Changes to the taxation of non-domiciled individuals

The long-awaited draft non-dom legislation has now been published as part of the draft Finance Bill 2017. The proposals are broadly moving forward as discussed in the various consultations, with a few surprises and some small beneficial tweaks. It has been confirmed that the changes will take effect from 6 April 2017.

The government had four broad objectives:
  • ending permanent non-dom status;
  • expanding business investment relief;
  • preventing UK born domiciliaries of origin from claiming non-dom status on their return to the UK; and
  • applying IHT to all non-doms who own UK residential property indirectly.
However, the draft legislation does not deal with the income tax profile of offshore trusts with further legislation promised for a date ‘not later than the date for the Finance Bill 2017’. This means that the details of the new income tax rules for offshore trusts may not be known until March 2017.

In summary:
  • The current regime deems an individual to be UK domiciled for inheritance tax only once resident for more than 16 years out of the previous 20 years of assessment, but not for income tax and capital gains tax purposes.
  • The remittance basis allows income and capital gains to accrue outside the UK free of tax provided they are not remitted to the UK and the remittance basis charge is paid as appropriate.
  • The new regime deems an individual to be UK domiciled for all taxes where they have been resident for more than 15 out of the previous 20 years of assessment, and the remittance basis will no longer be available.
  • There are transitional reliefs which allow someone who will become deemed domiciled on 6 April 2017 to rebase their offshore assets to market value on that date (provided they were held or acquired after 16 March 2016). This applies only to personally held assets and provided they are not taxed as offshore income gains.
  • All non-doms will be able to ‘clean up’ bank accounts which hold a mixture of income, capital gains and clean capital provided this is completed by 5 April 2019. 
  • Offshore trusts would be transparent for inheritance tax, income tax and capital gains tax once the settlor has become deemed UK domiciled unless they fall within the new protective regime.
  • Protection applies provided additional funds are not added to the offshore trust after 6 April 2017 by a deemed UK domiciled settlor, and the settlor does not acquire an actual domicile in the UK.
  • The settlor will be taxable on capital distributions made to close family members unless they are taxable in their own right.
  • Changes have been made to the capital gains tax regime for all offshore trusts (unless they are treated as tax transparent) which alter the way that capital gains are matched to distributions.
  • The income tax treatment of offshore trusts is still to be clarified, but it should not be treated as transparent provided it meets the criteria for protection mentioned above.
  • UK residential property will be subject to inheritance tax even if owned indirectly through offshore companies and / or trusts. There are complex rules which may deny a deduction for borrowing connected to such properties and / or create a double tax charge.
  • Individuals born in the UK who had a domicile of origin here but acquired a domicile of choice outside the UK will be treated as UK domiciled on their return to the UK. They will not be entitled to claim the remittance basis. There are no transitional reliefs that apply to them. Broadly, any offshore trusts settled by them will be transparent for inheritance tax, capital gains tax, and income tax purposes.
  • Business investment relief has been extended to cover a wider range of investments and some of the conditions which could trigger a remittance of the funds used to make the investment have been eased.
These matters are discussed in more detail below.

Planning points

If you will become deemed domiciled under the 15 out of 20 rule:
  • Consider your residence status.
  • Review offshore assets to determine whether inherent capital gains should be realised before or after 6 April 2017.
  • Review offshore structures to determine whether distributions need to be made prior to 6 April 2017 and whether existing distributions could be brought into charge after that date.
  • Review lending into the structure, as this is capable of losing protected status for the trust. 
  • Review segregation in structures/personal holdings so that remittance basis funds are not mixed with post 6 April 2017 arising basis funds.
If you will become deemed domiciled under the returning UK domiciliary rule:
  • Review offshore structures and consider their liquidation.
  • Consider new holding structures, and how to structure bank accounts and portfolios going forward.
  • Consider realising capital gains / taking income whilst the remittance basis is available to you.
If you have UK residential property held through offshore structures:
  • All structures holding UK residential property should be reviewed in advance of the changes, and alternative strategies such as insurance, transfers to spouses on death, and gifting to the next generation considered.
  • In particular, lending arrangements will have to be considered carefully to avoid double tax charges.
  • If you hold property through an offshore company, consider transferring the shares to the next generation prior to 6 April 2017 whilst the transfer is free of inheritance tax (providing you are not yet deemed UK domiciled). You would not be able to use the property post-transfer, but there would be no inheritance tax charge even if you died in the seven years immediately following the gift. 
Ending permanent non-domicile status

Currently, an individual is treated as domiciled in the UK for inheritance tax purposes only once they had been resident in the UK for more than 16 out of the previous 20 years of assessment. However, it is possible currently to claim to be non-domiciled for income tax and capital gains tax purposes no matter how long an individual has been resident in the UK provided they have not formed an intention to settle in the UK permanently or indefinitely.

From 6 April 2017, new deeming rules will treat long term non-domiciled UK residents as domiciled in the UK once they have been resident for more than 15 out of the previous 20 years.

Once deemed UK domiciled, an individual will be taxable on their worldwide income and capital gains, and subject to UK inheritance tax on their worldwide estate.

There has been one alteration to the original proposals which will make it easier for someone to lose their deemed domicile status for inheritance tax purposes once they have ceased to be UK resident. Under the original proposals it would have taken six years of non-UK residence before a long term non-dom would lose their deemed domiciled status. Under the existing pre 6 April 2017 rules, deemed domicile status could be lost after three years of non-UK residence, provided an individual remains non-UK resident for the whole of the fourth year after departure.

The government have now said that it will retain the three year non-UK residence rule for inheritance tax purposes, provided they do not return to the UK within six years of their departure. The full six year rule will still apply for income tax and capital gains tax.

Individuals who become deemed domiciled on 6 April 2017 should consider how to structure their assets going forward. It will be important to segregate historic funds taxable on the remittance basis from future funds which will be taxed on the arising basis. It may be necessary to crystallise inherent gains on certain assets before that date. It may also be worthwhile creating a non-UK trust prior to becoming deemed UK domiciled, and there are opportunities available under the transitional provisions which are discussed further below.

Transitional arrangements

Rebasing assets

For individuals who become deemed domiciled on 6 April 2017, and who have paid the remittance basis charge at least once in respect of any year up to and including 2016/17 (and not merely claimed the remittance basis) a transitional relief will be available.

Personal foreign assets held on 16 March 2016 can be rebased to their market value on 5 April 2017. Assets acquired, whether by purchase or trust distribution in specie after that date can similarly be rebased. The asset must always have been held outside the UK during this period.

The rebasing is automatic but it is possible to elect for the rebasing not to apply where this is advantageous (for example where the asset is standing at a loss as at 5 April 2017).

This relief does not apply to trust assets or assets held through companies.

It will also not apply to personally held assets where gains on disposal are subject to income tax (offshore income gains) e.g. the capital gains realised on the disposal of certain non-UK hedge funds and non-reporting funds.

Cleansing mixed funds

Mixed funds are bank accounts (or other assets) which represent a mixture of income, capital gains or untaxable capital. There are strict rules as to which element is treated as remitted when funds are brought to the UK out of a mixed fund, and the computations required to determine the amounts remitted are complex and challenging. Once a mixed fund has been established, it is normally not possible to ‘unmix’ the constituent parts of that account.

However, under the cleansing rules announced by the government, it will be possible to separate out mixed funds by transferring funds from the 'host' mixed fund account into other accounts. Originally, this was intended to be completed by the end of the tax year 2017/2018 but this has now been extended by an additional year to the end of 2018/2019, potentially because of the complexity of the calculations that will be required in most circumstances.

This relief only applies to bank accounts holding cash and the government have decided against extending the relief to other assets. However, it will be possible to liquidate non-cash assets prior to 5 April 2019 to benefit from the unmixing rules.

The relief will apply to all non-UK doms and not just those who become deemed domiciled on 6 April 2017 (but not to returning deemed doms) provided they have claimed the remittance basis at some point. However, they need not necessarily have paid the remittance basis charge. 

Offshore trusts

Generally

A UK domiciliary would usually be taxed in respect of a non-UK resident trust that they had settled and can benefit from, as if it was a look through for income tax, capital gains tax and inheritance tax purposes.

Currently, an individual who remains non-UK domiciled under general law but has settled a non-UK trust before he becomes deemed UK domiciled for inheritance tax purposes, is currently not taxed in this way. Provided the remittance basis is claimed by the settlor, only UK source income of the trust can be attributed to the settlor and benefits can be provided by the trust outside the UK without UK tax obligations. In addition, the assets held by the trust should be outside the scope of inheritance tax provided the trust is structured correctly.

It had previously been confirmed that the inheritance tax protections for non-UK trusts settled by non-UK domiciled settlors would continue. However, without any protections, the income tax and capital gains tax trust regime for long term deemed domiciled settlors would be the same as for UK doms as noted above.

To avoid this issue, those trusts settled by a non-deemed domiciled settlor will fall into a special regime after 6 April 2017 where, broadly, beneficiaries (including the settlor) will only be taxed on benefits as they are paid out of the trust. However UK source income will remain taxable on the settlor whether or not paid out of the trust.

The above treatment applies whether the income or gains are received by the trust directly, or by companies owned by the trust.

This post 6 April 2017 special regime will only apply provided no assets are added to the trust, at a time when the settlor is deemed domiciled, whether directly by the settlor or by someone else acting as a conduit for the settlor, or indirectly from another trust with the same settlor. However, it will be possible to add funds to meet trust expenses and tax liabilities where these cannot be funded out of income. Otherwise, if funds are added, then the trust will become transparent for all taxes in the same way as if the settlor were UK domiciled. It may be that existing interest free loans from settlors would be treated as an addition after 6 April 2017. Protection may also be lost if the trust is resettled or split into sub-funds.

Prior 6 April 2017, the taxable amount in relation to the provision of non-cash benefits to beneficiaries would be calculated using an imputed ‘market rate’. However, from 6 April 2017, it will only be possible to compute such benefits using the applicable HMRC official rate as determined from time to time. So the use of assets such as yachts, paintings, and interest free loans or borrowing where the interest is rolled up and not paid, will be charged at (currently) 3% of the value of the asset or amount of the outstanding loan. It is not clear whether it will apply to accommodation benefits – although this may be referred to in the announcement of the new provisions, we do not yet have the legislation. 

This means that broadly speaking the existing rules which match trust income and gains to capital payments provided to beneficiaries will continue subject to some important changes which are set out below.

Capital gains

Broadly, capital gains will match to capital payments in the same way as under the current regime, that is, that every pound distributed matches to a pound of capital gains realised by the trust. However, there will be an order of priority of matching – if a payment to a beneficiary is taxable on them, either because they are UK resident and deemed domiciled, or UK resident and not domiciled but the payment is remitted, then it will not be taxable on the settlor. But where a capital payment is not taxable because the payment is made to a non-UK resident or to a UK resident non-dom who does not remit, then it will be taxable on a UK deemed domiciled settlor (but only if the payment is made to a close relative, defined as spouse, cohabitee and minor children, but not minor grandchildren). It therefore follows that capital payments provided to adult children cannot be matched to and taxed on the settlor.

Where a capital payment has been matched, then it cannot be matched again. For example, where a capital payment is taxed on the settlor because it has been paid to his spouse or minor child, but the recipient was paid outside the UK and a UK resident non-dom beneficiary on the remittance basis, the capital payment cannot be taxed again when it is later remitted to the UK by the spouse or minor child.

It is important to note that the settlor must remain non-domiciled under general law, even if deemed domiciled for tax purposes, to benefit from the protections noted above. On-going review of settlor’s domicile position will therefore be required. 

There are consequential changes that have been made to the taxation of offshore trusts, which will apply to all such trusts whether the settlor is deemed domiciled or not.

It will no longer be possible to wash out trust capital gains to non-UK residents after 6 April 2017. If a non-UK resident beneficiary receives a distribution from a non-UK resident trust after that date, this will not take out trust gains from the trust unless the individual falls within the temporary non-residence rules (where the beneficiary has spent fewer than five complete years outside the UK since their departure so that the capital payment is treated as received in the year of their return to the UK).

A beneficiary who receives a capital payment whilst they are UK resident that does not match to capital gains (for example if the trust has not realised any gains at that point), cannot be taxed if they then cease to be UK resident (subject to the temporary non-residence rules) and capital gains are then realised by the trust which would otherwise match to the capital payment.

However, if a capital payment is made prior to 6 April 2017 to an individual becoming deemed domiciled on that date, which does not match to trust capital gains, that payment can be taxable if it is matched to capital gains realised after that date. Care is therefore needed regarding trust distributions being made to non-domiciled beneficiaries prior to 6 April 2017 which are unmatched to trust gains at this date and can no longer be protected by the remittance basis in future years.

There will be anti-avoidance rules to prevent distributions being made to beneficiaries who are not taxable due to non-UK residence, or who are claiming the remittance basis, which are passed to taxable beneficiaries within three years of the date of the receipt of the distribution. In these circumstances, the taxable beneficiary will suffer the charge and careful record keeping will be required in these circumstances. This could potentially catch distributions made prior to 6 April 2017 but gifted after that date. Transactions along these lines would always have been open to challenge where they were pre-ordained and the recipient had not been able to deal with the assets freely before the onwards transfer.

There will be a right of reimbursement from the trustees or a beneficiary where the settlor has paid capital gains tax on a distribution to another person, though this may be difficult to enforce in practice.

Income tax

As noted above, frustratingly, the income tax provisions for trusts have not yet been published and therefore we only have details which are taken from the HM Treasury document “Reforms to the taxation of non-domiciles: response to further consultation” published on 5 December.

Under the new proposals, foreign income arising in an offshore trust or any underlying corporate structure will not be taxable on the settlor once they become deemed domiciled under the 15 out of 20 year test. UK income will be attributed to the settlor, as currently.

Whilst a settlor is deemed domiciled (but remains foreign domiciled under general law) then the foreign income of the trust will not be taxable on him but will instead be taxed when benefits are conferred out of that income on the settlor, or close family members (as defined above) if not taxed on them. The settlor will be taxed on benefits received on the remittance basis if they are non-domiciled and a remittance basis user, or on benefits received worldwide if they are deemed domiciled.

It had been thought under the last round of proposals in August 2016, that it would be necessary for income arising in underlying companies to be paid up through the structure to benefit from the income tax protection. However, it has been confirmed that this will not be the case, although this is subject to confirmation once the income tax rules for offshore trusts are finally published.

The interaction between the various income tax rules that could apply to offshore structures remains unclear pending the publication of the delayed legislation.

Offshore companies

It should be noted that companies directly held by an individual will be transparent for income, capital gains tax, and inheritance tax purposes after 6 April 2017, and there are no rules to protect them as discussed above in relation to offshore trusts.

Business Investment Relief

Business investment relief allows non-doms to bring funds to the UK to invest in a qualifying business without triggering a remittance, provided certain conditions are met. Broadly, the investment must be by way of a loan to a qualifying entity, or by way of subscription for new shares. A qualifying entity must either be a trading company, a stakeholder company which invests in trading companies, or a holding company of a trading group. For these purposes property development and investment both qualify as a trade. The trade must start within two years of the date of the investment.

There are complex rules which apply to treat a remittance as occurring where the investor receives a benefit from the target company or others associated with it (an involved company). These rules have acted as a disincentive to investment, as even the smallest benefit can trigger a remittance of the entire invested funds, and it is not always possible to take steps to mitigate the charge.

The government is aware of these concerns and is taking steps to try to make the relief more attractive to potential investors. The relaxations proposed include:
  • The start-up period before which a trade must commence will be extended from two to five years.
  • There will no longer be a trigger event when a benefit is received from an involved company This test will be replaced by a one of receiving a benefit directly or indirectly from the making of an investment. This is still capable of having a disproportionate effect.
  • The definition of a qualifying entity will include a hybrid company which is both a trading and a stakeholder company, which is not possible under the current rules.
  • A qualifying investment will be extended to include the purchase of shares as well as the current qualifying investments of loans to companies and subscriptions for new shares.
  • A potentially chargeable event would usually trigger a tax charge unless the investment is taken out of the UK within a grace period of 90 days – this will now be extended to two years where the company becomes non-operational.
The government has indicated that it will consider further relaxation of the rules in future.

Returning deemed UK domiciliaries

Where an individual is born in the UK to parents who were UK domiciled, they would acquire a UK domicile of origin at that point. They could later lose that domicile status by leaving the UK and taking up residence in another country with the intention to settle there permanently or indefinitely. It is possible (as a number of high profile examples have demonstrated) for such an individual to return to the UK but without intending to settle here indefinitely and still maintain that they were non-UK domiciled.

From 6 April 2017, anyone in this position will be deemed to be UK domiciled from that date, or on their return to the UK if later. There is a grace period of a year for returning deemed UK doms for inheritance tax purposes only, which means they will not be deemed to be UK domiciled unless they were resident in one of the previous two tax years as well as the tax year in question.

There are no transitional reliefs, and a returning deemed domiciliary who has settled a non-UK trust from which they can benefit will be taxed to income tax, capital gains and inheritance tax as if the trust was a look through. It is also possible for there to be double tax charges on any distribution from the trust, where the capital gain on a disposal of an asset post 6 April 2017 has been charged on the settlor, but the recipient of a distribution representing the proceeds of sale would still be taxable as matching to historic capital gains.

It is imperative that anyone in this situation takes tax advice before 6 April 2017 so that they can take advantage of the remittance basis whilst it is still available, to reorganise their offshore funds / structures. It should also be noted that personally held income and capital gains that were protected by the remittance basis prior to 6 April 2017 will remain taxable when brought to the UK after the individual becomes deemed UK domiciled.

UK residential property

Currently a non-UK domiciliary is not liable to inheritance tax on UK residential property that is held through an offshore company, provided they have not become deemed domiciled for inheritance tax purposes. This treatment is extended to offshore trusts created at a time when the settlor was not domiciled or deemed domiciled in the UK.

From 6 April 2017, the following assets will be liable to inheritance tax:
  • Loans to, or shares in, closely held companies which directly or indirectly derive their value from UK residential property.
  • Interests in partnerships which hold UK residential property.
  • Loans made to enable an individual, trustees or a partnership to acquire, maintain or improve a UK residential property (whether directly or indirectly). This will extend to assets used as collateral for such loans. Without amendment, this could lead to excessive tax charges, as typically collateral exceeds the amount borrowed by several orders of magnitude.
There is potential for double charging where both the loan used to purchase a property and the property itself is taxable, and it is vital that any lending or collateral arrangements are reviewed before 6 April 2017.

Where the settlor is living and retains an interest in the trust, there is potential for double tax charges as the settlor would be taxable on the value residential property on death whilst the trustees will face charges on the ten year anniversary of the creation of the trust on the residential property.

It had been thought that one option would be for trustees to sell affected properties to take the funds outside of the scope of the new regime. However, there are provisions which can apply in certain circumstances to treat the proceeds of sale of a property as if it were UK residential property where the property has been sold in the previous two years. 

There had been discussion as to whether there would be transitional reliefs for individuals looking to wind up offshore structures holding residential property, but no such reliefs are available. Winding up such structures will generally trigger capital gains tax charges (and potentially SDLT and IHT charges in certain circumstances), and these can be considerable depending on the values involved. Affected individuals should therefore be taking urgent action to consider their options ahead of 6 April 2017.
 

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