19 March 2008

Stop Press: Budget 2008 - Residence, domicile and offshore trusts


Overview

After extensive lobbying on numerous fronts, this Budget has seen a softening of the proposed new regime regarding offshore trusts, in addition to certain other welcome amendments to the position for residency and the £30,000 levy. Whilst it is now clear that the new regime will be introduced with effect from 6 April this year, the proposed expansion of the disclosure rules for offshore trusts has been dropped, it will be possible to secure the remittance basis for investments in UK assets via offshore trusts and particular concessions have been made in relation to art.

Whether or not these modifications will be sufficient to address the concerns of the non-UK domiciled community remains to be seen. The concern remains that the £30,000 levy will deter intellectual capital from coming to the UK (or remaining here for more than 7 years) and that many non-UK domiciled individuals still feel that they have been betrayed by a sweeping new set of rules that has been introduced at great speed and with little consultation.

Residency

An individual will be considered UK tax resident if he is in the UK for more than 182 days in that tax year or visits the UK for an average of more than 90 days per year over a period of four consecutive years.

HMRC guidance had indicated that days of arrival into, and departure from, the UK should not be counted in computing an individual’s days in the UK in a year in considering these tests. It was proposed in the Pre-Budget Report of 9 October 2007 that any day in which an individual is present in UK (otherwise than merely airside in an airport) would be relevant from 6 April 2008. It has now been announced, however, that the test that will be applied from 6 April 2008 will mean that days will only be counted if the individual is in the UK at midnight.

There will also be an additional exemption for passengers who are in the UK merely because they are in transit between two places outside the UK. Days spent in transit through the UK will not be relevant even where the individual is in the UK at midnight so long as he does not engage in any activity in the UK that is substantially unrelated to his passage through the UK.

Although these provisions in relation to the 182 day test will be statutory, they will be contained in the HMRC guidance in relation to the 90 day test and cannot be relied on in court/tribunal proceedings where the 90 day test is at issue.

£30,000 remittance charge

Annual £30,000 charge for some users of the remittance basis

The introduction of the £30,000 charge to use the remittance basis was confirmed, with effect from 6 April 2008.

This was initially announced in the 2007 Pre-Budget Report, and applies such that non-domiciliaries who have been UK-resident for more than seven of the past ten tax years and who wish to continue to be taxed on the remittance basis, and in some instances, not to be subject to certain anti-avoidance provisions, will have to pay £30,000 for each tax year in question.

A number of clarifications as to the manner in which the charge will operate were announced, and of note:

  • The charge will only apply to adults. This is a significant change from the original position, under which there had been no exemption for minors;
  • The charge has been redefined as a charge on unremitted foreign income and gains and not a stand-alone charge. In practice, the £30,000 fee will serve as an offset against income tax or capital gains tax of up to that amount due on unremitted income and gains, and taxpayers can choose which unremitted funds the charge is to be set against. Those specific funds may subsequently be remitted without charge – in practice this means that payment of the charge will frank the tax liability on £75,000 of offshore unremitted income (or a higher amount of gains given the proposed 18% rate). While the clarification is welcome, a significant sting in the tail is that ordering rules will apply to deem unremitted funds on which the £30,000 has not been paid, to be remitted before the funds on which it has been paid. It is not yet clear whether it will be possible to arrange for a certain identifiable amount of income and/or gains to be placed in a separate account (so that the £30,000 can be paid by reference to such funds, which themselves can then be remitted).
  • The de minimis level has been raised so that the charge does not apply to remittance basis users with less than £2,000 of unremitted foreign income and gains in the relevant year of assessment.
  • The use of untaxed offshore funds to pay the £30,000 will not constitute a remittance provided the funds are wired or paid by cheque directly to HMRC.

Individuals can elect to pay the £30,000 charge on an annual basis, and can opt in and out of the charge, by electing to be taxed on the remittance basis for one year but not for the next year. However, as previously announced, the current rules will be changed so that foreign savings and investment income arising in a year in which the remittance basis is claimed will be taxed if remitted to the UK, irrespective of whether or not remittance basis is claimed in respect of the year of remittance. It has previously been indicated that not paying the charge does not equate with acquiring UK domicile.

Individuals will need to think carefully in relation to their income and gains position for each year whether or not to pay the £30,000 charge but at a minimum it would appear that taxpayers with unremitted income or gains of less than £75,000 in any given year would be unlikely to pay it.

Impact of annual £30,000 charge for US persons

The likelihood of the £30,000 UK charge being creditable for US tax purposes has been helpfully increased by restructuring the charge as allocable to specified unremitted offshore income or gains. Regardless, many (and perhaps most) US taxpayers living in the UK will nevertheless find themselves with UK tax bills significantly higher than what was previously owed in the US and dramatically increased compliance costs.

Even with the enhanced likelihood of a tax credit in the US, it is inevitable that Americans will need to review in detail the extent to which they would benefit from the credit and there are no simple answers. Those not paying the charge will, generally speaking, become subject to UK tax on their worldwide income and gains (and potentially income and gains attributed to them under UK principles from certain trust and holding company structures). This will still result in many US investments, such as most US mutual funds, being taxed at 40% in the UK, rather than 15% in the US and most dividends being taxed at 32.5% in the UK, rather than 15% in the US. While the US/UK Income Tax Treaty generally will serve to eliminate double taxation, the treaty does not perfectly address all potential mismatches leaving families with trust, limited liability company and other holding company structures particularly at risk. Additionally, a host of timing issues remain with respect to when an American will have to pay his UK tax liabilities to obtain full credit in the US.

To help minimize the impact of these additional UK tax charges, US taxpayers should now consider the use of US and offshore trust structures to eliminate UK capital gains tax on disposals of the underlying investments.

Remittance rules

Anti-avoidance provisions

As was considered likely following the 2007 Pre-Budget Report and in light of the consultation paper, a number of strategies to avoid taxation on remittances will no longer be possible from 6 April 2008.

  • Offshore mortgages
    Currently resident non-domiciled individuals can repay the interest on monies borrowed from an offshore bank against UK property with untaxed foreign income or gains without there being a taxable remittance for UK purposes.
    Legislation will be introduced such that interest payments out of untaxed foreign income will be taxable as remittances. This legislation will, however, include grandfathering provisions such that the use of untaxed relevant foreign income (such as foreign dividends and interest, foreign property income, foreign trading profits) to fund interest repayments on existing mortgages secured on UK residential property will not be treated as a remittance until 5 April 2028 (assuming the loan has not been repaid by this point). If the terms of the loan are changed or further advances are made at any time after 12 March 2008, the interest repayments will be treated as remittances from that point. It does not appear that these grandfathering rules will apply to back-to-back arrangements.
  • *Source ceasing


*Currently, if an individual claims the remittance basis of taxation in respect of foreign savings and investment income arising in one tax year he can remit that income in the following tax year without paying tax. It is confirmed that legislation is to be introduced to close this planning technique.
  • Assets
    Previously, if a remittance basis taxpayer used relevant foreign income to acquire an asset, that asset could be imported into the UK without UK tax until the asset was sold in the UK. Legislation will be changed so that the importation of that property and the receipt in the UK of services derived from relevant foreign income will be treated as a taxable remittance. There will be exemptions from the new rules for personal effects (such as watches), assets costing less than £1,000, assets brought into the UK for repair or restoration and assets in the UK for less than a total nine month period. Any asset purchased out of untaxed relevant foreign income owned by an individual on 11 March 2008 will be exempt from a charge under the remittance basis for as long as he still owns it even if it was then outside the UK and is later imported. There will be no change to the current rules relating to assets purchased out of foreign employment income and foreign gains (which will remain subject to UK tax when they are brought to the UK).
  • *Non-resident companies


*It was confirmed that legislation currently preventing UK resident domiciliaries from realising chargeable gains free of UK tax through the use of offshore companies will be extended to apply to all UK residents whether UK domiciled or not.
  • *Alienation of income and gains


*Legislation will be introduced to ensure that tax charges will arise on an individual under the remittance rules where he disposes of money or assets offshore and then arranges for the money or assets to be brought into the UK (or services or benefit to be provided in the UK funded from untaxed foreign income or gains), if the individual or a member of his €˜immediate family’ benefits in any way. The definition of immediate family includes spouses, civil partners, and those living together as spouses/civil partners, and their minor children or grandchildren, trusts of which any of them are settlors or beneficiaries, close companies and certain €˜close’ foreign companies. It appears however that this rule will only apply to foreign income and gains realised after 5 April 2008.
* *

Art

Concerns were raised by the art world that the new remittance rules could lead to art purchased abroad with funds comprising unremitted relevant foreign income being kept outside the UK because the income used to purchase the art works might be taxed in the UK under the new rules if the art works were brought into the UK. In response to these concerns, new provisions will be introduced allowing such works (and also those purchased with unremitted untaxed employment income or capital gains) to be imported into the UK (either temporarily or permanently) without a tax charge so long as they are then put on public display.

Offshore trusts

The draft legislation published in January 2008, based on the original proposal in the Pre-Budget Report in October 2007, suggested that the capital gains tax anti-avoidance provisions would be extended to both non-domiciled settlors and beneficiaries of offshore trusts (and, in the latter case, would tax benefits in the hands of beneficiaries whether or not received in the UK).

Taxation of settlors and beneficiaries

The Government has taken on board some of the criticisms levelled at the proposals and has taken expert advice. So, while it will press ahead with some of the changes, these have been cut back substantially. It appears that the general rule going forward will be as follows:

  • A non-domiciled settlor will not pay tax on trust gains unless or until he receives a capital payment.
  • A non-domiciled beneficiary (including the settlor) who is taxable on the remittance basis will pay tax on capital payments received in or brought to the UK which are matched with trust gains (capital payments kept outside the UK will not be taxed even if matched with UK gains).

Under the rules as originally proposed the tax benefits for a non-domiciled resident individual setting up an offshore trust would have been limited to the inheritance tax protection given to excluded property trusts. Under the current proposal a non-domiciled settlor will not pay capital gains tax on trust gains (even UK source gains) unless or until he receives a benefit from the trust. The cost of obtaining the inheritance tax advantages and the ability to invest in the UK without a capital gains tax charge on an arising basis is the potential for an increased capital gains tax charge when capital payments are received in the UK but this may be a small price to pay.

Rebasing

HMRC announced after the publication of the draft legislation that gains arising or accrued before 6 April 2008 would not be caught by the new rules. The new proposals permit the trustees of non-UK trusts (not the settlor or beneficiaries) to make a one-time election to treat all assets held by the trust (and/or held by an underlying company owned by the trust) as if they had been sold and reacquired at market value on 6 April 2008, effectively rebasing the assets and washing out the accrued gain. The election must be made on or before 31 January following the first tax year during which a capital payment is made to a UK resident beneficiary or part of the trust fund is transferred to a new trust.

The election, however, will not be treated as realising the gain. When the asset is actually disposed of and the gain actually arises, that gain will be split between a pre-6 April 2008 pool and a post-5 April 2008 pool. Non-UK domiciled beneficiaries will not pay tax on benefits matched with gains in the pre-6 April 2008 pool.

Many offshore trustees were considering whether it would be necessary to realise gains pre-6 April 2008. In light of the proposed rebasing provisions, this may no longer be necessary provided the trustees are willing and able to make the relevant election. It should be noted, however, that HMRC expressly state that where a rebasing election is made, a beneficiary receiving a capital payment may be required to provide information to HMRC to enable them to assess the correct capital gains tax exposure.

Taxation of benefits

The anti-avoidance provisions apply by treating capital payments made to a beneficiary from an offshore trust as being made in the following order:

  • from income; or if, none or the income tax anti-avoidance provisions do not apply
  • from offshore income gains; or, if none
  • from capital gains.

Under the old rules, capital payments matched with capital gains were matched with the gains arising in earlier years first. In addition, capital gains were matched proportionately among capital payments made in the current or earlier years. Both these rules are to be changed so that in relation to capital payments made on or after 6 April 2008, a last in first out €˜LIFO’ rule will apply (except in certain circumstances where a rebasing election is made) therefore:

  • trust gains of the current year will be matched with a capital payment before gains of previous years and trust gains of later previous years will be matched before those of earlier previous years;
  • current year capital payments will be matched with trust gains before capital payments of previous years and capital payments of later previous years will be matched before those of earlier previous years.
  • It is also possible (although this is not yet clear) that gains realised or capital payments made later in a particular tax year will be matched before gains realised or capital payments (as the case may be) made earlier that year.

This may be beneficial in certain circumstances as capital payments matched with current gains will be taxed at 18% compared to a potential 28.8% if matched with gains of earlier years (see an explanation below of the supplemental charge). It does, however, have implications for distributions made to non-domiciled beneficiaries after 5 April 2008 and this is discussed below.

Taxation of capital payments

There was concern when the draft legislation was published that capital payments received by non-domiciled beneficiaries before 6 April 2008 which had not been wholly matched with trust gains would be taxed after 5 April 2008 and that capital payments made after 5 April 2008 could be taxed if matched with pre-6 April 2008 gains. An attempt has been made to clarify this and the following is a summary of the proposed rules.

  • A capital payment received by a non-domiciled beneficiary before 12 March 2008:
    - if matched with gains realised before 6 April 2008 will not be taxed
    - if matched with gains treated as accrued at 6 April 2008 as a result of a rebasing election will not be taxed
    - if matched with gains realised after 5 April 2008 will not be taxed unless the beneficiary is UK resident and domiciled at the time the benefit is matched with the gain
  • A capital payment received by a non-domiciled beneficiary on or after 12 March 2008 and before 6 April 2008
    - if matched with gains realised before 6 April 2008 will not be taxed
    - if matched with gains treated as accrued at 6 April 2008 as a result of a rebasing election will not be taxed
    - if not so matched it will not be taxed but it cannot be matched in the normal way with post 5 April 2008 gains and so will not reduce the gains pool which will be carried forward to be matched against later capital payments
  • A capital payment received by a non-domiciled beneficiary on or after 6 April 2008
    - if matched with gains realised pre-6 April 2008 will not be taxed
    - if matched with gains treated as accrued at 6 April 2008 as a result of a rebasing election will not be taxed
    - if matched with post-5 April 2008 gains will be taxed unless the payment is received and retained offshore and the beneficiary claims the benefit of the remittance basis.

Where trustees already have substantial realised gains, consideration should still be given as to whether a capital distribution should be made to a non-domiciled beneficiary who is resident in the UK to support his UK expenses at least for the next few years. A capital payment made before 6 April 2008 which is wholly matched with pre-6 April gains will not be subject to UK capital gains tax. With the new matching rules (described above) a capital payment made to a non-domiciled beneficiary after 5 April will first be matched against current gains (i.e. those after 5 April 2008) which will be taxed if remitted to the UK before it can be matched against pre-6 April gains which will not be taxed. As time goes on, therefore, it is going to be more difficult to match pre-6 April gains to avoid a capital gains tax charge.

Taxation of offshore income gains within trusts

The taxation of offshore income gains has been clarified. Offshore income gains arise on the disposal of an interest in an offshore fund which does not have €˜distributor’ status, typically a hedge fund or other similar collective investment vehicle which rolls up its income. The following rules will apply to offshore income gains arising after 5 April 2008:

  • An offshore income gain will be taxable under the capital gains tax rules described above if it is matched with capital payments in the year in which it arises.
  • If, however, the offshore income gain is not matched with capital payments in the year in which it arises it will be added to the trust income pool which is taxed under other anti-avoidance provisions and will be removed from the capital gains tax pool.
  • If the income tax anti-avoidance provisions do not apply to the trust (on the basis that HMRC have accepted that the trust was not established for UK tax avoidance purposes) then the offshore income gain will remain taxable under the capital gains tax provisions.

Whichever of the anti-avoidance provisions applies, the offshore income gain will be taxed at 40% (it is assumed that the penalty if there is a delay between the offshore gain being realised and being matched with a capital payment will not apply as is currently the case).

The difference between the capital gains tax rate of 18% on trust gains and the income tax rate of 40% on offshore income gains may make investment in offshore funds unattractive from a fiscal perspective (although the investment benefits may well outweigh the potential tax disadvantages).

It should be noted that the non-distributor /distributor status regime is to be changed and a new reporting fund status introduced.

Supplemental charge

The supplemental charge applies to increase the rate of tax payable by a beneficiary who is taxed on a capital payment from a trust. The supplemental charge is 10% of the tax that would be have been paid for each year of delay between the gain being realised and the benefit being matched with a capital payment up to a maximum of 6 years. Where the rate of capital gains tax is 18%, the maximum rate of tax with the full supplemental charge will be 28.8%. Where the capital payment is made to a non-domiciled beneficiary it is the delay between the gain being realised and the payment being made that counts. No account is taken of any delay before remittance.

Reporting

Under the original proposals, non-domiciled settlors were going to be required to notify HMRC of the existence of offshore trusts they had established. This proposal has been dropped and there will be no new requirement on non-domiciled settlors to notify the creation or existence of non-UK resident trusts.

Foreign dividend income

The income tax rate for UK resident non-domiciliaries remitting non-UK source dividends has been increased to 40% with effect from 6 April 2008 (previously this rate was 32.5%).

Authors

Category: Article