Mark Davies article ‘Consultation on non-dom and IHT reforms’ has been published in the latest issue of Taxation Magazine. Click here to see the article on their website, or continue reading below.
George Osborne, the former Chancellor, announced the proposed changes over a year ago now, in the 2015 Summer Budget. The “further” condoc released by HMRC on 19 August and the new detail it provides has been long-awaited. What is abundantly clear for non‑doms and their advisers is that there is much work to be done between now and 5 April 2017.
This article aims to highlight some of the key planning opportunities and pitfalls of which advisers need to be aware , based on the condoc.
Unsurprisingly, the condoc confirms the introduction of the “15/20 test” which is the cornerstone of the reforms. Any non-dom who has, as of 6 April 2017, been UK resident for 15 out of the previous 20 tax years will become deemed UK domiciled for all taxes.
Deemed UK domicile is a new concept for income tax and capital gains tax. In practice it will limit the number of years for which a non-dom can continue accessing the remittance basis. Up until now, use of the remittance basis by long-term UK resident non‑doms (those who have been resident in more than 7 out of the previous 9 tax years) has been curtailed only by the requirement to pay the Remittance Basis Charge (“RBC”). Once deemed UK domiciled a non-dom will have to pay taxes on their personal worldwide income and gains as they arise, but see below.
The existing inheritance tax legislation already treats non-doms as deemed UK domiciled once they have been UK resident in 17 out of 20 tax years. From 6 April 2017 onwards, deemed domiciled status for IHT will be triggered sooner, under the same 15/20 test that applies for income tax and capital gains tax. There is some logic to having three taxes, one rule.
One side-effect of the new 15/20 test is that the £90,000 RBC applicable to non-doms UK resident in 17 of the past 20 tax years will no longer exist. The £90,000 RBC will be confined to history as a two-year phenomenon applicable in 2015/16 and 2016/17 only.
- The key implication of becoming deemed UK domiciled for inheritance tax is that the individual’s worldwide assets, not only their UK situs assets, are brought within the scope of inheritance tax. This makes lifetime gifts of foreign assets potentially taxable events. A deemed UK domiciled person who settles foreign assets into trust may trigger an immediate inheritance tax liability.
- The 15/20 test will apply to children born in the UK to non-domiciled parents. If they are continuously UK resident as they grow up, then they will become deemed UK domiciled by the time they reach 16 years old.
- Split years under the Statutory Residence Test will count as full years of residence for the 15/20 test.
- The £2,000 de minimis (whereby the remittance basis applies automatically for non-doms with less than £2,000 of unremitted foreign income and gains for a particular tax year) will continue to apply once an individual becomes deemed UK domiciled.
Rebasing of foreign assets
Now for some good news.
The government accepts that it would be unfair if long-term resident non-doms were liable to capital gains tax on gains that accrued on foreign assets before they become deemed domiciled.
If an individual becomes deemed UK domiciled on 6 April 2017 then they will (in some cases at least) be able to “rebase” the cost on foreign assets to their market value as at 5 April 2017.
However, it is worth noting that the government’s sympathy only extends so far. Under the current proposals, rebasing will only be available to long-term resident non-doms who have actually paid the remittance basis charge in any year before April 2017. In addition, it will only apply to individuals who become deemed domiciled on 6th April 2017. These rules do not apply to individuals who become deemed domiciled in a later year.
There was no mention of a requirement to have paid the RBC when the original announcements were made, so it is fair to call this a pitfall. It will also come as a disappointment to some clients.
The rebasing opportunity will apply on an asset-by-asset basis and, before you get carried away, only directly held foreign assets will be eligible for rebasing.
It also seems likely that the foreign assets will need to have been in the taxpayer’s direct ownership as at 8 July 2015 (the date of the 2015 Summer Budget). If so, this will prevent clients from shoehorning trust or company-owned assets into the new rebasing provisions by moving them into their personal ownership before 5 April.
- Rebasing is only available to individuals who become deemed domiciled in April 2017. There is currently no intention to offer a rebasing opportunity to those who become deemed domiciled in later tax years.
- Clients might consider paying the RBC for 2016/17 if they have not done so in previous tax years and the CGT-free rebasing opportunity would be valuable to them.
There is a further, unexpected silver lining tucked away in the condoc.
The government has proposed a one-off window of opportunity for non-doms to “cleanse” overseas bank accounts containing a mixture of capital, income and/or capital gains. Once a so-called “mixed fund” has been created, the existing legislation makes it virtually impossible to access the clean capital and remit it to the UK without incurring a tax liability. Once foreign income and gains become taxable on an arising basis the mixed fund rules as they stand might have made it very difficult for deemed UK domiciled individuals to pay their taxes without incurring a further tax charge on the remittance.
So, the 2017/18 tax year will be a temporary window in which individuals can “rearrange” their mixed funds, enabling them to separate them out into their constituent parts. The object of the task will be to quantify the constituent parts, and then separate out the capital by transferring it to a separate bank account so that it can be remitted to the UK tax-free in the future.
In contrast to the rebasing opportunity, “cleansing” will be available to all non‑doms, regardless of how long they have been UK resident; not just those caught by the 15/20 test. It is in the government’s interest to widen the scope of this relief as they are hoping to encourage inward UK investment.
We anticipate a cleansing bonanza as clients and their advisers try to rectify the sins of the past between 6 April 2017 and 5 April 2018.
- The condoc indicates that the opportunity to clean up mixed funds will not extend to taxpayers who are unable to identify the source of their funds. This may require time consuming analysis to identify the constituent parts of the mixed funds.
- The opportunity will only be available for mixed fund bank accounts or similar. If the taxpayer owns an overseas asset comprising a mixed fund, then they will need to sell it (during the transitional window) and deposit the proceeds in a bank account to enable the mixed fund to be split out.
- This treatment will not be available to non-doms who become deemed domiciled from 6 April 2017 because they were born in the UK with a UK domicile of origin and have since returned to live in the UK. So-called “boomerang non-doms” are not invited to the party.
This is where it all becomes rather complicated.
The 2015 Summer Budget announcement introduced the idea that offshore trusts set up by non‑doms before they become deemed domiciled would be “protected”. Foreign income and gains would not be taxed as long as they are retained in the trust (or its underlying entities).
One of the earlier proposals was to introduce a “benefits charge”, whereby all distributions from trusts would have been taxed, possibly at a flat rate, regardless of whether they represented income or gains.
The government has decided against a benefits charge, which is welcome news – particularly for beneficiaries of so-called “dry” trusts with no history of generating income or gains. Beneficiaries of these trusts would have been unduly penalised by such a rule.
Instead, there will be amendments to the already complex anti-avoidance rules, designed to “switch off” the settlor/transferor charges in certain scenarios.
Capital gains tax
Currently, the rule which attributes the capital gains arising to an offshore trust to the settlor, Section 86, TCGA 1992, does not apply to non-doms.
The condoc confirms that non-dom settlors who become deemed domiciled under the new rules will continue to remain outside the scope of Section 86, provided the trust was set up before they became deemed domiciled.
However, there are important conditions attached. The settlor cannot add further assets to the trust once they become deemed domiciled. Nor can the settlor, their spouse or their minor children receive any benefits from the trust.
If either of these things happen, the settlor’s protection from taxation on trust gains will be switched off. All trust gains will become taxable on the settlor from that point onwards. In unfortunate cases, the resulting tax charges may be disproportionate to the benefit received from the trust.
Currently, any beneficiary who receives a capital payment from an offshore trust can have a proportion of the capital gains imputed to them under Section 87, TCGA 1992. However, going forwards Section 87 will not be relevant for settlors who become deemed UK domiciled. If they receive any capital payments themselves, then they will (under the new proposals) become liable for all trust gains under Section 86 in any event. These provisions appear punitive as £1 of benefit to a beneficiary can mean that all the gains of the trust are taxable on the settlor as they arise.
If a deemed UK domiciled trust beneficiary receives a capital payment on or after 6 April 2017 and the settlor charge under Section 86 does not apply, then the capital payment is matched to trust gains under Section 87. The beneficiary will be unable to claim the remittance basis and the matched capital payment will be taxed regardless of where in the world it is received.
- The condoc makes it clear that the protected status of the trust will be lost if “the settlor, their spouse, or their minor children and/or stepchildren receive any actual benefits from the trust”.
- Remoter issue, e.g. grandchildren, are not mentioned specifically. It will be interesting to see whether this is significant or not. Will capital gains tax protection continue to apply to the trust if a grandchild of the settlor or a wider family member receives a benefit?
- It seems that there will be no loss of protection until there is an actual benefit granted, i.e. the entitlement of the settlor, spouse or minor child to benefit alone should not result in a loss of protection.
- However, if trustees are given the power to benefit the settlor, their spouse or minor children, then there is a chance they could do so without realising the UK tax implications for the settlor. The safest option will be to exclude these parties from the beneficiary class.
Where it applies, the settlements legislation (Section 624, ITTOIA 2005) taxes the settlor on trust income as it arises. The settlor is caught if they retain an interest in the trust. These rules can apply to settlors of both UK resident and non-resident trusts.
The existing legislation does not distinguish between UK domiciled and non-domiciled settlors; both are within the ambit of Section 624. However, currently non-dom settlors can potentially shelter any foreign trust income imputed to them by claiming the remittance basis.
Once a settlor becomes deemed UK domiciled, they will no longer have the option of claiming the remittance basis. So, the law will be amended to ensure that deemed domiciled settlors are not taxed on foreign income arising to a non-resident trust they set up before becoming deemed domiciled. It is proposed that Section 624 will be switched off for foreign income; as long as the income is retained within the trust. UK source income will continue to be taxed on a deemed domiciled settlor.
However, the settlor will still be liable if their spouse, minor child or other relevant person receives a distribution of relevant foreign income in a year in which the trust is protected, and the distribution can be matched with foreign income arising in that year and/or any other years when the settlement is protected (and the settlor is a long-term resident non-dom).
The use of the trust making loans to avoid tax on distributions will be precluded. The intention is that Section 633 will continue to apply to non-dom settlors once they become deemed domiciled. Section 633 is an often overlooked provision. It states that where the income of a trust is not taxed on the settlor under section 624, any capital sums paid to the settlor by the trustees, including loans, are taxed as income of the settlor.
- The settlor can still be taxed where their spouse, minor child, or other relevant person receives an income distribution. By contrast, the capital gains tax protections make no reference to “other relevant persons”. It will be interesting to see who will be considered to fall within this mystery category, and whether its omission from the capital gains tax section of the condoc was meaningful.
Transfer of assets abroad
The current transfer of assets abroad (TOAA) legislation is notoriously wide-reaching; particularly in the eyes of HMRC.
The key provision to be aware of for transferors, for example settlors of offshore structures, is Section 720, ITA 2007, which seeks to attribute income arising within a structure to the “transferor”. Only UK resident transferors are caught by these rules.
Section 720 is similar in effect to Section 624 of the settlements legislation (see above) and the two provisions often overlap. However, there are important differences. Section 720 is broader in scope. It applies not only to settlements (or trusts) but also to other offshore entities, such as companies, where the transferor still has the “power to enjoy” the income.
Again, the government intends to build in protections to save deemed UK domiciled settlors (who settle offshore trust and company structures before becoming deemed domiciled) from being taxed on foreign income arising within their structures.
The government intends to achieve this by partially dis-applying Section 720, but for foreign income only. UK source income will continue to be taxed as usual; either under Section 624 or 720 depending on whether the income arises to a trust or company.
Instead of foreign source income being attributed under Section 720 as it arises, the transferor will be liable to income tax on any worldwide benefits received. It is envisaged that a similar “matching” mechanism might be introduced to that currently used for the purposes of Section 731. In any event, the take-away point here is that worldwide benefits will be taxable on the settlor if, and to the extent that, the benefit can be matched with relevant foreign income arising in that tax year.
If the settlor’s spouse, minor child or “other relevant person” (there it is again) receives a distribution or otherwise benefit from the trust, then the protected status of the trust will not be lost, but the benefit will be taxed on the settlor.
- In contrast to the capital gains tax rules, the loss of protection is seemingly less harsh. The condoc indicates that where a benefit is received in a particular tax year, the settlor will be taxed on relevant foreign income arising in that year only. This would be a year-by-year approach, rather than the “all or nothing” nature of the capital gains tax protection.
Excluded property trusts
The government is not proposing to change the existing “excluded property” rules.
Even under the new rules, it will be possible for non-doms to settle their foreign assets into a non-resident trust before they become deemed domiciled, and keep those assets outside the scope of inheritance tax. The excluded property status of the trust will continue, even after the settlor becomes deemed domiciled; provided they do not contribute additional assets to the trust after that point.
Therefore, indefinite deferral of inheritance tax is still possible in some cases. However, please note the targeted changes in relation to UK residential property set out below.
Inheritance tax on UK residential property
This is a fundamental change in policy.
From 6 April 2017, shares in an offshore close company can no longer be excluded property if, and to the extent that, the company derives its value (either directly or indirectly) from UK residential property. There will be no change to the treatment of companies other than close companies and “similar entities”.
For these purposes, the government is currently leaning towards borrowing the definition of residential property from the existing non-resident capital gains tax (“NRCGT”) legislation. Consistent with NRCGT, it seems there will be no relief from the new inheritance tax rules if the UK residential property is let out commercially.
Disappointingly, whilst the government recognises that taxpayers wishing to de‑envelope in response to the new changes could face significant tax liabilities, they have concluded (without explanation) that a de‑enveloping relief would be inappropriate.
It seems bizarre that the government has changed the rules such that the ownership of UK residential property through offshore structures is penalised, yet it is offering taxpayers no clear path to restructuring their affairs in response to these changes.
When April 2017 comes around, many non-doms will find themselves caught between a rock and hard place. Some will be faced with ongoing annual tax on enveloped dwellings (“ATED”) charges, coupled with a latent inheritance tax exposure, yet there might be no satisfactory way of de-enveloping (at least not without triggering immediate capital gains tax and SDLT liabilities).
It begs the question: why wouldn’t the government want to make it easier for people to exit these structures, when incentivising people to do so was the main purpose of the ATED regime in the first place?
The cynical observer might conclude that ATED has been a surprise cash cow for HM Treasury and, actually, it suits the government quite well to leave taxpayers trapped in these structures. Welcome to the Hotel California, Britain is open for business.
Without wishing to give false hope, Question 9 on the condoc asks whether there are any “hard cases or unintended consequences” that will arise as a result of there not being any tax relief for those who want to exit their enveloped structures.
If readers have any good examples illustrating the harsh tax consequences that will result from the absence of a de-enveloping relief then we would encourage you to respond to the consultation in writing before 20 October 2016. This could be the last opportunity to influence the outcome.
So, after this veritable whirlwind of reforms, what planning opportunities are likely to emerge from the wreckage? These are our top five based on the condoc.
Clearly there will be a loss of inheritance tax protection for UK residential property held within offshore structures in some cases. However, other assets can still be sheltered from inheritance tax using an offshore trust structure established prior to becoming deemed UK domiciled. The inheritance tax changes impact UK residential property, but UK commercial property is, for the time being at least, unscathed by the government’s proposals.
There will be an ongoing role for excluded property trusts established prior to becoming deemed UK domiciled. However, there is likely to be a trade-off between settling assets into trust before April 2017 to shelter them from inheritance tax, and benefitting from the tax-free rebasing for capital gains tax purposes for personally held assets.
The new rules for residential property only apply to overseas close companies. Therefore, there may be scope for pooling investments in UK residential property in such a way that a company is not considered to be “close”. For example, where there are at least eleven unconnected equal shareholders then the company should not, in theory, be caught by the new rules.
Long live the offshore trust? It is fair to say that the protections for offshore trusts set up by non-doms before becoming deemed domiciled have been half-delivered. The draft legislation to be included in Finance Bill 2017 should provide further detail. However, it should be possible for non-doms to use offshore trusts as a “money box” subject to certain limitations.
As long as no further assets are added to the trust, and no benefits are provided, it seems that these “protected trusts” will act as a tax-free wrapper. This may be particularly appealing to non-doms planning their move abroad, as they should be able to access the trust assets free of UK tax once they are non-resident and safely beyond the reach of the labyrinthine anti-avoidance provisions.
On a related point, non-doms with existing offshore structures might consider dividing the assets into separate trusts depending on whether they will be used to benefit beneficiaries, or can potentially be left untouched in a protected trust so that income and gains can accumulate tax-free.
Where appropriate, clients and their advisers should make the most of the one-off opportunities such as the asset-by-asset rebasing to 5 April 2017 market value for CGT purposes, and the ability to clean up historic mixed funds between 6 April 2017 and 5 April 2018.
The government has also signalled that it is open to suggestions as to how the existing Business Investment Relief (“BIR”) rules could be amended to widen the appeal of the relief. These changes will also take effect from 6 April 2017 and it will be interesting to see what is included in Finance Bill 2017.