In July 2015’s Summer Budget, the incumbent chancellor George Osborne announced changes to the laws under which UK resident but not domiciled individuals (RNDs) are taxed in the UK. Despite the changing of the guard at 10 Downing Street and the uncertainty created by June’s vote for the UK to leave the EU, the Government is pressing ahead with these changes, and released a further consultation and draft legislation in August.
The consultation included further details on changes to the laws relating to deemed domicile, under which UK resident individuals who are not domiciled in the UK under the general law are nevertheless deemed to be UK domiciled for certain tax purposes. Although the final form of the changes is yet to be confirmed, the main substance is now clear.
UK resident and domiciled individuals are taxed on their worldwide income and gains. RNDs can however claim the remittance basis of taxation, under which they are still taxed on any UK income and gains, but foreign income and gains are not taxed as long as they are not remitted to the UK. Longer term users must pay an annual charge to access the remittance basis.
Non-domiciled individuals also have limited exposure to inheritance tax (IHT), with only their UK situs assets falling within the scope of the tax. However if an RND has been resident in the UK for 17 out of the last 20 tax years, they will become deemed UK domiciled for IHT purposes at the start of the 17th year of residence and will thenceforth be subject to IHT on their worldwide estate. Even if the individual then leaves the UK, they will remain deemed UK domiciled in the year of their departure and for the following three tax years; only in the fourth tax year following their departure will their deemed domicile status fall away.
The new “15 out of 20 rule” and “returning UK domiciles”
Under the proposed new laws, which are set to come into force on 6th April 2017, an RND will be deemed UK domiciled for all tax purposes (that is, for income tax and capital gains tax (CGT) as well as IHT) if:
- They have been resident in the UK for 15 of the previous 20 tax years (the "15 out of 20 rule"); or
- They are UK resident and have a non-UK domicile of choice, but were born in the UK with a UK domicile of origin ("returning UK domiciles").
For the purposes of these two tests, 'residence' is determined using the residence rules in place at that time. The statutory residence test should therefore be used from 6th April 2013 onwards, but the pre-existing law on residence will have to be considered for earlier years. Note too that all years in which an individual is UK tax resident will count towards the threshold for the 15 out of 20 rule, including any years when an individual was under 18 and any years which are split years for tax purposes.
The proposed new laws also affect how an individual can lose their deemed domiciled status once they leave the UK. For individuals who are deemed UK domiciled under the 15 out of 20 rule, that status will not fall away for IHT purposes until they have been non-UK resident for more than four consecutive tax years. For capital gains tax and income tax purposes the domicile tail is longer: deemed domicile status will not cease until the individual has been non-resident for six years. It is not clear if the Government intended this discrepancy in the number of years, or how the loss of deemed domicile for IHT purposes after four consecutive years of non-residence will operate alongside the 15 out of 20 rule if someone returns to the UK. The Government will need to clarify this position in its response to the most recent consultation.
Exceptions and reliefs
The effect of these changes is that if the laws come into force as anticipated, many RNDs who are long-term users of the remittance basis will become deemed UK domiciled for all tax purposes from 6th April 2017. There is however some solace for those affected:
- There is an existing de-minimis exception for RNDs with less than £2,000 of unremitted income and gains: such individuals are automatically entitled to the remittance basis, even after they become deemed UK domiciled, and this will continue.
- Individuals becoming deemed domiciled under the 15 out of 20 rule on 6th April 2017 will be able to rebase their overseas assets to their market value on 5th April 2017 for capital gains tax purposes provided those assets were non-UK situs on 8th July 2015. Note that under the current proposals, individuals meeting the 15 out of 20 test in later years will not be able to benefit from this.
- There will be a transitional rule under which all RNDs (and previous RNDs) with mixed funds have one year from 6th April 2017 to rearrange them and to segregate out the different parts.
- Returning UK domiciles will have a two year grace period, in that they will not be 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 question. Note that this will not extend to income tax or CGT.
Changes to the taxation of offshore trusts
Summer Budget 2015, the Government announce that distributions to UK residents from offshore trusts will be taxed regardless of whether the trust has made any income or gains.
September 2015, the Government launch a consultation on this proposal.
August 2016, the Government responds to the earlier consultation and launches a further consultation. In it they move away from their initial proposal.
Instead they revert to a modified form of the current rules:
- Capital gains tax – The existing regime of matching capital gains to benefits received from a non-resident trust will continue to apply if created before the settlor is deemed domiciled. However, if a deemed domiciled settlor adds further funds to their trust or a benefit is received by a deemed domiciled settlor (or spouse, minor children/ stepchildren), the trust will then be subject to the same CGT rules as those settled by UK domiciliaries, i.e. trust gains taxed on the settlor as they arise.
- Income tax – Where a settlor retains an interest in a trust, the trust income is treated as arising directly to the settlor for income tax purposes but non-UK income can be taxed on the remittance basis if the settlor makes a claim (UK source income is currently taxed on the settlor as it arises and this will not change). Deemed domiciled settlors may therefore continue this protection if the settlor created the trust before becoming deemed domiciled and the income is retained within the trust. Distributions of such income to the settlor, his spouse, minor children or other relevant person will be taxed at the time of payment.
October 2016, the Government is rumoured to be changing its mind on some of the proposals above to maintain the UK’s competitiveness in attracting wealthy entrepreneurs to these shores.
Despite all the above, a well-structured and managed offshore trust will still protect the trust assets from UK inheritance tax and may defer or avoid UK capital gains and income tax. However, all existing structures and proposed new structures need an urgent review to see whether action should be taken before 5 April 2017 or even before the Government Autumn Statement on 23 November, when it is possible anti-forestalling measures will be introduced.
Inheritance tax on UK residential property
The consultation document published in August also contained further information about the proposal to bring any residential property in the UK owned by a non-UK domiciled individual within the scope of UK inheritance tax (IHT).
Currently for individuals who are not domiciled in the UK or deemed domiciled in the UK only their UK situs assets are within the scope of inheritance tax. UK assets, including UK residential property, are protected from exposure to IHT if they are held through a non-UK company. In addition, if a non-UK domiciled individual settles a trust before they become deemed domiciled in the UK (or indeed acquires a UK domicile of choice) then to the extent the trust holds non-UK assets (or holds assets through a non-UK company) these are protected from IHT even after the individual becomes deemed domiciled or actually domiciled in the UK and, according to HMRC guidance, even if the settlor has reserved a benefit in the trust. Normal rules would say that where a domiciled or deemed domiciled settlor has reserved a benefit in trust property then on their death that property is part of their estate and taxable. But the fact the trust assets are excluded property trumps the reservation of benefit rules, and although this is not explicitly confirmed by HRMC in the current version of their manual, it is generally agreed that this is the case even where the underlying asset in the trust is UK residential property.
The Government has indicated that in April 2017 all this will change. To quote the August 2016 consultation document, “shares in offshore close companies and similar entities will no longer be treated as excluded property if, and to the extent that, the value of any interest in the entity is derived, directly or indirectly, from residential property in the UK … similarly, where a non-domiciled individual is a member of an overseas partnership which holds a residential property in the UK, such properties will no longer be treated as excluded property for the purposes of IHT”. No change will be made to the taxation of corporate structures owned by, or trusts settled by, UK domiciled individuals, as these are already within the scope of inheritance tax. UK residential properties owned indirectly through non-UK companies owned by individuals or trustees will cease to be viewed as excluded property.
This change means that where a non-UK domiciled person owns a non-UK company which owns UK residential property, there may be an IHT charge on their death, or if they make a gift of the shares and reserve a benefit or die within seven years of the gift. Where trustees of a trust settled by a non-UK domiciled person hold a non-UK company which owns UK residential property then if the settlor has reserved a benefit, there may be an IHT charge on the settlor’s death or if the settlor gives up their benefit and dies within seven years, and the trustees themselves may be liable for ten-year charges and exit charges.
The government is proposing a wide definition of residential property, excluding only care or nursing homes, student accommodation with more than 15 bedrooms and prisons and military accommodation. IHT will apply even where properties are rented to third parties on commercial terms (unlike the Annual Tax on Enveloped Dwellings (ATED)).
It is proposed that only debts which relate exclusively to the property such as amounts outstanding on a mortgage used to purchase the property will reduce the value of the property for IHT purposes. Loans between connected parties will be disregarded.
There will be a targeted anti-avoidance rule the effect of which will be to disregard any arrangements where their whole or main purpose is to avoid or mitigate a charge to IHT on residential property.
Individuals and trustees will now wish to consider restructuring the ownership of residential property before April 2017, particularly as there may now be no IHT benefit to corporate ownership but an ATED cost, and find alternative ways of planning for future IHT events. There may be reasons to carry out this restructuring before April 2017, while the shares in the company still qualify as excluded property, and before wider changes to the taxation of trusts kick in. However restructuring may come with an SDLT or CGT cost, and the Government has indicated that it does not intend to provide any reliefs in this regard.