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Amendments to the taxation treatment of UK resident, non-UK domiciled individuals: 18 January 2008

In the Pre-Budget Report 2007, the Chancellor announced that the rules relating to the taxation of UK resident non-UK domiciliaries would be overhauled and draft legislation has now been released to implement these changes. Although there appears to be scope for retrospective application of the new rules in some cases, the majority of the changes will have effect from 6 April 2008.

The new rules have resulted in a significant tightening of the entire tax regime for UK resident non-UK domiciliaries, which is likely to affect most offshore structures and could significantly increase the amount of UK tax payable.
There is a small window of opportunity until 5 April 2008 for affected taxpayers to re-organise their affairs in anticipation of the new rules and, therefore, it is crucial for UK resident non-UK domiciliaries to consider their options in the immediate term.

The main changes to be introduced by the draft legislation include:

imposing an annual charge of £30,000 on UK resident non-UK domiciliaries who claim the remittance basis of taxation if they have been resident for seven out of the last nine years;
removing income tax personal allowances and the capital gains tax annual exempt amount from those who claim the remittance basis;
expanding the potential scope of the remittance rules;
expanding the scope of anti-avoidance provisions to UK resident, non-UK domiciliaries leading to potential taxation on capital gains realised by off-shore entities, including trusts and companies;
requirements to disclose offshore settlements; and
changes to the residence rules, resulting in the days of arrival in and departure from the UK now counting towards the day test for the purposes of establishing UK residence.

These main changes are summarised below.

Claiming the remittance basis and the £30,000 charge

The current system ensures that UK resident non-UK domiciliaries are generally subject to tax in the UK on foreign income and foreign capital gains only to the extent that amounts representative of such income and gains are brought into the UK. This is known as the "remittance basis" of taxation. Conversely, UK resident, UK domiciled taxpayers are taxed on their worldwide income and gains, wherever they originate. This is known as the "arising basis" of taxation.

Claiming the remittance basis

Currently, the remittance basis automatically applies to foreign employment income and foreign capital gains and also applies to foreign investment income upon the making of a claim by the taxpayer. However, the draft legislation proposes that from 6 April 2008, UK resident non-UK domiciliaries will have to make a claim for the remittance basis on their self assessment tax return for all types of income and gains. If such a claim is not made, such individuals will instead be taxed on an arising basis. The only exception to this rule is where a taxpayer's unremitted foreign income and gains are less than £1,000 in the year in question.

As the claim for the remittance basis must be made annually, it is possible to opt into the remittance basis one year, and be taxed on an arising basis the next.

Loss allowances and exemptions

As a consequence of claiming the remittance basis, a taxpayer will forfeit any entitlement to income tax personal allowances, tax reduction amounts (such as the standard and age-related personal allowances, the blind person's allowance and the married couple's/civil partner's allowance) and the annual amount which is exempt capital gains (currently £9,200).

The £30,000 charge

The draft legislation provides that, starting from the 2007/8 tax year, where a UK resident non-UK domiciliary makes a claim for the remittance basis, a £30,000 charge is imposed if they have been resident in the UK for at least seven out of the last nine tax years immediately preceding the relevant tax year.

The £30,000 charge will be due on 31 January following the end of the tax year in question, so UK resident non-UK domiciliaries will have until this time to decide whether their offshore income and gains for the relevant year are sufficient to justify the cost of claiming the remittance basis.

HM Revenue & Customs ("HMRC") explain that the use of foreign income or gains to pay the £30,000 charge will be regarded as a taxable remittance. Moreover, although the charge is not a tax on income it will not be creditable against other UK tax liabilities and will be collected through the self-assessment system. It will be up to overseas jurisdictions to decide whether the charge will be dealt with as if it were a tax for foreign tax credit purposes under a double tax agreement with the UK. However, it seems unlikely that this will be accepted.

Expanding the potential scope of the remittance rules

The draft legislation extends the definition of "remittance", and this definition will now apply equally to relevant foreign income (broadly, foreign trading and investment income), foreign employment income and foreign chargeable gains.

The new legislation will introduce a broad "catch all" meaning of remittance, being any money or other property "brought to, or received or used in the United Kingdom" which "derives (wholly or in part, and directly or indirectly) from the income or chargeable gains" and is used for the benefit of any "relevant person". In addition, a taxable remittance includes the use of income or gains to satisfy a debt where property has been brought to or used in the UK and the debt relates "directly or indirectly" to that property.

The definition of "relevant person" includes the individual and persons connected to the individual, namely:

spouses or civil partners (or a man and woman living together as if they were husband and wife, or two persons of the same sex living together as if they were civil partners);
any relative;
any relative of a spouse or civil partner;
any spouse or civil partner of a relative;
any trust of which the individual, or someone connected with him, is the settler;
any company under the control of the individual; and
a person with whom the individual is in partnership.

These changes, as well as the removal of a number of what HMRC refer to as "flaws and anomalies" which currently exist in the operation of the remittance basis included in the draft legislation will broaden what is deemed to be remitted by UK resident non-UK domiciliary to the UK.
Some of the "flaws and anomalies" sought to be removed are examined below.

Ceased source

Currently, a UK resident non-UK domiciliary will not be subject to UK tax on overseas income remitted to the UK if the source of such income no longer exists in the year of remittance. This is known as the "source doctrine". This means, for example, that where an individual closes a bank account at the end of one tax year and remits the interest in the next year, there is likely to be no UK tax liability.

The draft legislation overturns the source doctrine, so that a charge can be imposed whenever relevant foreign income benefiting from the remittance basis is remitted, whether or not the source exists in the year of remittance.

"Cash only" loophole for relevant foreign income

Currently in order for there to be a remittance of relevant foreign income, there is a requirement for "sums" to be "received" in the UK. The general view is that "sums received" is limited to actual money for remittance purposes. For example, if relevant foreign income is used to purchase a car or a painting overseas, and such car or painting is subsequently remitted to the UK, this is unlikely to constitute a taxable remittance as the car or painting do not amount to "sums received" in the UK.

However, the draft legislation now provides that, where an individual receives relevant foreign income in the UK or has power to enjoy that income in the UK, the amount received or enjoyed in the UK is properly chargeable to tax whatever form that income takes, meaning that it will no longer be possible for non-domiciliaries to avoid UK tax by purchasing assets with foreign income and bringing them to the UK.

Mixed funds

The current legislation does not expressly provide for the treatment of remittances of mixed funds (that is, funds remitted to the UK that consist partly of amounts of taxable income or gains and partly amounts that have already been taxed or are not taxable). However, in practice, such remittances are taxed on a pro rata basis between the taxable and non taxable elements.

The draft legislation provides that, from 6 April 2008, there will be a clear statutory basis for identifying transfers made from a mixed fund. The component parts of the remittance are identified as representing various categories of income or capital, and these amounts are then set successively against the remittance until it is reduced to nil. The order in which items will be taken to be remitted from mixed funds on an annual basis is:

employment income already taxed in the UK;
foreign employment income taxed on the remittance basis;
relevant foreign income taxed on the remittance basis;
foreign chargeable gains (whilst they are subject to income tax, offshore income gains fall into this category); and finally
anything else, principally tax free capital (presumably, this would include UK taxed income or gains other than employment income).

This is far more onerous than current practice as all the taxable elements of a mixed fund will now be treated as remitted first to the UK. For example, as a consequence of the ordering provided for above, where proceeds from sale of a capital asset are credited to a single account, the gain element from the disposal will, from 6 April 2008, be identified and treated as remitted prior to any capital originally invested in the asset (rather than the more logical practice of treating capital and gains as being remitted on a pro rata basis).

Alienation

HMRC expressly recognises that, at present, a transaction involving a UK resident non-UK domiciliary donor making a gift to a connected person (such as a spouse or civil partner), where the gift is subsequently brought to the UK in such a way that the individual whose income or gain it was may effectively have the use or enjoyment of it in the UK, may result in no UK tax charge. The same may also apply where an individual's overseas income or gains are passed through an entity such as a non-UK resident trust or company. This is because once the gift has been alienated from the donor, it loses the (taxable) income or gain characteristics that it represented in the hands of the donor and becomes non-taxable capital in the hands of the transferee which can be remitted by the transferee without a charge to UK tax.

The draft legislation now makes clear that gifts between connected persons, such as spouses or civil partners are caught under the remittance basis and therefore, perfecting gifts offshore to a partner who then brings the gift into the UK will no longer be an effective method of avoiding taxable remittances. In particular, foreign income or gains will be treated as remitted when:

an individual makes a gift, which either includes unremitted foreign income and foreign gains, or was purchased using such funds, to a "relevant person" (as defined above); and
the gift recipient remits any part of the gift (with the definition of remittance being the new, wider definition explained above).

In these circumstances, a tax liability arises on the UK resident non-UK domiciliary who made the gift as though he or she had made the remittance personally.

It is noted that if an asset is transferred to a connected person for less than full consideration, any gain which arises as a consequence of the transfer is treated as being inherent in the asset transferred. Therefore, the connected person who receives the gift is not taken to have received at its market value but rather at the value at which the UK resident non-UK domiciliary acquired it. Thus upon the disposal by the recipient of the gifted asset, any gain includes the gain which arose on the original gift. The entire gain will be attributed to the resident non-UK domiciliary as a consequence of the "relevant person" definition.

A remittance would also arise on a UK resident non-UK domiciliary who gifts income to a foreign trust or company, if the recipient entity then uses the gift to make an investment in the UK.

The provisions relating to alienation through related persons is due to take effect from 6 April 2008. However, it appears that foreign income and gains arising in 2007/8 or earlier will not be subject to these provisions. This means that if property representing such income and gains has been gifted to a relevant person before 6 April 2008, then, even if that relevant person (other than the taxpayer) remits such property after 5 April 2008 this would seem to fall outside the scope of the new legislation. The new rules will apply to gifts of foreign income and gains arising after 5 April 2008.

Expanding the scope of anti-avoidance provisions

Significant anti-avoidance provisions, which did not previously apply to UK resident non-UK domiciliaries, will be extended under the draft legislation so that they will apply to these individuals. These anti-avoidance measures target UK resident non-UK domiciliaries with interests in closely-held companies and trusts. Structures of this nature will need to be carefully reviewed in light of the operation of these anti-avoidance measures from 6 April 2008.

Attribution of foreign corporate gains

Under current law, UK resident non-UK domiciliaries are exempt from anti-avoidance measures which operate to apportion gains in certain foreign companies to UK resident shareholders whose interest in the company exceeds 10%. The draft legislation removes this exemption. As a consequence, where a non-UK resident company that would be treated as a "close company" if it were UK resident realises a capital gain after 5 April 2008, that gain will be attributed to any UK resident non-UK domiciliary shareholder whose interest in the company (when taken with persons connected with him) exceeds 10%. Such a gain will be attributed to the relevant shareholder in the proportion which represents their participation in the company.

In respect of gains attributed to the UK resident non-UK domiciliary shareholder, if the asset is situated in the UK, the participator will pay UK tax on their share of the gain on an arising basis, as though they had realised it personally. However if the asset sold is a foreign asset, the participator will pay CGT when they remit the proceeds to the UK (i.e. on a remittance basis).

The immediate concern in respect of this change is for UK resident non-UK domiciliaries who have used a foreign company to acquire UK assets. In addition, the corporate anti-avoidance measures currently discussed interact with anti-avoidance measures relating to non-resident settlements. As a consequence, certain planning structures previously adopted by UK resident non-UK domiciliaries involving the settlement of foreign trusts to hold shares in foreign corporate vehicles which are then used to acquire UK property, will be impacted.

Attribution of gains of a foreign settlement to a settlor

The draft legislation includes provisions which allow for settlors of non-UK resident trusts to be liable to CGT on capital gains accruing to the trustees, where the settlor is resident, or ordinarily resident irrespective of whether they are UK or non-UK domiciled. Currently there is an exception from the application of these provisions for UK resident non-UK domiciliaries.

In order for the settlor anti-avoidance provisions to apply, the settlor must have an "interest" in the settlement. The settlor will have an interest where a broadly defined range of persons may benefit from the settlement (including the settlor, their family members and controlled companies).

The settlor anti-avoidance provisions will apply from 6 April 2008. Where the settlor makes a claim to be taxed on the remittance basis, they will be taxable on gains from UK assets upon realisation and on gains from foreign assets treated as remitted by the UK resident non-UK domicilary (or by a connected person such as the trustee).

Attribution of gains of a foreign settlement to beneficiaries

Under the existing rules, a CGT charge arises on gains made by non-UK resident trusts that are attributed to the trusts' beneficiaries when capital payments are made to those beneficiaries. However, this does not apply when the beneficiaries are UK resident non-UK domiciliaries. The draft legislation will extend the operation of this anti-avoidance measure to attribute trust gains by non-UK resident trusts to UK resident non-UK domiciliaries upon the distribution of trust capital.

However, the draft legislation goes further than was anticipated in relation to the attribution of gains of a foreign trust to beneficiaries. Beneficiaries receiving capital distributions or benefits from an non-UK resident trust may be subject to CGT charges whether or not the benefit is received in the UK. The remittance basis will not be available under these circumstances (irrespective of whether a claim for the remittance treatment or a payment of the £30,000 fee has been made).

The draft legislation does not include any transitional provisions. As such, unmatched capital gains made by an offshore trust prior to 6 April 2008 will give rise to a CGT charge on capital distributions to UK- resident non-UK domiciliaries occurring after 5 April 2008. Furthermore, capital payments to UK resident non-UK domiciliaries made prior to 6 April 2008 but not franked by trust gains would fall to be matched with trust gains arising after 5 April 2008 with the beneficiary falling be subject to tax.

Reporting Requirements

The draft legislation will extend the existing notification requirements which apply to UK resident, UK-domiciled settlors to settlors who are UK resident but non-UK domiciled. The provisions will apply to settlors of:

settlements created before 6th April 2008 where the settlor is already resident or ordinarily resident in the UK;
new settlements created on or after 5th April 2008; and
settlements created before the settlor became resident or ordinarily resident in the UK.

Residence - day counting

The draft legislation will confirm changes to the way in which days of arrival and departure are treated when conducting the so-called "day-tests" for the purposes of determining an individual's residence status.

An individual who spends 183 days or more in the UK in a given tax year is resident in the UK for that tax year and, for the purposes of measuring the amount of days spent in the UK, days of arrival and departure will now be included.

It appears that the practice of including days of arrival and departure when day-counting, although not included in the draft legislation, will also apply to the 91-day average test. The non-statutory 91 day average test operates such that individuals who spend an average of 91 days in the UK over four years are normally treated as UK resident.

Conclusion

It is clear that those UK resident non-UK domiciliaries who choose the remittance basis (and subject to a £30,000 fee for this right) will be choosing a far stricter regime than they currently enjoy. However, the alternative is to be taxed on an arising basis on their worldwide income and gains.

In light of this, UK resident non-UK domiciliaries should seek tax advice as a matter of priority. They should review their current position to ensure that where possible appropriate action is taken prior to 6 April 2008 and future structuring opportunities are considered.

This note only deals with what we consider to be the main issues for most non-UK domiciliaries and the trustees of non-UK trusts in which they have an interest and is based on our understanding of the draft legislation as issued on 18 January 2008. This is a very complex area there remain a number of uncertainties. The information and comments contained in this note are for general information purposes only, and are neither intended as nor constitute advice or opinions to be relied upon in relation to any particular circumstances. Bespoke professional advice should always be sought in respect of the application of the law to any specific situations.

Since this Note was written, HMRC have issued a letter 'clarifying' its position with relation to the tax rules on residence and domicile. To view this letter, please click here.