.