A nasty surprise was lurking in the budget for foreign sovereign investors. Badged as modernising sovereign taxation it was, in fact, an announcement that sovereign investors in UK property will be losing their longstanding tax free status from 1 January 2029.

The proposed rules do offer a lower tax rate of 15% for sovereigns investing via UK real estate investment trust (REIT) structures but this is still a tax increase that will make the UK less attractive from a tax perspective.

This announcement is relevant to both sovereign investors and those investing alongside sovereign capital in UK property.

For decades, foreign governments, sovereign wealth funds and state pension funds have invested in the UK with a broad exemption from UK direct tax.

From 1 January 2029, a new statutory "sovereign tax status" will replace the previous practice. HM Treasury published a consultation on the proposals today as part of the budget. The measure is expected to raise up to £690 million a year.

In an effort to soften the blow, sovereigns will benefit from rebasing of assets on 1 January 2029 meaning that only gains from that point will be subject to tax. Also, certain state-operated overseas pension funds will keep their exemption for capital gains.

What are the proposed changes to sovereign immunity?

Key points are:

  1. rent and other income from UK land, gains on UK land and certain property-rich vehicles, and UK trading income will become taxable.
  2. UK interest income and most dividends from UK companies will remain exempt.The changes will not affect investments in UK corporates (other than REITs or UK property rich vehicles).
  3. State pension funds that qualify as "State-operated Overseas Pension Funds" keep an exemption for capital gains. Investors seeking to rely on this category should assess if they meet current criteria in the consultation document (see below). 
  4. Sovereigns will need to change the way they invest into REITs. In practice, other than for holdings of less than 10%, sovereigns will need to invest via a 'sovereign REIT holding company' and that company will pay 15% tax on the gross amount of property income distributions it receives. Whilst this is presented in the consultation as a good thing it is actually worse than the current position for most sovereigns investing in UK REITs (which is usually, effectively, tax free).
  5. There will be transitional provisions to help minimise the initial impact on gains and restructuring. Assets can be revalued to market value at 1 January 2029 for capital gains purposes. A time-limited stamp duty land tax (SDLT) relief runs from 2028 until at least 31 December 2030 to support restructuring (albeit with a three year clawback).
  6. Sovereign tax status will need to be applied for. Existing sovereigns must reapply. Sovereigns are likely to have concerns about confidentiality and becoming liable to submit UK tax returns.
  7. The consequences for existing structures will need to be carefully considered by sovereigns, their joint venture partners and REITs themselves.
  8. London investment offices managing a sovereign's own portfolio will be exempt from corporation tax (other than on UK source activities).

What is the rationale for the reform?

This is a resurrection of a measure that was abandoned in 2022 following consultation. That was, presumably, abandoned because of fears about a negative impact on investment in the UK at time when capital investment was much needed. It is not clear what has changed now. Sovereign investors are major investors in UK property and the Government acknowledges in the consultation that "We value the role that sovereign investors play in the UK as important providers of capital across a wide range of UK investments".

The Government's position is that the UK is an outlier compared to other counties and that the UK will remain an attractive investment proposition "comparable to, or more generous than, those provided by most other countries". Whilst tax is not the only factor when considering where to invest, it is clearly a material one.

What is the likely impact?

Returns on foreign sovereign investments in UK real estate will be negatively affected.

Direct holdings by sovereign investors in UK real estate, or holdings via partnerships or unit trusts are likely to become less popular and a REIT structure (with 15% tax leakage) is likely to become the preferred investment vehicle. Existing investments may need to be restructured to optimise the tax position and this could involve several stakeholders such as joint venture partners and lenders.

To the extent possible, structuring a UK real estate investment with an interest return (if possible) will now attract the most beneficial UK tax treatment. Hybrid debt and equity structures may be beneficial.

Non-sovereign investors (provided they don’t need access to sovereign capital) who are in competition with foreign sovereign investors for assets may benefit from the proposals.

Existing REITs will need to monitor the changes to the REIT rules and ensure they ascertain the tax status of sovereign investors to establish whether they will trigger a 'holder of excessive rights' charge for the REIT.

What is a State-operated Overseas Pension Fund ("SOPF")?

In summary, the current proposed requirements to be categorised as a SOPF are:

  • Establishment: the fund must be set up outside the UK by or under an enactment of a foreign sovereign state, or of a constituent territory of a federal state. Funds set up by local authorities or municipalities are excluded.
  • Purpose: the fund must be set up and run exclusively or almost exclusively to provide retirement benefits, plus ancillary or incidental benefits.
  • Members: the benefits must go to people employed exclusively or almost exclusively in government, public or social services for that state or territory. "Almost exclusively" allows some private-sector members without the whole fund losing SOPF status.
  • Funds included: the definition of SOPFs will include national insurance funds, social security funds, state-mandated workers' compensation funds, and state pension funds for the general population.
  • Investment vehicles: the definition will include entities or arrangements set up and run exclusively or almost exclusively to invest for a SOPF. This includes wholly owned subsidiaries, pooled investment vehicles and special purpose vehicles used for commercial, regulatory or legal reasons. It applies even where the gains arise in those vehicles rather than in the fund itself.
  • Who is excluded - Personal pension arrangements and occupational pension schemes that are not for public service are excluded.

What happens next?

The consultation states that "the Government wants the UK to continue to be an attractive location from which sovereign investors can manage their global investments and can invest over the long term". Time will tell how this affects sovereign investment in the UK going forward as it will clearly have an impact on expected returns. Tax is not the only reason sovereigns invest in the UK but it is clearly an important factor.

Affected parties should consider existing UK investments and whether restructuring is required. There may be a benefit to doing this in advance of the legislation being published given the timescales involved.

Consultation responses are due by 20 January 2027 and we intend to respond - please get in touch if they would like to contribute. This measure was previously consulted on in 2022 and dropped. The consultation indicates that the Treasury have already decided to bring this measure in but are willing to consult on the detail of implementation, so evidence from those likely to be affected will be key.

To understand what these proposals could mean for your existing structures or future transactions, speak to Matt Poole or a member of Gowling WLG tax team.

Legislation is expected to be included in Finance Bill 2027-28.