With three days left before the 2017/18 tax return filing deadline, HMRC yesterday confirmed that they do not consider offshore income gains to be covered by the so-called “protected settlements” regime.
Offshore income gains and protected settlements – a recap
The “protected settlements” regime, intended to protect non-UK domiciled settlors from arising basis taxation in relation to non-UK income and gains of the trust, applies only to income qualifying as “protected foreign source income” (PFSI). Originally, it was widely assumed that all non-UK income would qualify as PFSI. However, as reported previously in our Collective Insanity note, as a result of what appears to be a technical drafting glitch in Finance (No 2) Act 2017, offshore income gains (OIGs) arising on the disposal of non-reporting funds seem to be excluded from the definition of PFSI unless the settlor is a remittance basis user.
On that basis, non-UK settlors who have become deemed domiciled will be subject to income tax on the arising basis in respect of OIGs realised within a “protected settlement”. The drafting is also problematic for settlors who have not yet become deemed domiciled – such individuals are strictly required to claim the remittance basis in order to secure protection from arising basis tax, which may result in the payment of remittance basis charges that would otherwise not need to be incurred.
An almost identical issue exists in relation to the accrued income scheme. Where a security, such as a bond, is sold with accrued interest, the element of the sale proceeds representing that accrued interest is deemed to be income for tax purposes. Again, on a literal reading of the legislation, such deemed income can only qualify as PFSI if the settlor is a remittance basis user.
Appeals to HMRC - falling on deaf ears
Published Government policy has always been that, under the new regime, non-UK domiciliaries would be protected from arising basis tax on non-UK income and gains of non-resident trusts created by them. There is no possible policy justification for treating OIGs or accrued income profits differently from other gains of a protected settlement.
Representations were therefore made to the Government by professional bodies calling for legislative change and submitting compelling evidence of the scale of the problem. However, HMRC issued a statement in November 2018 confirming that they have no current intention to amend the legislation to include OIGs within the definition of PFSI. Instead, they made the rather empty promise that they would “continue to monitor this situation and engage with stakeholders.”
Towards the end of 2018, professional bodies made a further attempt to address the problem. An alternative reading of the legislation was suggested, under which OIGs would qualify as PFSI via a somewhat roundabout route. Accrued income profits were not expressly addressed, but presumably it was hoped that this creative reading of the legislation would also save the day with respect to this form of deemed income.
It was hoped that this, admittedly rather ambitious, interpretation of the relevant provisions could be accepted by HMRC as a means of addressing the drafting defects without the need to pass corrective legislation. HMRC seem to have given the proposal due consideration, but have concluded that they disagree with the alternative analysis, setting out their reasoning in some detail. Their response reiterates that HMRC consider OIGs (and presumably also accrued interest profits) to fall outside the definition of PFSI on technical grounds.
The final countdown – decision time
Although HMRC’s rejection of this approach is perhaps unsurprising, with just a few days to go until the 31 January filing deadline for 2017/18 tax returns, it leaves many non-UK domiciled settlors of trusts that otherwise have protected status facing an urgent reporting dilemma in relation to OIGs and accrued interest profits.
Foreign domiciled settlors who became deemed domiciled on 6 April 2017 have two options: (1) report the OIGs / accrued interest profits and pay the tax due, or (2) include a “white space” disclosure in the return asserting that the OIGs / accrued interest profits should qualify as PFSI and so not be taxable on the arising basis. It is difficult to see what could be lost in opting for the second approach, but as HMRC have made their position explicit, the taxpayer would need to be prepared for HMRC to assess the tax due anyway.
For a non-UK domiciled settlor who was not deemed domiciled in the 2017/18 tax year, the position is arguably clearer. If a remittance basis claim can be made without incurring the remittance basis charge, or would have been made in any event, it should be made. The claim should ensure that trust OIGs and accrued interest profits qualify as PFSI and so cannot be taxed on the arising basis. In all other cases, it is likely to be preferable for the settlor to use the arising basis of taxation and make a “white space” disclosure - bearing in mind the scope to make a retrospective claim to use the remittance basis up to four years from the end of the relevant tax year.
- On a literal reading of the legislation, trust OIGs and accrued income profits cannot qualify as PFSI unless the settlor is a remittance basis user.
- Deemed domiciled settlors who are potentially taxable on trust OIGs / accrued income profits for 2017/18 may wish to make a “white space” disclosure in their tax returns, taking the position that these forms of deemed income are PFSI. However, they will need to be prepared for HMRC to assess the tax due in any event.
- For settlors who are not yet deemed domiciled, it may be advantageous not to claim the remittance basis (unless no charge would be incurred / the claim would be made in any event) but to diarise to review the position before the deadline for retrospective claims, four years after the end of the relevant tax year, ie April 2022.
- Trustees of trusts affected by this issue should ensure that bonds are sold on, rather than between, interest payments dates, or are kept to maturity, so that no further accrued income profits arise in the trust.
- Trustees of affected trusts should also review their investment strategy and consider moving away from non-reporting to reporting funds, or continuing to invest but via an offshore life bond.