Investing in UK commercial property through fund structures: what are the options?

Insight

09.05.2024

Sophisticated family offices and other private clients often approach us for help with UK commercial property investments. While they are often experienced in acquiring individual properties, they may not have experience of planning, structuring, marketing and operating an investment fund. There are several considerations to keep in mind when considering the establishment of such a structure. This includes:

The jurisdiction and legal form of the fund manager and fund vehicle,
Tax treatment (which will usually be the principal structuring driver),
The regulatory framework in the establishment jurisdictions of both the fund manager and the fund vehicle, and
Ensuring that the structuring at fund level does not cause issues for transaction execution.

This article considers these issues in more detail within the context of UK commercial property investment. Whilst this market has seen a slowdown in recent years, there are still a number of viable options available when considering how best to structure investment into UK-based assets.

Location and legal form

There are an almost infinite variety of ways to structure a fund focussing on investment into UK commercial property, and each approach has its own advantages and risks depending on a person’s or family’s circumstances. The two initial considerations for a potential investor should therefore be the structure and jurisdiction of the fund manager and main fund vehicle.

A client who already has an offshore structure established will usually wish to at least consider establishing their new fund in the same jurisdiction in order to benefit from their existing contacts and knowledge of the culture there. However, for clients who do not already have a suitable jurisdiction in mind, the UK itself, Jersey, Guernsey and Luxembourg are all good options for investing into UK commercial property.

When deciding on the legal form of the main fund vehicle and its location the following key factors should be considered:

Investor familiarity and comfortability: Luxembourg domiciled funds are very popular among European investors. In terms of legal form, many investors are familiar with the limited partnership framework which provides a good degree of flexibility in terms of freedom around commercial terms, while maintaining limited liability for investors. Jersey and Guernsey both have specialised property unit trust structures. In this structure, the legal ownership of the assets is vested in one or more trustees who hold the assets on trust for the benefit of the unitholders upon the terms of a written trust instrument. These benefit from the same tax-efficiency and flexibility of a partnership. The UK continues to develop the flexibility of its fund structure offering, the new Reserved Investor Fund (RIF) being a case in point, and will also merit consideration for onshore UK property investments.
Specific investor requirements: In some cases, particular key investors have specific domestic tax or regulatory requirements. Feeder funds can provide flexibility for these investors, acting as a pooling vehicle for certain groups of investors and then injecting the capital into the main or “master” fund. Cases where this approach is commonly used include where some of the investors are US persons and therefore need to be kept separate from non-US investors, and for Middle East investors who wish to have a separate Shariah-compliant feeder.
Cost of formation and maintenance: When structuring the fund, fund managers will seek to minimise the set-up and ongoing maintenance costs of their fund structure. These include incorporation expenses, advisor fees, fund administrator fees, custodian fees and ongoing compliance costs. Fund managers should also be aware that the complexity of the overall fund structure will generally add to the fund’s overhead costs. This may be unavoidable to a degree when balanced against the structuring considerations set out above.
Availability of third-party providers: These can be varied and wide ranging. The Channel Islands, the UK and Luxembourg all have an excellent pool of fiduciary, corporate services, lawyers, accountants, fund services.

Tax

Tax will be a key driver in determining the structure for a UK commercial property investment. The optimal tax structure always depends on its specific terms, usually driven by factors such as the residence of investors, funding requirements, and the tax profile of the relevant asset. However, current investors in UK commercial property can generally expect to incur at least some exposure to UK tax on a successful investment (in one form or another). This is a marked difference to the historical position, where it was often possible for investors to structure investments "offshore" to limit their UK tax exposure. There remains, however, important tax differences between the structures that can be used for UK property investments.

In the majority of newer structures, UK properties are held directly by companies. It is becoming increasingly common to use UK companies for this purpose, as they are often more straightforward in terms of compliance and many of the historic tax advantages offered by "offshore" companies no longer exist in this context. Such a company (whether located in the UK or elsewhere) will typically be liable to UK corporation tax at a current rate of 25 per cent on income and gains from its UK property.

However, it can sometimes be advantageous to use a non-UK vehicle to hold the shares in the company that directly holds UK commercial property. For example, this may mean that non-UK investors are not exposed to UK inheritance tax on the value of their investment and investors may also acquire shares of the holding company without incurring any liability to UK stamp duty. In some, albeit usually quite limited, cases it may also be possible to structure a non-UK holding company so that investors can dispose of their shares without any liability to UK tax on any capital gains.

In more complex cases, particularly where a diverse range of investors is anticipated, alternative structures may be appropriate. An outline of the tax treatment of some of the more common options is below:

Partnerships/LPs/LLPs: These vehicles are normally treated as transparent for most UK tax purposes. This means that income and gains from the property would not be taxed in the vehicle itself and instead the members would be treated as though they received them directly. As a general rule, this means that individual investors would be subject to UK income tax on income (currently up to 45 per cent) and capital gains tax on gains from the property (currently up to 20 per cent), whereas corporate investors would be subject to UK corporation tax instead (currently up to 25 per cent). One potential downside of these vehicles is that transactions by investors in their membership interests can attract UK Stamp Duty Land Tax (normally at rates up to 5 per cent).
UK Property Authorised Investment Funds (PAIFs) and Real Estate Investment Trusts (REITs): PAIFs and REITS are not normally liable to tax on income and gains from their underlying properties. However, tax is withheld at a current rate of 20 per cent on distributions to most classes of investor. Investors may then be subject to further tax on their income and gains from the fund (depending on each investor’s circumstances and how the fund is structured). If the fund is a UK PLC, transfers of units would also be subject to UK Stamp Duty at 0.5 per cent but not to the higher rates of Stamp Duty Land Tax (which would instead by payable by the PAIF or REIT when it acquires properties).
UK Reserved Investor Funds (RIFs): With the proviso that we do not have finalised rules for the UK’s new RIF structure, RIFs will be treated as transparent for income tax purposes but opaque for capital gains purposes. This means that investors may be liable to tax on the RIF’s income and to UK capital gains tax on a disposal of their units. If the RIF meets certain conditions, it may make a tax election so that it is not itself subject to UK tax on capital gains made from underlying property sales. Transactions in RIF units held by investors should not be subject to Stamp Duty Land Tax (which will instead be payable by the RIF itself when it acquires properties) but may be subject to Stamp Duty.
Jersey Property Unit Trusts (JPUTs): JPUTs and their Guernsey and Isle of Man equivalents are usually not liable to tax on their UK property income. It is also often possible to make a tax election to ensure they are similarly exempt from UK tax on gains (though alternative elections may be possible in some circumstances). Very broadly, investors are then normally taxed as though they received the relevant income and gains from the property directly (in which case the overall effect can in some ways be similar to a partnership – see above).
Luxembourg SICAV: The tax treatment of SICAVs depends on their form. Often, these are companies and so are subject to UK corporation tax on income and gains from their UK properties accordingly. However, as with other structures described above, the SICAV may be eligible to make a tax election to ensure it is exempt from UK tax on its property gains. If such an election is made, investors in the SICAV would be liable to UK tax on gains instead (it was historically possible for non-UK investors to escape this tax liability due to a quirk in Luxembourg’s tax treaty with the UK, but that is no longer the case).

Regulation

The impact of the Alternative Investment Fund Management Directive (AIFMD) regime (and its’ UK derivative) is an important consideration for fund managers raising money from UK and European investors. If set up in the UK or the EU, the fund manager will need to be authorised by the relevant national financial regulator. In some jurisdictions, it is possible to be “hosted” by a service provider, essentially paying an ongoing fee to “rent” their regulatory licence.

Fund managers will need to comply with the ongoing requirements of the AIFMD, notably as to investor disclosure, the requirement to appoint a depositary and as to internal governance. AIFMD also includes a marketing passport for EU established funds (for UK property vehicles typically Luxembourg) managed by fund managers established inside the EU to professional investors. Where passporting is not available, it may also be possible to market to EU investors through the various national private placement regimes and/or via reverse solicitation, but this might not be the most practical option for funds that are intended to be marketed to numerous countries in Europe as approaches to what is allowed in terms of marketing varies from jurisdiction to jurisdiction.

For those wishing to stay outside of the AIFMD perimeter, there are a number of exclusions and exemptions available within the regime. for example for family office vehicles, single investor funds and for vehicles which may have a general commercial or industrial purpose, which is can be particularly useful for, for example, property development vehicles.

“Downstream” real estate considerations

Once the fund structure has been established, the core investment activity of the fund can then start in earnest and the portfolio can be built up. The AIFM will set out the investment strategy to the investors and this will be put in place with targeted acquisitions and active management of the portfolio, with the help of the fund’s external advisers and property managers.

Managing the assets will usually include decisions to made on the following matters across the full lifespan of a commercial property:

The grant of new leases,
The surrender and regearing of existing leases,
Rent reviews and rent concessions,
Dealing with tenant applications for consents to alter, assign or underlet,
Wayleaves and agreements for telecoms and data apparatus with tenants and telecoms operators, and
Upgrades to the asset’s sustainability and ESG credentials, such as PV cells, rain harvesting systems and EV charging points/power supplies.

Where there are landlord and tenant relationships, there will often be disputes to manage, such as:

Tenant insolvency and rental/service charge arrears disputes,
Company Voluntary Arrangements introduced by tenants and the effect on arrears enforcement,
The validity of break notices and the operation of break clauses,
Rights of light disputes,
Trespass,
Landlord and Tenant Act 1954 renewal proceedings,
Dilapidations and reinstatement on lease expiry,
Alternative dispute resolution between landlords, tenants and third parties, and
Contentious planning and telecoms matters.

There may also be improvements to the quality of the portfolio with capital investment and development projects at the assets involving:

Planning and environmental consents and appeals,
Statutory and environmental compliance,
The procurement of construction services for development and refurbishment (building contracts and warranty packages), and
Construction delays and disputes over breach of contract/warranty.

Property tax matters affecting acquisitions and disposals will also need to be considered: most commonly Stamp Duty Land Tax, VAT and Capital Allowances.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.