The UK’s first-tier Tax Tribunal (Tribunal) has recently considered a number of issues relating to the anti-avoidance rules which attribute the income of offshore structures to UK residents in the case of A Rialas v HMRC  UKFTT 520.
Some of the comments made by the Tribunal could be quite helpful to taxpayers. Whilst tribunal decisions are not binding in other cases, they are frequently referred to.
Income tax anti-avoidance rules
Income from an offshore structure (for example a trust or a company) can be attributed to an individual who has transferred or procured a transfer of assets to the structure if there is a possibility of the transferor benefitting from the income.
This attribution rule does not generally apply to offshore trust structures set up by non-domiciliaries except in relation to UK source income.
Where there is no attribution to the transferor, the income of the structure can instead be attributed to any UK resident who receives a benefit from the structure.
None of the attribution rules apply if the taxpayer can show that the structure was not set up for UK tax avoidance purposes.
The background to the Tribunal case
Mr Rialas comes from Cyprus. At the relevant time, he was a UK resident, non-domiciliary paying tax on the remittance basis. He and his business partner each owned 50% of a UK company (Argo) which carried on an investment management business.
In order to facilitate a sale of Argo, Mr Rialas agreed to buy out his business partner. He set up a discretionary trust in Cyprus for himself and his family and transferred 10 Cypriot pounds to the trust. The trust acquired a BVI company which in turn acquired all of the shares from the business partner at what was agreed to be market value. The purchase was funded by a loan from a third party to the BVI company.
Over the next two years, the BVI company received approximately £2.7m in dividends. HMRC argued that these dividends should be attributed to Mr Rialas on the basis that he was a transferor in relation to the structure, thus giving rise to an immediate tax charge even though Mr Rialas was a remittance basis taxpayer as the dividends had a UK source.
The Tribunal decided that Mr Rialas was not liable to tax. In doing so, they discussed four interesting points:
- Who is a transferor?
There was no doubt that Mr Rialas had set up the trust structure and had transferred ten Cypriot pounds to the trust. He was therefore, to some extent, a transferor.
However, income is only attributed to a transferor if it arises as a result of the transfer or an associated operation.
The Tribunal decided that this was not the case as the purchase had been funded by a loan from a third party and that the ten Cypriot pounds contributed by Mr Rialas had nothing to do with this.
In some ways, this could be seen as a surprising result as the income would not have been received by the structure had Mr Rialas not established it in the first place. However, the clear message from the Tribunal is that, where the settlor only makes a modest contribution to the trust and the actual funding for the purchase of an asset comes from elsewhere, the income from that asset will not be attributable to the settlor.
- Procuring a transfer
Income can be attributed to an individual not only where they make a direct transfer to the offshore structure but also where they have procured a transfer.
HMRC will often try to argue that an individual is a “quasi-transferor” in relation to a structure. In this case they tried to argue that because Mr Rialas had made all of the arrangements for the purchase of the shares, he had in some way procured the transfer of the shares.
The Tribunal quite rightly rejected this. The shares were transferred by Mr Rialas’ business partner at market value and Mr Rialas had no control over whether his partner agreed to sell the shares or not. The transfer of the shares was therefore made solely by the business partner and not by Mr Rialas.
The important point which can be taken from this is that where an offshore structure has acquired an asset at market value from a third party, it is extremely unlikely that another individual who is not a transferor in relation to the structure can be treated as having procured the transfer and so be taxed on the income received by the structure.
- Tax avoidance
A number of reasons were given by Mr Rialas for the creation of the trust structure. All of these were non-tax reasons except for one which was that he was aware that the trust structure would reduce his exposure to UK inheritance tax. The reason for this is that the shares in Argo were UK assets but holding them through a BVI company converted them into non-UK assets on which Mr Rialas, as a non-domiciliary, would not be subject to inheritance tax.
The Tribunal followed an earlier decision of the Special Commissioners (the predecessor to the Tax Tribunal) in deciding that where a non-domiciliary holds a UK asset through a non-UK company, this amounts to tax avoidance for the purposes of the income tax anti-avoidance rules.
Clearly this is unhelpful to non-domiciled taxpayers and in one sense goes beyond the previous Special Commissioners’ decision. In that case, the taxpayer held a UK asset which they transferred to a Jersey company. The Special Commissioner said that this was tax avoidance as there was no real change in the investments held by the taxpayer. The change was only technical in the sense that the UK asset was now held by the Jersey company rather than being held directly.
Mr Rialas of course never owned his business partner’s shares in Argo himself and so the acquisition of the shares by the BVI company was not just a technical change to the way in which an existing investment was held. It seems surprising that choosing to acquire a UK asset through an offshore company should amount to tax avoidance for this purpose.
One of the points made by Mr Rialas was that parliament has recently introduced a rule under which inheritance tax is still chargeable on the shares in an overseas company which owns UK residential property. They have however chosen not to impose an inheritance tax charge for non-domiciliaries on the shares of overseas companies which own other UK assets.
The Tribunal dismissed this argument on the basis that this legislation was not in force when the relevant events took place. This could perhaps be taken as tacit acceptance that, based on parliament’s intention in bringing indirectly owned UK residential property within the inheritance tax net, holding other UK assets through a non-UK company is no longer tax avoidance.
- EU freedom of movement of capital
The final point considered by the Tribunal was whether the income tax anti-avoidance rules interfered with Mr Rialas’ right under EU law to the free movement of capital.
Given that the income attribution provisions only apply to overseas companies and not to UK companies, it was relatively straightforward for the Tribunal to conclude that these anti-avoidance rules do infringe the right to the free movement of capital.
Such infringement can be justified if the purpose is to combat tax avoidance.
The concept of what constitutes tax avoidance has recently been extended by the European courts to cover not only arrangements which are totally artificial but also those which have as one of their main purposes, the artificial transfer of profits to a non-EU country with a low tax rate.
On this basis, the Tribunal found that the income attribution rules were in principle justified. However, that was not the end of the story as they went on to consider whether the effect of the rules was proportionate or whether, in this case, they were penal in nature.
The Tribunal’s view was that, in this particular case, the rules were disproportionate as, had the investment been structured through the UK, the interest paid by the company on the loan to fund the purchase would in principle have been deductible whereas the amount of the income attributed to Mr Rialas would be the whole amount of the dividends without any deduction for interest.
As the anti-avoidance rules could not be interpreted in a way which avoided a disproportionate effect, the Tribunal’s conclusion was that EU law required them to be disapplied.
It was recognised some time ago that these anti-avoidance provisions were not consistent with EU law. Changes were therefore made to the legislation to introduce an “EU defence”. However, those provisions contain numerous restrictions. Although they were not considered by the Tribunal as they were not part of the law at the time the relevant events took place, it is clear from the Tribunal’s decision that the changes made are not sufficient to make the anti-avoidance rules compliant with EU law.
This is therefore a potentially important line of defence for taxpayers should HMRC try to tax them on the income of an offshore structure.
The income tax attribution rules relating to offshore structures are one of the most complex areas of the UK tax code. They are wide enough to apply in many circumstances, as HMRC will often point out.
They should always be considered where income arises to an offshore structure which is in some way connected with one or more individuals who are UK resident. There are however a number of reasons why the rules may not apply in any given situation. This is well illustrated by the Tribunal’s recent decision.
There may of course be an appeal. But unless there is and HMRC are successful, the Tribunal’s comments will in many cases be of assistance to taxpayers where there is a dispute with HMRC.