Fundamental changes to the taxation of resident non-domiciliaries (RNDs) were due to take effect from April 2017 and were outlined in Christie's Spring 2017 Bulletin for Professional Advisers. The reforms have now been delayed because of the upcoming election in June 2017 but they remain in the pipeline. The below refers to the intended reforms as they currently stand.
Once an individual has been resident in the UK for more than 15 tax years he will be deemed domiciled in the UK for income tax, capital gains tax (CGT) and inheritance tax (IHT) purposes. This is a significant change for income tax and CGT and a shortening of the current 17 year period for IHT.
For the first time, the RND will not be able to elect to be taxed indefinitely on the more favourable remittance basis. Taxation on the remittance basis broadly means that the RND is only taxed on foreign income and gains which are brought into or used in the UK, where applicable on payment of an annual charge. Instead once deemed domiciled, the remittance basis will no longer be available to the RND and he will instead be taxed in the UK on all foreign income and gains as they arise.
More drastically," formerly domiciled residents" - a UK resident who is now domiciled outside the UK but who was born in the UK and has a UK domicile of origin (broadly someone with a UK-domiciled father, or mother if his parents were unmarried) - will have no access to the remittance basis at all whilst he remains resident in the UK.
For as long as individuals qualify, there can still be considerable advantages for owners of artworks opting to be taxed on the remittance basis: any profits from sales of art owned outside the UK can be kept outside the UK tax net. However, as can be seen below care must be taken that a remittance is not inadvertently triggered when artwork is brought to the UK. Long term residents will also now need to consider their position once they have become deemed domiciled and some RNDs may consider owning art through a trust or trust company structure as an alternative to individual ownership.
Art and the remittance basis
If a RND brings works of art into the UK a tax charge may arise on any foreign income or gains initially used to purchase them. If the art was purchased from funds that have already been taxed in the UK or that arose prior to the individual becoming UK resident or from other sources of ‘clean’ capital there will be no remittance. Nor do the remittance rules catch assets purchased out of foreign income (excluding earnings) which were already owned at 11 March 2008 or works of art (and other assets) which were purchased afterwards but were already in the UK on 5 April 2008.
Where the purchase was funded in full or in part by foreign income and gains it is those funds that are taxable if remitted not the value of the art itself. Whilst this may be helpful where the value of the art has appreciated, if the value has gone down since purchase, the RND may be taxed on a greater sum than the art is actually worth.
There are however various exemptions that allow art to be remitted without triggering an initial income tax or CGT charge. For instance works of art (and other assets) can be brought to the UK for temporary purposes (upto 275 days in total) without triggering a remittance as can assets purchased from foreign income or gains totalling less than £1,000. In addition assets can be brought to the UK for restoration or repair or to be put on public display without triggering a remittance. The difficulty, however, is that these exemptions end whenever the art is sold, lost or stolen and technically a remittance of the original purchase funds would be triggered at that point as well as CGT on any profit arising on sale.
However in a move designed to encourage sales of assets by UK auction houses, since 6 April 2012 a tax charge will not be triggered on the original income or gains used to purchase the asset if the proceeds are taken offshore or reinvested in a particular type of qualifying investment within 45 days of the sale proceeds (defined as purchase price minus any agency fees and other incidental costs of the disposal that were deducted prior to payment) being ‘released’. The term ‘released’ is rather convoluted but means the day on which the sale proceeds were first made available by the seller for the use or benefit of the owner (or any relevant person see - below). In practice therefore owners will generally have 45 days from receiving the proceeds of sale to take them offshore. If the proceeds are paid in instalments (e.g. because the value is very high) each instalment must be taken offshore within 45 days of that instalment being released. In exceptional circumstances HMRC may agree to extend this 45 day period on request. The whole of the sale proceeds must be paid to the seller either in one tranche or in instalments by the first anniversary of the 5 January following the tax year in which property ceases to be exempt property.
There are, as one would expect, various anti-avoidance provisions and conditions that have to be met. Essentially to qualify for this relief the sale has to be an ‘arm’s length’ sale and once sold no ‘relevant person’ e.g. the owner, his spouse, minor children or grandchildren or a trust or company in which he is interested, can retain any sort of interest or benefit in the artwork. In other words the sale must be a genuine commercial sale to a third party to ensure that no remittance is made. Similarly agency fees that are paid directly or indirectly to a relevant person are not deductible. In case these measures prove ineffective at preventing non-commercial arrangements designed to avoid tax, there is also a "catch all" provision that prevents the exemption applying if the sale is made as part of or as a result of a scheme or arrangement, a main purpose of which is the avoidance of tax. As a result of all this, if a RND owner wants to sell a valuable artwork to a trust or company or a close relative, for tax reasons or perhaps simply because they would like to make a lifetime gift, great care should be taken not to trigger a remittance, if indeed this is achievable at all.
For a remittance of the purchase funds not to be triggered on sale, the proceeds have to be taken out of the UK in such a way that they can no longer be used or enjoyed in the UK in any way that would count as remitting income or gains. For instance using untaxed foreign income and gains to pay for a service provided in the UK but to an offshore account (e.g. the RND's professional fees for advice relating to, say, a property) is still a remittance under the normal remittance rules. The other circumstance in which a remittance is not triggered is if the proceeds are reinvested in a type of investment that attracts a particular type of relief: Business Investment Relief (BIR) allows RNDs to bring unlimited funds to the UK broadly for investment in UK commercial trading companies without triggering a remittance. There were suggestions that the relief should be extended to allow the proceeds of a sale to be used to purchase other works of art in the UK but unfortunately this was not taken up.
Further, and most helpfully, where works of art (and other chattels) are sold in the UK by a RND who is still able to claim the remittance basis, the resultant gain can be subject to the remittance basis (if appropriate) rather than being automatically subject to CGT. In practical terms, no CGT will arise where the proceeds are removed from the UK or reinvested within 45 days. Any gain will only become taxable if the proceeds of sale are subsequently brought back or otherwise used or enjoyed in the UK. This is potentially a very important concession, as without it, even if the income or gains used to purchase the object were not taxable when it was sold in the UK, any profits would have been.
In addition since 6 April 2013, no tax charge will arise if exempt property is lost, stolen or destroyed in the UK. Where compensation is received for such property, this will not be treated as a remittance so long as either the entire payment is taken offshore within 45 days or used to make a qualifying investment.
Long term residents
From April 2017 once a RND has become deemed domiciled in the UK, he will be taxed on profits from sales of foreign artworks going forward as they arise. The remittance basis is no longer available to him. However, perhaps surprisingly, this does not mean remittance issues can be completely ignored when art is brought into the UK. Art which was purchased using untaxed income and gains will continue to be taxed on the remittance basis when brought to the UK or when an initial exemption (e.g. where brought to the UK for temporary purposes, restoration, repair or public display in the UK etc) expires (for instance because the art is sold, lost or stolen as explained above), even if at that point the owner is taxed on the arising basis. Further, if the vendor has since become deemed domiciled in the UK, he will be taxed on the arising basis on any capital gain on a sale of artwork that had been exempted from the remittance rules, regardless of whether he takes the proceeds out of the country within that 45 day concessionary period. Please note the above is our interpretation of the proposed new rules as drafted at the time of writing but the final version of the legislation may result in a different outcome.
Long term residents who will be deemed domiciled from 6 April 2017 may be able to benefit from re-basing on the sale of an art work from that date where they have previously claimed the remittance basis and the asset was situated outside the UK between 16 March 2016 (or, if later, the date it was acquired) and 5 April 2017. Interestingly, and of particular application to art owners, there is a concession in the draft legislation that assets which are temporarily in the UK (to which one of the above exemptions applies) can also qualify for re-basing provided the exemption does not expire triggering a remittance before 6 April 2017.
The ability to re-base is very helpful, as it will mean that only that part of the gain accruing after 6 April 2017 will be subject to CGT, although there may still be a remittance of the initial purchase funds. If re-basing does not apply it may be better for the asset to be sold outside the UK, which is bad news for UK auction houses.
An alternative transitional relief is also available to RNDs who have at some point been taxed on the remittance basis (whether deemed domiciled under the new rules or not) and have purchased artwork from mixed funds e.g. a mixture of clean capital income and gains. For a transitional period, for 2017/18 and 2018/19 only, the art could be sold and the proceeds separated out into their component parts so that the RND can remit the proceeds in the most tax efficient way going forward (e.g. clean capital first).
Income tax and CGT are not the only taxes that RNDs need to worry about; even before he becomes deemed domiciled in the UK, if he directly owns UK assets worth more than £325,000 (in total), he will be liable to IHT at 40% on death (and in some cases gifts), unless specific exemptions apply. Therefore it is often advisable for RNDs who do not need or want to keep valuable art with them in the UK to keep it elsewhere anyway or to utilise an offshore structure.
Once he becomes deemed domiciled in the UK for IHT (currently after 17 years, and from 6 April 2017 after 15 years) he will also be subject to IHT on artwork (and any other assets) which is directly owned by him anywhere in the world. These individuals may therefore like to consider owning their artwork - both that kept in the UK and that housed overseas - through a trust or corporate trust structure, and ideally setting up such arrangements before they become deemed domiciled. However this is not without its complexities, as the following section describes.
Owning art through an offshore trust structure
Firstly, if the settlor transfers a work purchased out of foreign income or gains into a trust or directly funds the trust's purchase of art work out of these funds and that art is transferred to the UK, this may trigger a taxable remittance of the purchase funds, as the trustees are relevant persons in relation to them.
Additionally, it is important to understand that the income tax and CGT treatment of artworks owned by the offshore trust is different from that owned by individuals: the provision of an art work to a beneficiary to enjoy in the UK (for instance to hang on the walls of his/her home) amounts to a benefit provided by the trust. When an offshore trust provides a benefit to a beneficiary in the UK, an income tax or CGT charge can arise on the value of that benefit if it is matched with income/gains arising or which have already arisen in that trust.
The benefit accrues annually and is currently based on the value of the benefit rather than the whole value of the art work. That benefit is then matched to any income and/or gains in the structure, and an annual tax charge may then arise. Even if the structure is "dry" at the outset so that there is no income or gains to "match" to the benefit, if income/gains subsequently arise they can then be matched to benefits received in previous years, so a tax charge may arise at that later point.
To prevent the benefit being matched to the user, he could pay a market rent to the trustees for use of the work and to that end professional valuations would have to be obtained and a negotiation carried out on behalf of both the user and the trustees. At present, in some cases the rental valuation can be significantly reduced if the burden of use is placed on the beneficiary, such as responsibility for repair, insurance and security. The figures would however have to be carefully considered, as depending on the value of the work and what other funds the trust generates, if any, paying rent could prove more expensive than any tax bill. In addition the payment of rent introduces income into the trust structure which can then become taxable when matched to capital payments paid to and benefits given to any beneficiaries who are taxable in the UK, so this may be best avoided.
However note a recent government consultation has proposed changing the method of valuing the benefit of the use of art to the official rate of interest (currently 3%) multiplied by the acquisition price less any payments actually made by the beneficiary for use of that art including insurance and storage. No further details are known at the time of writing. [14 February 2017.]
Turning to IHT, if the settlor retains a right to use the art (or other trust assets) then he risks any UK situs art being deemed to be in his estate for IHT on his death, if the gift with reservation rules cannot be circumvented. Further, a trust created since 2006 which owns art located in the UK will have an IHT exposure, on 10 year anniversaries/capital appointments, at a maximum rate of 6% based on the current value of the art.
If IHT is the main concern, a subsidiary offshore company could be inserted into the structure. Such company then owns the art directly. As the trust owns non-UK assets (the shares in the offshore company) no IHT charges arise and the gift with reservation rules are not in point. Even though changes will be introduced from April 2017 to prevent UK residential property owned in an offshore structure being outside the IHT net, these provisions do not extend to other assets including works of art, at present at least.
It should be noted that, again, formerly domiciled residents are subject to a harsher regime: from their second year of UK residence IHT trust charges will apply to all their trust assets (whether located in the UK or overseas) and if the settlor retains an interest in the trust and the gift with reservation rules apply, all the trust assets (both UK and foreign) may be deemed to be in his estate for IHT on his death.
Care must be taken by the trustees in allowing their beneficiaries to use the art works. Where art is directly owned by trustees, a formal agreement is required, such as a Bailment Agreement, setting out the terms on which the beneficiaries are in possession of the trust property, such as who pays for insurance etc.
If instead a corporate structure is utilised, whilst one might expect that the beneficiary can be benefitted in the same way, due corporate process must be followed. A company cannot decide to allow a third party free or non-commercial use of its assets; the directors have a fiduciary role and why would it be in the interests of their shareholders to allow such free use of its assets? In practice, the trustees would need to decide (and formally resolve) in their capacity as shareholders of the company to confer a benefit on one of the trust's beneficiaries, and then formally direct the directors of the company to resolve to allow that beneficiary to use the art free of charge. The company would need to ensure that their governing documents allowed them to use assets in this way and may also need to seek corporate advice based on the laws of its jurisdiction of incorporation on such process. As the corporate is the owner of the artworks, it is that entity that then needs to enter into a Bailment Agreement directly with the user.
Critically, aside from tax aspects and irrespective of whether a corporate is interposed, trustees also have the usual fiduciary duties in relation to the artwork. Broadly this means that they must manage the works professionally and treat them like an investment, as they would any other trust asset. They need to obtain updated valuations regularly to identify the best strategy for the trust in order to maximise its assets and to act in the best interests of its beneficiaries. This may not be appropriate or possible if an individual simply wants to enjoy his art in the UK on his own terms.
This article first appeared in the Christie's Bulletin for Professional Advisers Spring 2017 edition.
Please note that since going to press some of the proposals outlined above are on hold due to the General Election