Restricting the scope of sovereign immunity from taxation

The government is consulting on restricting the scope of sovereign immunity from taxation to passive interest income. The consultation document, “Sovereign immunity from direct taxation: consultation on policy design”, sets out the government’s proposal for how sovereign persons will be treated for direct tax purposes going forward. The proposal is more restrictive than current practice, but the government sees it as a fair and proportionate restriction which will bring the UK more in line with the exemptions that other countries provide.

As part of this process, the government is also proposing to codify the reformed exemption in legislation to provide greater clarity and certainty for foreign investors. It is proposed that the changes will take effect from April 2024.

Background

In the UK, the way that sovereign immunity has been interpreted in the area of tax is that foreign sovereigns have exemption from liability to direct taxes. That includes natural persons, and extensions of the State including entities such as funds or bodies corporate. This exemption applies to all activities of sovereign persons, including both those generally associated with their sovereign functions and those of a commercial nature.

The consultation notes that most other comparable countries also have arrangements in place to provide tax exemptions for sovereign persons and States. However, the exemptions of other countries do not apply to all activities of sovereign persons, mostly being restricted to investment income. In this respect, the UK’s approach is currently outside the international mainstream.

In addition, there have been significant changes in the territorial scope of UK taxation over recent years, particularly in relation to UK property income and gains. The consultation notes that these changes in the tax treatment of non-UK resident persons have had the effect of creating a significant disparity between the tax treatment of sovereign immune persons (who remain exempt from tax on their UK property income) and other non-UK resident persons (who are no longer exempt). This disparity, coupled with the growth and variety of Sovereign Wealth Fund (SWF) investments, demonstrates to the government the need to reform sovereign immunity.

Proposed changes

First, the government proposes that both the principle of, and the conditions underpinning entitlement to, sovereign immunity should be comprehensively set out in legislation to provide greater certainty regarding both the persons for whom, and the income in respect of which, the exemption is available for.

Second, the government proposes that sovereign immunity from direct tax should be targeted to income that:

• arises from investment rather than trading activity;
• 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; and
• 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.

Based on these criteria, the consultation proposes that exemption be targeted at UK source interest income. Practically, this means that sovereign persons’ income and gains from UK immovable property and income from UK trading activities would be brought within the scope of tax.

These changes will also require a number of associated changes. For example, the government proposes to also ensure that a State is not to be immune from the jurisdiction of the UK courts in respect of proceedings relating to its liability for direct taxes. Once the UK has moved away from absolute immunity from liability to tax, it will be consistent to allow for UK courts to enforce any tax liabilities to which Sovereigns become subject.

Who will be covered?

The government proposes that all constituent territories of a federated State will be eligible for immunity from tax. However, it is not proposed to extend the scope of immunity beyond constituent territories to municipal authorities. Municipal authorities are levels of authorities below the level of constituent territories. Certificates can be sought from the Secretary of State of the FCDO to confirm whether any territory is a constituent territory of a federal State for this purpose.

Sovereign immunity would also apply to any Head of State and the government of the State. The consultation welcomes views on how this should be defined so that it appropriately captures different government manifestations, for example:

• government departments and agencies;
• central banks; and
• government funds, such as sovereign wealth funds and social security funds.

The consultation also notes that there is a question as to whether government pension schemes should benefit from being included in a reformed sovereign immunity regime, or whether they should be ineligible, since those currently benefitting from sovereign immunity may be eligible to register for tax purposes under existing alternative exemptions. These alternative exemptions will continue to exempt them from tax on their investment income and gains.

The government is also seeking views on whether the definition of foreign government should extend to controlled entities, where they are wholly owned and controlled by the State.

The government proposes that qualifying foreign sovereign non-natural persons will generally be treated as non-resident companies and therefore liable to corporation tax on the forms of income from which they are not exempt.

What will be covered?

The government is proposing that exemption be refocused on income from investment activity and specifically investment of a more passive nature in assets that are more commonly held as part of the undertaking of sovereign functions. In particular, the government believes that the most appropriate approach for the UK is to ensure income from debt and equity investments in the UK is exempt from tax.

The UK does not tax non-residents on UK source dividend income, so that does not need to be exempted from tax for foreign sovereigns. Therefore, the government proposes an exemption for foreign sovereigns in respect of UK source interest income, over and above the existing exemptions that are available such as the Quoted Eurobond Exemption and gilts with FOTRA (Free Of Tax for Residents Abroad) status.

The government does not propose that the exemption be limited to portfolio investments (i.e. investments in debt of a person in which there is a non-controlling interest) to avoid the complexities that could come in having to administer such a test.

Other tax consequences

The consultation also recognises that the restriction on sovereign immunity from direct taxes may have other consequences.

For example, currently, the tax system provides certain institutional investors with different beneficial treatment to other investors in order to provide certainty and promote an open investment environment in the UK. In some cases, sovereign immune investors are deemed to be qualifying investors, which ensures that their immune treatment is not disturbed when they invest indirectly in certain assets through holding or investment fund structures. These regimes include the substantial shareholdings regime, the recently introduced qualifying asset holding company regime (QAHC), the REITs regime and a number of other fund-related regimes. Qualifying investor status ensures that large institutional investors such as SWFs are encouraged to use UK fund structures, which brings wider economic benefits.

However, the consultation suggests that in some cases, allowing sovereign persons to remain as qualifying investors within individual regimes of the existing tax legislation could undermine the proposed reform set out in this consultation. The consultation notes that the operation of each of the regimes alongside a reformed sovereign immunity regime will need to be considered carefully. The government is therefore seeking further detail on the scale of foreign sovereign investment through such structures in the UK, and any practical issues that could arise if sovereign persons were no longer considered to be qualifying investors for such purposes, and any mitigating actions that could be taken.

The consultation states that the government is not minded to change how all of these areas of tax code operate in relation to sovereign persons, given that many are seeking to capture large institutional investors with particular structures and profiles as opposed to capturing those with tax
exempt status in respect of a particular stream of income. It gives as an example the fact that the list of qualifying investors within the QAHC regime is not one that is driven by tax exempt status but rather one that seeks to identify genuine investors for which holding companies are commonly used in making investments. Removing sovereign immune persons from the list of qualifying investors would not be justified in that instance and, focusing on this as an example, would have a negative impact on the objective of the QAHC reforms in making the UK a more attractive place to hold and manage large-scale assets.

The consultation states that the government does not intend to disturb the existing treatment of registered overseas pension schemes which can also benefit from qualifying investor status in existing parts of tax legislation. This means that if a foreign public pension fund is benefitting from
sovereign immunity currently, and is also registered as an overseas pension fund and is a qualifying investor, that benefit would not change following the introduction of sovereign immunity legislation.

Inheritance tax

The government proposes to only provide sovereign immunity from inheritance tax (IHT) where state property situated in the UK held by a foreign Sovereign or Head of State passes to his or her successor (as Sovereign), or to other persons in circumstances where it remains state property.
This means that where a foreign Sovereign or Head of State disposes of any private property situated in the UK, it will be in scope of IHT. It also means that where a foreign Sovereign or Head of State disposes of any state property situated in the UK, that following or upon its transfer ceases to be state property, the government intends to ensure that HMRC can collect the tax from all liable people, including the foreign Sovereign or Head of State, including where he or she is acting in a representative capacity.

Commencement

The government proposes that the new rules will apply, from 1 April 2024 to income recognised in accounting periods ending on or after that date for entities chargeable to Corporation Tax, and from 6 April 2024 to sovereign natural persons. Apportionment rules would apply where a sovereign entity’s accounting period straddles 1 or 6 April.

Comments

The consultation is open for comments until 12 September 2022 and responses should be sent to sovereignimmunity@hmtreasury.gov.uk.

The government will be consulting relevant stakeholders and interested parties on the proposals through meetings during the consultation period.

The government intends to publish draft legislation for technical consultation ahead of the inclusion of the legislation in a future Finance Bill.