Taxation of non-domiciled individuals: further consultation published

Practical Law UK Legal Update w-003-3562 (Approx. 10 pages)

Taxation of non-domiciled individuals: further consultation published

by Practical Law Private Client

Taxation of non-domiciled individuals: further consultation published

Current deemed domicile rules and UK tax implications

Currently, non-UK domiciled individuals pay inheritance tax (IHT) only on their UK assets and can claim the remittance basis for income tax and capital gains tax (CGT). UK domiciled individuals pay IHT on their worldwide assets and pay income tax and CGT on worldwide income and gains on the arising basis.

For IHT purposes, an individual is deemed to be UK domiciled if they have been UK domiciled within the threeyears immediately preceding the relevant time (three-year rule) or if they have been UK resident in at least 17 out of the 20 tax years ending in the tax year in which the relevant time falls (17 out of 20 rule) (section 267(1), Inheritance Tax Act 1984 (IHTA 1984)). There is no deemed domicile status for income tax and CGT.

For more information about the concept of domicile and its UK tax implications, see Practice notes:

•Domicile.

•Residence, ordinary residence and domicile: UK tax implications.

•Remittance basis: what individuals need to know: overview..

•Inheritance tax: spouse exemption for non-UK domiciled spouses.

•Taxation of offshore trusts: overview.

July 2015 Budget announcements

At the July 2015 Budget, the government announced that it would publish consultations following the 2015 summer recess on the following measures:

New deemed domicile rules to prevent UK-resident individuals from benefiting from non-UK domiciled status indefinitely for UK tax purposes. The new rules would provide that:
- individuals who were resident in the UK for at least 15 out of 20 tax years would become deemed domiciled in the UK for all tax purposes from their 16th tax year of residence (15 out of 20 rule); and
- individuals who had a UK domicile of origin but acquired a domicile of choice elsewhere would be deemed domiciled in the UK for all tax purposes at any time when they were subsequently tax resident in the UK (returning UK dom rule).
Deemed domiciled individuals would be subject to income tax, CGT and IHT in the same way as UK-domiciled individuals, with limited exceptions. The new rules would not affect the individual's domicile under the general law (actual domicile) for other purposes.
Charging IHT on UK residential property owned indirectly by non-UK domiciled individuals (IHT anti-enveloping rules).

These measures would have effect from 6 April 2017, but the new deemed domicile rules were to be included in the Finance Bill 2016 (FB 2016) and the IHT measure in the Finance Bill 2017.

HMRC also published a technical briefing (HMRC technical briefing) on each measure. For details of the proposals as originally announced, see Legal update, July 2015 Budget: key private client tax announcements: Permanent non-domiciled tax status abolished and IHT on UK residential property owned indirectly by non-domiciled individuals.

Post-July 2015 Budget developments

The Institute of Chartered Accountants in England and Wales (ICAEW) has published a consolidated report of meetings held by HMRC and HM Treasury (HMT) to discuss the two measures with stakeholders on 23 July, 13 August and 25 August 2015. The report made it clear that although the overall policy behind the proposed reforms was unlikely to change, HMRC and HMT thinking was at a very early stage at the time of the meetings and that views they expressed at the meetings might not be reflected in the consultation documents.

On 30 September 2015, HMT published a consultation (with the consultation period ending on 11 November 2015) providing some detail that was not announced at the Budget and including draft legislation for:

•The new deemed domicile tests that were to be incorporated in the Income Tax Act 2007 (ITA 2007) and the Inheritance Tax Act 1984 (IHTA 1984).

•Amendments to transitional provisions for the statutory residence test (SRT) in the Finance Act 2013 (FA 2013).

•An amendment to the election that can be made by non-UK domiciled spouses and civil partners for IHT purposes.

For further details of the first consultation, see Legal update, Deemed domicile reform: consultation published.

Further and amended draft legislation was published on 9 December 2015 (see Legal update, Draft Finance Bill 2016 legislation: key private client measures: Permanent non-domiciled tax status abolished) and 2 February 2016 (see Legal update, HMRC publishes draft clauses to introduce deemed domicile for income and capital gains tax).

2016 Budget announcements

At the 2016 Budget, the government announced that the new deemed domicile rules would be included in the Finance Bill 2017 (and not the Finance Bill 2016, as previously announced). A brief mention was also made of possible transitional rules (see Legal update, 2016 Budget: key private client tax announcements: Taxation of non-domiciled individuals).

Further consultation document published

On 18 August 2016, HM Treasury published a further consultation containing an update on the proposals that were published in the original consultation on the new deemed domicile rules and fleshing out the proposals to charge inheritance tax on UK residential property held indirectly (enveloped) through offshore structures. The consultation is accompanied by draft legislation, to be included in the Finance Bill 2017, and also invites views on the ways in which business investment relief could be changed to encourage greater investment from non-domiciled individuals into UK businesses. HM Treasury has announced that the Finance Bill 2017 will be published in draft on 5 December 2016. (see Legal update, Draft Finance Bill 2017 clauses will be published on 5 December 2016).

IHT on UK residential property

The government proposes extending the scope of IHT to cover UK residential property held indirectly (enveloped) by non-UK domiciled individuals and trusts with settlors or beneficiaries who are non-UK domiciled. This will be achieved by carving out certain types of asset from the definition of excluded property in sections 6 and 48 of the IHTA 1984, including:

Shares in offshore close companies, to the extent that their value is derived directly or indirectly from UK residential property.
Interests in non-UK partnerships or LLPs with a non-UK domiciled partner or member, to the extent that their value is derived directly or indirectly from UK residential property.

These changes will be effective for all chargeable events (including ten-year anniversary and exit charges within relevant property trusts) occurring on or after 6 April 2017.

Definition of UK residential property

Having considered whether the definition of UK residential property used in the legislation introducing an annual tax on enveloped dwellings (ATED) could be adapted to extend the scope of IHT, the government now favours using the definition of UK residential property in the non-resident capital gains tax legislation (NRCGT) (paragraph 4, Schedule B1, Taxation of Chargeable Gains Act 1992). The consultation document states that the draft legislation that accompanies it reflects this proposal. However, draft Schedule A1 to the IHTA 1984 (to be inserted by the Finance Bill 2017) uses the definition of a chargeable interest from the ATED legislation in Finance Act 2013 rather than the NRCGT provisions in Finance Act 2015. For more information on the definition that HMRC proposes to adopt, see Practice note, Capital gains tax: disposals of UK residential property by non-residents: Disposal of UK residential property interest.

The NRCGT definition takes into account periods in which UK property was used for a non-residential purposes so that a just and reasonable apportionment of the property value is used to calculate the tax charge. Given that IHT is charged on the value of an asset at a particular moment in time, rather than, in the case of CGT, in relation to a particular tax year, the government proposes to introduce a rule based on the two years' ownership test for IHT business property relief in section 106 of the IHTA 1984. This would work by triggering an IHT charge if the property has been a UK residential property within the relevant definition at any time within the two years preceding a transfer of value. To deal with situations where a property is used for residential and non-residential purposes at the same time, the government proposes a wholly or partly test so that if the property wholly or partly meets the NRCGT definition within the relevant two year period, it will be chargeable to IHT based on the proportion of the property that comes within the definition.

Valuation

The government proposes to value relevant UK residential property based on its open market value at the time of the chargeable event. In practice, this would mean that:

An estate will be subject to IHT to the extent that any underlying assets consist of UK residential property.
An estate holding shares in a non-UK company that owns UK residential property will be charged to IHT to the extent that the value of the shares relate to that property. In such a scenario, the open market value of the shares rather than the underlying property would be the starting point.

Debts that relate exclusively to the property will be taken into account in determining the value subject to IHT. Where debts relate to other assets as well or where the holding entity only owns part of the property, the extent to which debt will reduce the chargeable value will be pro-rated. Loans made between connected parties will be disregarded.

Targeted anti avoidance rule

The government proposes the introduction of a targeted anti avoidance rule (TAAR) in the legislation so that any arrangements whose whole or main purpose is to avoid or mitigate IHT on UK residential property will be disregarded. The definition of arrangement in section 74C of the IHTA 1984 will be used.

Expanded HMRC powers

The government proposes that HMRC should have wider powers to enable it to more easily impose an IHT charge on offshore structures holding UK residential property. It plans to introduce a power to prevent the sale of UK residential property until any outstanding IHT is paid. It also proposes to expand the categories of those who are liable to pay outstanding IHT to include directors of companies that hold UK residential property. The draft legislation for these provisions will be published later in 2016 for inclusion in the Finance Bill 2017.

No transitional provisions to assist in de-enveloping

The government does not propose introducing any measures to encourage de-enveloping of UK residential property structures at the moment, although it has asked stakeholders to consider whether the lack of tax relief on exit might cause hardship in some cases.

Responses to earlier consultation on new deemed domicile rules

Using statutory residence test to establish residence status for periods before 2013-14

Some respondents thought that, when considering deemed domicile, taxpayers ought to be able to use the statutory residence test (SRT) to establish their tax residence for years prior to the introduction of the test.

The government intends to carry on using the pre-SRT rules because applying the SRT for prior years would mean that some taxpayers might be able to disregard a year, for deemed domicile purposes, even if they had filed a tax return on the basis that they were UK resident in that year. It would also result in the test for deemed domicile being different from the test for the long term residents' remittance basis charge.

Counting childhood years in the UK

A large number of respondents to the earlier consultation felt that it was unreasonable and unfair to treat years spent in the UK during childhood as counting towards the deemed domicile test.

The government believes that childhood years should not be disregarded because it would be unfair for individuals who have lived in the UK all their life to be able to defer deemed domicile until their thirties. The proposed test is sufficiently flexible that non-domiciled individuals can choose to leave the UK for a period of time in order to avoid becoming deemed domiciled.

Disregarding split years

Some respondents felt that there was a mismatch between split year relief under the SRT and the IHT rules which do not give relief for a chargeable transfer made in a part of a year where the transferor is non-UK resident.

The government believes disregarding split years would make the new deemed domicile rules more complicated. There should be no mismatch because deemed domicile will apply for all tax purposes and will apply across a whole tax year.

Extension of CGT charges on offshore trusts

Section 86 charge on settlors

The government proposes to extend the scope of the CGT charge under section 86 of the TCGA 1992 (section 86 charge) (subject to certain protections detailed in Transitional protections) to cover all those who are deemed domiciled under both the 15 out of 20 rule and the returning UK dom rule. For information on the current rules, see Practice note, Taxation of offshore trusts: overview: The CGT charge on the settlor: section 86 of TCGA 1992.

Section 87 charge on capital payments

Following the introduction of the new deemed domicile rules, UK resident deemed domiciled individuals who receive capital payments from an offshore trust or underlying entity owned by the trust will be subject to CGT under section 87 regardless of where the benefit is received.

Individuals who become deemed domiciled under the new rules because they were born in the UK with a UK domicile of origin will not be able to benefit from the rebasing election introduced in 2008 for pre-2008 matched capital gains and capital payments.

Extension of income tax charges on offshore trusts

Income tax charge: settlements legislation

Under current rules, non-domiciled individuals who claim the remittance basis are only taxed on foreign source income that is remitted to the UK. Under the new deemed domicile rules, as settlors who are deemed domiciled will no longer be able to claim the remittance basis, the settlements legislation will apply to all foreign source income so that income from trusts where the settlor has retained an interest will be taxed on the settlor on the arising basis. This will be subject to certain protections (see Transitional protections).

Income tax charge: transfer of assets abroad

Following the introduction of the new deemed domicile rules, transitional protections will be introduced to partially dis-apply the transfer of assets abroad rules as they apply to deemed domiciled settlors (see Transitional protections).

Under the new deemed domicile rules, any actual benefits received by deemed domiciled settlors, spouses, minor children and other relevant persons from foreign-source income from an offshore trust (whether as a result of an income or capital distribution or through enjoyment of the trust assets) will trigger an income tax charge on the settlor under section 720 of the Income Tax Act 2007 to the extent that it can be matched against relevant foreign income arising in that year.

New matching rules will be introduced to match benefits against relevant foreign income. Rules similar to section 731 of the Income Tax Act 2007 will be used but they will not apply to protected trusts (see Transitional protections).

The government is still considering whether the non-transferor provisions should be extended to all non UK domiciled individuals.

The consultation makes it clear that there will be different rules for the transfer of assets abroad, the settlements legislation and for CGT. This may make it difficult for settlors and trustees to navigate through the anti-avoidance provisions for offshore trusts in order to avoid tainting pre-existing trusts. HMRC is likely to monitor transactions carried out by trustees of offshore trusts closely. With the introduction of inter-governmental exchange of information agreements and the common reporting standard (CRS), HMRC will have access to more information about offshore structures owned by non-UK domiciliaries than ever before.

Transitional protections

Following the earlier consultation, the government proposes that the following transitional protections be introduced to soften the impact of the introduction of the new rules:

The reforms will not be applied retrospectively to those individuals who are non-resident before the announcements were made on 8 July 2015.
Employment income relating to an earlier tax year will be taxable only to the extent that it is remitted to the UK.
Transfers of non-UK property by individuals while they are non-UK domiciled and who subsequently die after having become deemed UK domiciled will not be subject to UK IHT. However, individuals who left the UK and then returned (returning UK doms) will not be protected from the new rules even if they returned to the UK before 8 July 2015.
As announced in the 2016 Budget, individuals who will become deemed domiciled under the 15 out of 20 year rule in April 2017 will be able to rebase directly held foreign assets to their market value at 5 April 2017 with the result that any gain accruing before 6 April 2017 will not be charged to CGT. Rebasing will apply on an asset by asset basis with no requirement that proceeds relating to any gain arising before 5 April 2017 should be kept abroad. Where an asset was originally purchased with clean capital the entire disposal proceeds can be brought to the UK without triggering a remittance. This protection will only apply to assets having a foreign situs on 8 July 2015 and will only apply to individuals who had paid the remittance basis charge before 5 April 2017. Draft legislation for this measure will be published later on in 2016 to be included in Finance Bill 2017.
Individuals (including those who were born outside the UK but with a UK domicile of origin) with mixed funds (combining clean capital, foreign income or foreign gains) held outside the UK in bank and similar accounts will be able to separate the funds in the tax year 2017-18 in order to provide certainty about how they will be taxed should they be remitted to the UK later on. If other types of asset are sold and the proceeds separated out in that tax year, the proceeds can be remitted later on and still benefit from this protection. Funds that cannot be identified or traced will not benefit from this protection. Draft legislation for this protection will be published later on in 2016.
As announced in the July 2015 Budget, non-domiciled individuals who established a trust before they become deemed domiciled under the 15 out of 20 rule will not be taxed on trust income or gains retained in the trust or any underlying entities. Funds within these trusts will continue to be excluded property for IHT. Following concerns from respondents to the earlier consultation, the government proposal to introduce a benefits charge based on the taxable value of benefits actually received by such deemed domiciled individuals will not be taken forward.
Settlors of offshore trusts established before they become deemed domiciled will not be subject to a section 86 charge so long as no additions are made to the trust after they become deemed domiciled and so long as the settlor, spouse, minor children or stepchildren of the settlor do not receive any actual benefits from the trust. Any addition or benefit receipt after that date will result in the trust losing its protected status for all future tax years. Trusts set up by settlors who fall in and out of deemed domicile status will lose this protection on the first occasion additions are made or benefits received after the settlor becomes deemed domiciled.
Income tax on the arising basis charged to settlors under section 624 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005) will not apply to foreign source income arising in an offshore trust established by a settlor before he becomes deemed domiciled so long as the income is not paid out of the trust. Where a settlor, their spouse, minor children or other relevant person receives a distribution of relevant foreign income from a protected trust that arises in a year when the settlor was non-domiciled, the distribution will be taxed on the settlor only to the extent that it is matched with relevant foreign income arising in that year and in any other years while the trust is protected and the settlor is long term resident non-domiciled. However, the income tax charge on non-domiciled settlors who receive capital payments matched with trust income under section 633 of ITTOIA 2005 will be extended to deemed domiciled settlors under the new rules.
The transfer of assets abroad legislation (sections 720, 727 and 731, Income Tax Act 2007 (ITA 2007)) will be partially disapplied so that section 720 of the ITA 2007 will not catch deemed-domiciled settlors who set up an offshore trust before they became deemed domiciled. These individuals will not be taxed on the foreign income of the trust or any underlying entity if it makes a distribution to the trust.

Responses to earlier consultation

£2,000 de minimis rule

The government intends the de minimis protection threshold for remittances made by non-UK domiciled individuals to remain at £2,000 even after the individual concerned has become deemed domiciled.

Offset of foreign capital losses

The government does not intend to allow long term resident non-UK domiciled individuals who become deemed domiciled under the 15 out of 20 rule to set foreign capital losses against capital gains arising in the UK from the point at which they become liable to UK CGT. However, it intends to change the current rules that allow remittance basis users to elect for an offset. After 5 April 2017 a foreign loss election will only apply until the individual becomes UK domiciled or deemed domiciled. Another election can be made if their UK domicile status is subsequently lost.

IHT implications of the new deemed domicile rules for other taxes

The current rule that deems a non-UK domiciled individual to be UK domiciled for IHT purposes after he has been resident in the UK for 17 out of the last 20 years will be aligned with the new rules for income tax and CGT so that the 15 out of 20 rule will apply for IHT for transfers made on or after 6 April 2017. The old 17 out of 20 rule will still apply to non-UK domiciled individuals who leave the UK before 6 April 2017 even though, under the new rules, they would be deemed domiciled at that point. The government recognises that this change will mean that an individual who becomes non UK resident may remain deemed domiciled for IHT for up to six years after they have left rather than, according to the current rules, for up to four years. Respondents to the earlier consultation felt that this longer IHT liability tail was unduly onerous and could lead to cases of double taxation as well as non-compliance. The government has confirmed that the six year IHT shadow is an inadvertent side effect of the new 15 out of 20 rule. It will therefore change the new deeming rule so that, although individuals will become deemed domiciled for IHT purposes after spending 15 out of 20 years as a UK resident, that status will fall away once they have been non-resident for more than four consecutive tax years. This is reflected in the draft legislation accompanying the consultation (substituted section 267(1)(b), IHTA 1984).

Election by non-UK domiciled spouse to be treated as deemed domiciled

The four year period of non residence that applies before a spouse who elected to be treated as UK domiciled for IHT under section 267 ZA and 267ZB of the IHTA 1984 can fall outside the UK IHT net will be retained as this will fit with the proposed adaptation of the 15 out of 20 rule for IHT.

Returning UK doms

The earlier consultation outlined proposals to treat a UK born individual with a UK domicile of origin as being deemed domiciled for all tax purposes immediately on becoming UK resident again after having adopted a non-UK domicile of choice. The government does not intend to change this policy even though some respondents thought it was unfair to single out those born in the UK in a particular way.

However, as a concession, returning UK doms will not become deemed domiciled for IHT purposes unless they have been resident in the UK for at least one of the two tax years prior to the year in which the relevant transfer occurs. Such individuals will not be able to use the remittance basis of taxation for income tax and CGT during this grace period and the government does not agree with respondents who argued that this special treatment should be extended across all taxes.

So far as offshore trusts set up by returning UK doms are concerned, respondents argued that it would be difficult for trustees to track the residence status of the settlor and beneficiaries. The effect of the new deemed domicile rules might produce harsh results for returning UK dom settlors and respondents thought it was unfair to leave such individuals with unfavourable trust structures which could not be collapsed without triggering a tax charge. Some respondents have argued that the new rules should only apply to returning UK doms who return after 8 July 2015 or after 6 April 2017 or that a rebasing election should be made available. However, the government has confirmed that it intends to proceed with the measures as initially planned with no transitional arrangements in relation to offshore trusts established by returning UK doms.

Business investment relief

In the 2015 Autumn Statement the government announced that it would consult on ways in which business investment relief (BIR) could be extended and made easier to apply. Any legislative changes as a result of the consultation will be included in Finance Bill 2017 and will take effect from 6 April 2017. The consultation does not propose any particular changes but seeks views on how BIR can be improved to encourage more inward investment by non-UK domiciled individuals. The government is also seeking views on which particular areas of complexity in the BIR legislation are perceived as deterring inward investment.

Comment

Although the proposed changes are wide-ranging and non-UK domiciled individuals who will be affected may complain that the time-frame for their introduction is too tight, non-UK domiciliaries will still benefit from a more favourable tax regime than UK domiciliaries, particularly if they plan their affairs carefully and take advantage of the transitional protections before 6 April 2017.

The transitional provisions that will protect certain pre-existing offshore trusts set up by individuals before they become deemed domiciled are helpful but the possibility of tainting such trusts is quite high. Trustees and settlors of offshore trusts, as well as their advisers, will have to get to grips with the detail of the new rules quickly and plan any future transactions involving such trusts very carefully. In some instances, settlors may accept that their offshore trust will inevitably become tainted as a result of the extraction of a benefit or the addition of assets after 6 April 2017 and this may be preferable to living with a structure which is essentially frozen.

Advisers should review their non-domiciled clients' asset structures as soon as possible (in some cases before the relevant provisions have been published in draft) to assist them in accelerating the extraction of benefit and the transfer of assets from structures before 6 April 2017, as well as segregating funds to take full advantage of the transitional protections.

Sources

HM Treasury: Reforms to the taxation of non-domiciles: further consultation and HM Treasury: Reforms to the taxation of non-domiciles.

Taxation of non-domiciled individuals: further consultation published | Practical Law