Non Dom and IHT reforms – The wait is over
Readers will recall my description (in my last edition) of the 'flotilla of condocs' arriving on our shores this summer – well I'm now officially upgrading this to an armada, with the addition of two new battleships, in the form of the long awaited consultations on the reform of non-dom taxation and IHT on UK property. Despite beguiling rumours to the contrary, the government is determined to press on with these reforms in time for the new tax year, which means there's a lot of work to do between now and 5 April.
If you were to ask me for one word to describe the contents of these two consultations, it would be "disappointing" – there are promises half-delivered (protection for offshore trusts) or simply passed over (de-enveloping relief). The latter will be a crushing disappointment to people who have existing trust structures with enveloped properties as there is no clear path to de-envelope in order to avoid the "double whammy" of IHT and ATED from April 2017.
Here are the details:
Deemed UK domicile for long term residents
The government is pressing ahead with the 15/20 test, which is no surprise. They have clarified that this will also cover children, meaning that if you are born in the UK to non-domiciled parents, by the time you reach 16 years old you will have acquired a deemed domicile. Happy birthday!
Rebasing foreign assets
If you are searching for some good news then you will find it here. If the new rules lead you to become deemed domiciled on 6 April 2017 then, providing you weren't born in the UK, you will have the opportunity to rebase any directly held foreign assets to their market value as at 5 April 2017. However, this will not apply to assets held within trust or company structure. In case you are thinking of moving assets into personal names before 5 April then think again - the government has made it clear that the rebasing will only apply to those assets which are in your direct ownership as at the date of the 2015 summer budget (8 July).
Cleansing mixed funds
Here's a bit more good news; but after this it gets pretty dark. We have an unexpected but welcome relief which will allow non-doms to "cleanse" their offshore funds (and what they mean by offshore funds is non-UK bank accounts which contain a mixture of capital, income and/or gains). As practitioners will know, once mixed it is virtually impossible to separate income and gains from capital for the purposes of the remittance basis and the government has decided that it will introduce a "temporary window" in which individuals will be able to separate funds into their constituent parts, thereby enabling you to split out your clean capital and, joy of joys, to remit it to the UK. This exciting opportunity will last for one year only (hurry while stocks last) in the period 6 April 2017 to 5 April 2018. Surprisingly, this opportunity is open to all non-doms, not just those who become deemed domiciled on 6 April 2017. As always, there are some exceptions, which are those are people who were born in the UK or who have never claimed the remittance basis. I predict that there will be a huge amount of "cleansing" going on between the introduction of the rules and April 2018.
Protection for non-resident trusts
We had high hopes that the government would be sensible and make sure that settlors would be allowed to shelter their assets in offshore trusts following them becoming deemed domiciled. Whilst the government has responded with detailed proposals, it is disappointing that these have been significantly watered down. I set out the details below, but in the meantime point out that at least the government does not intend to pursue a "benefit charge" which would have caught all distributions from trusts, regardless of whether they represented income or gains. Instead there will be complex amendments to the anti-avoidance rules to "switch off" the settlor charges in certain circumstances.
This is where it gets quite complicated and, if I were you, I would take this opportunity to wrap a warm towel around your head and swallow a precautionary aspirin before reading on….
(a) Capital Gains Tax
At present, settlors who are non-UK domiciled are not taxed on capital gains arising to an offshore trust (per section 86 TCGA 1992). It is intended that section 86 will continue to protect settlors who become deemed domiciled, provided the trust was set up whilst they were non-deemed domiciled. However, this protection will be switched off if, either, funds are added to the trust after they have become deemed domiciled, or the settlor, their spouse, any minor children or any other relevant person receives any benefits from the trust. The government also proposes to "switch off" section 87 for settlors because, in their words, "their trusts will either not be protected, in which case they would be liable for all gains under section 86 or, if the trust is protected, it will lose its protection once a benefit is paid out to them, their spouse or minor children resulting in the settlor being taxed on all gains arising".
What we see here is an introduction of the concept of a "protected trust", which is essentially a big freezer in which you leave your trust assets, neither adding nor taking anything away, otherwise your protection is lost. It also seems that once the protection is lost, that's it – all gains then become taxable on the settlor from that point.
(b) Settlements legislation
Many people forget that we have settlements legislation which catches UK doms and non-doms alike (sections 624 and 633 ITTOIA 2005). Section 624 taxes the settlor on income arising from trusts, although hitherto non-dom settlors would not be taxed on foreign income arising to non-resident trusts because of the availability of the remittance basis. Section 633 is a much forgotten but utterly deadly clause which provides that where the income of a trust is not taxed on the settlor under section 624, any capital sums paid directly or indirectly to the settlor, including loans paid by the trustees to the settlor, are taxed as income of the settlor. Whilst the government intends to switch off section 624 for a "protected trust", they intend to leave section 633 unmolested – effectively ruling out the extensive use of loans to avoid a tax on distributions.
(c) Transfer of assets abroad legislation
The transfer of assets abroad (TOAA) legislation is extremely wide ranging and catches transferors (including settlors) of assets abroad. Where you have a protected settlement the TOAA rules will be switched off, provided no more assets are added to the structure nor any benefits taken. For the avoidance of doubt, they have made it clear that the enjoyment of trust assets will be considered to be a benefit and will lead to the value of the benefit being taxed on the settlor, to the extent it can be matched against relevant foreign income arising that year. The interaction of these new rules with the existing rules on the taxation of benefits received by beneficiaries looks to be a real problem, and we are told that "further thought" will need to be given to the matching process for income against benefits. One tiny piece of good news is that the loss of protection under TOAA is going to be less harsh than under the "all or nothing" CGT rules, in that where a benefit is received in a tax year the settlor will be taxed on any relevant foreign income arising in that year only. This suggests that they will be taking a year by year approach, meaning that the protection will only be lost in the years in which benefits are received.
The government confirms that the IHT rules will be amended so that there will now be a 15/20 rule rather than a 17/20 rule. This means that from the sixteenth year a foreign domiciliary will become deemed UK domiciled, compared to the current treatment where they become deemed domiciled from the seventeenth year. On the face of it this does not look like a harsh development.
Excluded property trusts
The government is not intending to change the rules which apply to excluded property trusts where a person has become deemed UK domiciled under the new rule. This means that offshore trusts set up by individuals who are not domiciled in the UK will remain outside of the scope of UK IHT even after they become deemed domiciled. Huzzah!
IHT on UK residential property
This represents the most disappointing part of the consultation. The government is intending to progress with the plan to remove UK residential properties owned indirectly through offshore structures from the current definitions of excluded property. The effect will be that such UK residential properties will no longer be excluded from the charge to IHT, whether they are owned by a company, individual or trust.
An immediate issue is that if the offshore company is owned by a trust then the latter will be treated as the owner, leading to IHT charges under the relevant property regime. If the company is owned by an individual then we have possible tax on lifetime gifts and/or death.
The government recognises that where property is owned through an overseas company, HMRC may have difficulties in identifying whether a chargeable event has taken place, and they are proposing to introduce a new liability on any person who has legal ownership of a property, including any directors of a company which owns the property, to ensure that IHT is paid. It seems that there will be a new rule introduced to the effect that indirectly held UK residential property cannot be sold until any outstanding IHT charge is paid. Perhaps we may see some amendments to the rules at HM Land Registry to prevent registration of property where the vendor is a company until there is an IHT clearance certificate. This will significantly increase the compliance around the sale and purchase of residential property in the UK.
Non-doms with existing structures that are already caught by ATED now have a real problem, as without a clear path to de-enveloping they will face the dreaded "double whammy" from April 2017. There has been a massive and inexplicable change of heart at HMRC which, in the last consultation document, recognised that there could be some harsh consequences for clients who de-envelope in order to cope with the new changes. However, HMRC's answer to this problem is to simply ignore it; suggesting that a de-enveloping relief would not be appropriate, but without giving any reason.
The act of de-enveloping property will, in many cases, lead to a double charge to CGT as well as, potentially, SDLT and all sorts of charges under the CGT 'beneficiary provisions' and the TOAA rules. Possibly the only "easy" solution for clients will be to sell their residential properties in the UK. This at least will stop the ATED charges and remove the IHT risk, although it does not ameliorate the CGT issues if there have been beneficiaries in receipt of "unmatched" capital benefits. One other easy option for people who do not want the double whammy is to kick their beneficiaries out of trust properties and instead rent those properties on the open market. This will cease the ATED liability whilst, I am afraid, doing nothing for the IHT liability.
I suspect this issue of existing structures, their pregnant gains, ATED liabilities and the forthcoming IHT relevant property rules will be the single largest concern facing clients and their advisors between now and April 2017. It is clear that the government does not intend to offer any quick fix or relief and each case will need to be looked at on its own merits. There are still possibilities for tax efficient de-enveloping, but at the moment it seems that this will be limited to structures where there are non-resident beneficiaries to whom you can "wash out" the taxable gains, or where the gain on the underlying property is not significant.
As you can tell from the length of this bulletin, there are a lot of complex and difficult issues to consider as part of these proposed reforms. Whilst the general principal of limiting the non-dom status to the 15/20 rule can generally be accepted, more work needs to be done to protect existing structures from taxation, both on de-enveloping and otherwise. The slipping of the timetable is also a worry – the consultations are open until 20 October and the earliest we can expect legislation is early December. This means that there will be (yet again) an unholy rush to sort out structures before the April deadline.