Report includes simplification of capital gains tax and changes to the United Kingdom’s residence and domicile regim

The Pre-Budget Report (PBR) 2007 was delivered by the Chancellor of the Exchequer, Alastair Darling, on 9 October 2007, and contained important changes to the UK tax system. This year’s PBR contained no shortage of headline-making announcements, such as the simplification of capital gains tax and changes to the United Kingdom’s residence and domicile regime. In addition, some relatively low-key targeted anti-avoidance provisions were announced together with welcome improvements to specific technical provisions.

Further details will follow once draft legislation is published under the next Finance Bill in early 2008.

Residence and Domicile

The taxation of non-domiciled UK resident individuals has long been a special feature of the UK tax system. Individuals who are tax resident in the United Kingdom, but who are domiciled in another country—broadly, where their “heart” is—have been taxed up to now on their non-UK income and gains only when remitted to the United Kingdom, and not on an arising basis.

However, changes announced in the PBR seek to charge certain non-UK domiciliaries for the privilege of using the remittance basis of taxation.

From 6 April 2008, a non-UK domiciled individual who has been resident for seven years (or possibly, seven years out of 10) will face a £30,000 flat rate charge if he or she wishes to claim the benefit of the remittance basis; otherwise the individual will be subject to tax on such income and gains when they arise. All non-UK domiciliaries using the remittance basis will lose the personal allowance on income tax (currently £5,225). Both of these rules are, seemingly, disapplied if the individual has less than £1,000 un-remitted income.

The government proposes to consult further on additional charges for those who have been resident in the United Kingdom for more than 10 years.

Changes have also been announced to the calculation of the number of days an individual is present in the United Kingdom. The current practice of HM Revenue & Customs (HMRC) is to ignore the days of arrival in and departure from the United Kingdom. From 6 April 2008, arrival and departure days will both be counted as a day of presence in the United Kingdom.

There are also likely to be other provisions reducing the scope of remittance planning opportunities, including the abolition of the “source-ceasing” rules.

One bonus for non-domiciliaries is that Irish-sourced income will in future be taxed on a remittance basis in line with other foreign income, rather than on an arising basis.

Draft legislation on these proposals is expected to be issued for consultation later in the year.

Capital Gains Tax

The Chancellor announced fundamental reforms to the structure of capital gains tax (CGT) as it affects individuals.

Currently, CGT is charged at the individual’s marginal income tax rate (either 20 per cent or 40 per cent). The effective rate is, however, reduced the longer that it has been held by virtue of taper relief. The business asset taper, which applies to the disposal of assets used in the business, unquoted shares and shares held in an individual’s employer, reduced the effective rate of tax to 10 per cent after two years, with other assets potentially benefiting from a minimum rate of 24 per cent after 10 years. In addition, assets held before April 1998 benefited from indexation relief up to that date, which was designed to give relief for inflation.

From 6 April 2008, both taper relief and indexation relief will be abolished altogether, and all capital gains will be chargeable at the flat rate of 18 per cent. Whilst trailed as a tax increase for private equity managers on their “carried interests”, which are normally taxable as capital gains rather than income, this change will also affect many investors in small companies, the owners of family businesses and employee shareholders, many of whom may be well advised to dispose of their assets before the start of the new tax year. Conversely, this change may be extremely beneficial for individual investors in property and other non-business assets.

Private Equity

This year’s PBR also contained announcements directed specifically at the private equity industry, mostly declaring that no targeted additional measures will be introduced.

  • The rules applying to shareholder debt in leveraged private equity structures will not be changed. However, the Government will continue to monitor the operation of the transfer pricing rules in this context.
  • Aside from the changes to the rate of CGT and the abolition of taper relief (and indexation) for individuals, no specific changes were made to the way in which “carried interest” is taxed. The memorandum of understanding between HMRC and the British Venture Capital Association survives. However, the PBR states that the Government “remains interested” in the way in which private equity managers are remunerated.

Investment Manager Exemption

The Investment Manager Exemption provides exemption from the charge to UK tax for non-UK resident persons who carry out investment transactions in the UK through a UK investment manager. Changes to this statutory exemption will be made to have effect on and after the date that the Finance Bill 2008 receives Royal Assent.

The statutory rules will be amended to do the following:

  • Clarify and simplify the definition of an “investment transaction” capable of benefiting from the exemption
  • Remove a rule which may have caused a non-resident to lose the benefit of the exemption for all transactions even where the investment manager carries out just one non-investment transaction on behalf of the non-resident

Offshore Funds: a Discussion Paper

The UK Treasury has published a discussion paper setting out its proposals for amendment of the tax regime applying to UK investors in offshore funds. The stated objectives of these proposals are, inter alia, to remove UK tax barriers to commercial developments in this industry, simplification and a strengthening of existing anti-avoidance rules.

The key proposals are as follows:

  • Replacing the current two-stage test of “material interest” in an “offshore fund” with a definition of “offshore fund” based on the commercial characteristics of such investment vehicles
  • Replacing the concept of “distributing fund” with “reporting fund” (a broadly similar concept) and allowing a fund to make a one-off election for reporting fund status with immediate effect
  • Removal of current investment restrictions limiting the extent to which distributing funds can invest in non-distributing funds. Reporting funds will not have such restrictions on their ability to invest in funds which do not qualify as reporting funds (non-reporting funds).

The UK Treasury has invited comments on the proposals from any interested parties by 9 January 2008.

Corporation Tax: Disguised Interest

Rules introduced in the Finance (No. 2) Act 2005 provided for certain shares that produce a debt-like return to be treated as loans for UK tax purposes. Dividends paid in respect of such shares are subject to corporation tax as income, rather than being exempt (as is the case for “normal” distributions from UK companies).

A measure has been introduced, with effect from 9 October 2007, to extend the corporation tax charge to all types of distributions (not just straightforward dividends) paid in respect of “debt-like” equity.

Individuals Paying Interest in Advance

Schemes were being deployed whereby individuals sought accelerated tax relief for interest paid in advance at the outset of a loan. Under such a scheme, all interest on a loan is rolled-up and paid in advance at the outset of the borrowing, with a claim for tax relief on the entire amount of interest paid in that tax year.

With effect from 9 October 2007, tax relief will be denied for interest that relates to a later tax year than the year in which the interest is paid.

Leased Plant and Machinery

With effect from 9 October 2007, a measure has been introduced to counter perceived avoidance involving sale and finance leasebacks of existing plant and machinery. This measure will supplement rules adopted in 1997 aimed at arrangements involving the sale and leaseback of plant and machinery by entities that were not liable to UK tax.

Sale of Lessor Companies: Partnerships

In the Finance Act 2006, a regime was introduced which was designed to change the way in which lessor companies were taxed on a change in ownership. That regime, however, produced an unfair tax result in certain circumstances where a leasing business, carried on by companies in partnership, was sold to a single company. The PBR announced a retrospective rectification of that prejudicial tax treatment, which will be effective from 5 December 2005 (the date when the initial “sale of lessor company” rules in the Finance Act 2006 took effect).

Finance Derivatives

Following discussions with the Investment Management Association and asset management including representatives, HMRC has issued new guidance, clarifying its view of the tax treatment of certain financial derivative transactions.

Broadly, the new guidance is premised on certain basic assumptions:

  • There is no conceptual difference between transactions in a “real” financial asset (e.g., a share) and transactions in derivatives that replicate the risks and rewards of owning that asset.
  • “Short” positions are conceptually the same as “long” positions, in so far as each takes a view on the direction of movement in the price of the underlying asset.
  • Composite or multi-derivative transactions should be viewed as a whole and not separated out (or “unbundled”).

Stamp Duty: Exemption for £5 Duty Instruments

With effect from the day that the UK Budget 2008 is delivered, transfers of shares that would attract stamp duty not exceeding £5 (whether fixed or ad valorem) will be exempt from charge and will not have to be presented for stamping.

Stamp Duty Land Tax: Change in Notification Thresholds for Land Transactions

Legislation currently provides that taxpayers must notify most UK real estate transactions and self-assess the stamp duty land tax (SDLT) payable to HMRC.

Legislation will be introduced, with effect for transactions on or after the date of the UK Budget 2008, which provide, inter alia, that UK real estate transactions for consideration of less than £40,000 no longer need to be notified to HMRC. The aim is to reduce the administrative burden of SDLT on the taxpayer.

Stamp Duty Land Tax: Change to Anti-Avoidance Legislation Affecting Partnerships

Legislative changes have been announced to the SDLT regime applying to property investment partnerships purchasing interests in UK real estate.

Under current anti-avoidance legislation, introduced in 2007 to counteract specific tax avoidance schemes, SDLT is chargeable on transfers of UK real estate within property investment partnerships whether or not consideration is given for the transfer and whether or not parties are connected.

The legislative changes announced will remove this charge to SDLT with effect on and after the date of the UK Budget 2008 and applying retrospectively to transactions occurring on and after 19 July 2007.

Forex Hedging

Changes to the tax treatment of foreign exchange gains and losses on loans and derivatives used to hedge foreign exchange risk arising from a company’s non-sterling investments have been announced.

First, companies will be able to elect to value “matched” shares at the value of the net foreign currency assets underlying the shareholding, rather than at book value. Secondly, “straightforward and objective” rules for identifying which loans and derivatives are matched with shares will replace the current rules which rely on the company’s intentions.

In addition to these two specific changes, it was also announced that HMRC would publish a technical note in the first quarter of 2008 which would be accompanied by draft regulations to consult on more extensive changes that can be expected on or after 1 January 2009.

Inheritance Tax

Legislation will be introduced to allow the unused proportion of a deceased’s inheritance tax nil-rate band to be transferred to the estate of the surviving spouse or civil partner who dies on or after 9 October 2007.

For example, a deceased individual leaves their entire estate to their surviving spouse or civil partner. That transfer is exempt from inheritance tax. The nil-rate band of the surviving spouse or civil partner can, on making a claim, be increased by 100 per cent of the prevailing nil-rate band at the time of the survivor’s death.

Simplification

The United Kingdom’s tax code, which has become one of the lengthiest and most complex in the world, has recently come under scrutiny as being a potential obstacle to attracting business and inward investment. Later this autumn, a joint HMRC and Treasury initiative will be launched, involving consultation with business, looking at ways in which certain aspects of the United Kingdom’s tax regime can be simplified.

The areas on the government’s radar include the following:

  • Anti-avoidance legislation: examining the effectiveness of the current piecemeal approach of introducing targeted anti-avoidance rules and considering more generic approaches (an explicit general anti-avoidance rule, perhaps)
  • Related companies: streamlining group aspects of company taxation, including the chargeable gains regime

Advance Agreements Unit

The government also announced the launch of the Advance Agreements Unit (AAU), a single point of contact for inward investors. The AAU will issue rulings where there is uncertainty as to the application of tax law to a specific transaction, co-ordinate responses from different departments within HMRC, and operate a fast-track where certainty on a transaction is time-critical.