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TaxationWeb by Shiv Mahalingham BSc (Econ), ACA, CTA

A look at the present and future for non-UK domiciliaries, and some practical points and opportunities arising from the remittance basis of charge to income and capital gains tax, as explained by Shiv Mahalingham BSc (Econ), ACA, CTAThe publication of the United Kingdom residence and domicile background paper by the Treasury and the Inland Revenue in April 2003 (Reviewing the residence and domicile rules as they affect the taxation of individuals: a background paper, available on the Internet at www.inlandrevenue.gov.uk/budget2003/) has renewed speculation about the reform of the rules governing the remittance basis. Under these current rules, the overseas income and gains of those individuals who are resident in the United Kingdom, but who have non-United Kingdom domicile, will generally be subject to United Kingdom tax where such income and gains are remitted to this country. A credit for any foreign tax suffered may be available in the United Kingdom, but there are various planning opportunities that exist which allow foreign domiciliaries to enjoy the use of overseas income and gains here without having to pay any United Kingdom tax.

The background paper has reiterated that any forthcoming changes to the current system should reflect fairness, support the competitiveness of the United Kingdom economy and provide a system that is clear and easy to operate. This is, of course, not the first time the system has been under review. Fifteen years ago, the Inland Revenue published a consultation paper entitled ‘Residence in the United Kingdom’ which outlined proposals (that were dropped in the subsequent year) for eliminating the concept of domicile for income and capital gains tax purposes.

In preference to the outright abolition of the remittance basis of charge, changes could be expected to take the form of an extension of the United Kingdom inheritance tax deemed domicile rules to cover income and capital gains. Malcolm Gunn discussed some of the practical limitations of this option in ‘The Domicile Debate’ (Taxation, 25 April 2002 at page 83) and also highlighted the need for clearer guidelines regarding the operation of the remittance basis.

In the absence of such guidelines, this article looks at the definition of a remittance for United Kingdom tax purposes (drawing evidence from United Kingdom case law) and how such remittances may be made to this country without suffering United Kingdom tax.

What constitutes a remittance?

A remittance in its most basic form would be an amount of cash physically brought into the United Kingdom. Overseas income and gains that are used to settle United Kingdom debts or to discharge United Kingdom liabilities would also constitute a remittance (this would include the settlement of debts on United Kingdom credit cards). However, there is not always such a clear distinction between what constitutes a remittance, and what does not.

A useful definition was provided in Thompson v Moyse 39 TC 291, where a remittance was said to occur where economic value has been transferred into the United Kingdom ‘by whatever means the agencies of commerce or finance may make available for that purpose’.

It was also ruled in the above case that there was no requirement for income to be physically brought into the United Kingdom. For example, the use of overseas income and gains to settle debts on an overseas credit card used in the United Kingdom may risk being treated as a remittance as arguably the overseas income and gains are being enjoyed in the United Kingdom. This is the Revenue’s view as set out in the Inspector’s Manual at paragraph 1569. However, it could be argued that the debt owed is to an overseas credit card company and as such no remittance has been made.

Tax-free remittances

So how can remittances be made to the United Kingdom without suffering United Kingdom tax?

Maintain separate accounts

By remitting funds from separate accounts of income, capital and capital gains there is an opportunity for a foreign domiciliary to minimise his or her potential tax liability. Experience has shown that keeping the accounts at separate banks can help to defend that they are distinct accounts that contain separate sources of funds, although in Kneen v Martin 19 TC 33 separate accounts at the same bank were sufficient to avoid a remittance.

Capital accounts

Amounts that an individual held on account before taking up residence in the United Kingdom for the first time would be treated as capital and any amounts remitted to the United Kingdom from a pure capital account would not become taxable here. Similarly, any income arising in a year in which the individual was not resident in the United Kingdom could be treated as capital and credited to a pure capital account. Reliable evidence (especially with respect to the dates) would be required of income and gains arising whilst resident and whilst non-resident.

In the absence of separate accounts, it would be difficult for an individual to argue that funds remitted were pure capital instead of income or gains.

Capital gains account

The proportion of an overseas capital gain becoming chargeable in the United Kingdom would depend directly upon the amount of the disposal proceeds remitted to the United Kingdom; i.e. if 50 per cent of disposal proceeds are remitted to the United Kingdom, then 50 per cent of the gain would be assessable to United Kingdom capital gains tax. Therefore, specific amounts could be remitted to the United Kingdom from a pure capital gains account until the annual exemption for capital gains is utilised, giving a tax liability of zero.

As the account will only have comprised capital gains, the individual will be in a position to argue that the funds remitted to the United Kingdom are to be assessed only to United Kingdom capital gains tax.

If an overseas asset were sold at a capital loss, then to bring the disposal proceeds to the United Kingdom would not constitute a taxable remittance. It would be advisable to keep such proceeds separate from the proceeds of disposals that did result in a chargeable gain. Capital loss relief for the overseas capital loss will not be available against United Kingdom gains.

Interest on capital accounts

The full amount of interest arising on pure capital or pure capital gains accounts should be transferred out and kept in a separate account so that it does not ‘taint’ the pure accounts. It is advisable for such transfers to be made as soon as the amounts are credited to the account so that the risk of this income tainting the pure capital or capital gains accounts is reduced. This can be achieved most easily with the use of a pre-agreed electronic transfer.
Where a deposit and withdrawal to an account are closely connected in time and amount, then the Inland Revenue may accept that the funds in the account have not been tainted.

Income

It may also be advisable to keep such interest income and other overseas income separate from income that has been taxed in the United Kingdom on an arising basis and then transferred overseas.

Such income has already been taxed in the United Kingdom and if there were a need to remit funds to the United Kingdom from an income account (e.g. if capital and capital gains options had been exhausted), then this income would be preferable to income generated overseas.

Practicalities

In practice, separate accounts are not always easy to achieve and can be expensive to maintain. It can also be an extremely difficult task to separate existing accounts that already contain a mixture of different types of capital, income and gains. It is difficult to see how such a separation of already mixed funds could be justified.
However, the potential tax savings may far outweigh the costs of setting up and administering separate overseas accounts.

The source ceasing rules

The principle of the source ceasing rules is that an individual cannot be subjected to tax on certain types of income remitted in a tax year if the source of that income no longer exists for the individual in that same tax year. (See National Provident Institution v Brown 8 TC 57.)

Finance Act 1994 amended the application of the source ceasing rules, but there is still an opportunity for foreign domiciliaries to use these rules for income falling within Schedule D, Case IV and Schedule D, Case V (income earned from overseas securities and possessions), which is taxable on a remittance basis. It should be noted that the source ceasing rules are not applicable to employment income or capital gains.

Practicalities

An individual would be able to close a source of income in a particular tax year and then remit the proceeds to the United Kingdom in the following tax year. This would require some forward planning on behalf of the individual, but it should be noted that methods of closing the source would not be limited to simply closing an investment account, but may also include transferring an asset that generated investment income into a company or discretionary trust.

The individual would generally not need to close all sources of investment income, but just a particular source, and it would be theoretically possible to open and close sources of income from year to year. This may not be practical or cost effective for many individuals and excessive use of the source ceasing method of remittance may attract undue attention from the Inland Revenue.

Overseas gifts to another party

Overseas income and gains that are used to purchase an overseas asset where the asset is then brought into the United Kingdom by the foreign domiciliary may risk being classified as a remittance.

It is interesting to note that an asset purchased overseas out of employment income or gains and then brought into the United Kingdom has long been regarded as a remittance, but arguably not if the asset is purchased out of investment income. However, Grimm v Newman [2002] STC 1388 has provided an example of how this may not always be the case. There, the Court of Appeal held that a gift made to a spouse that was perfected overseas and then brought into the United Kingdom to purchase an asset jointly with the donor, was not a taxable remittance. (This followed the judgment of Carter v Sharon 20 TC 229 where a mother transferred funds whilst overseas to her daughter’s bank account, who then brought the funds into the United Kingdom. It was held that the mother had not made a remittance, as the transfer was perfected overseas and so the money being transferred into this country was that of the daughter.)

Lord Justice Carnwath provided a specific example in the case where a pair of cufflinks, purchased using overseas funds, are brought into the United Kingdom as an expendable resource for the individual. In such a situation, it was said that a taxable remittance may be created and no mention was made as to whether the asset was purchased out of investment income or other types of income. Lord Justice Carnwath appeared to be applying such reasoning to Schedule E and in particular section 132(5), Taxes Act 1988, but the principle of assets brought into the United Kingdom as an expendable resource could conceivably be applied to assets purchased using investment income.
To summarise:

- Overseas income and gains given to an individual whilst outside of the United Kingdom, where that donee then brings the income and gains into the United Kingdom for his or her personal use, will generally not constitute a taxable remittance in the United Kingdom. The gift should be perfected abroad and no consideration should be received in the United Kingdom. However, there is a risk that a taxable remittance will occur if the donor is to enjoy the use of the asset in the United Kingdom.

- An individual could under specific circumstances use an overseas gift of money to purchase an asset jointly with the donor in the United Kingdom and still avoid a remittance.

Tax-avoidance methods

Aside from the more conventional methods outlined above, there exist more aggressive structures that are used to bring overseas income and gains to the United Kingdom.
Consider a structure where the overseas income and gains of a foreign domiciliary are used to subscribe for shares in an overseas company. This company then makes a loan to a second overseas company that in turn makes a loan to the foreign domiciliary in the United Kingdom. This exact structure was ruled to be a remittance in Harmel v Wright 49 TC 149.

One can envisage taxpayers dreaming up more complicated structures to bring income and gains to the United Kingdom that will be less easy to identify as a remittance – however, such structures which include steps with no commercial basis will run a high risk of being challenged by the Inland Revenue.

Back-to-back loan structures are often used as a remittance tool and in the most basic of forms this would involve a foreign domiciliary with overseas income and gains lending funds to a United Kingdom institution with the understanding that the institution would then make a United Kingdom loan back to the foreign domiciliary. A large amount of funds would need to be transferred by an individual in this manner to make the transaction worthwhile for financial institutions. Section 65(8), Taxes Act 1988 specifically targets the use of back to back loan structures in remitting funds to the United Kingdom, but the use of more complex structures can make such funds difficult to trace. This highlights an important distinction between conventional remittance methods and remittance methods that are likely to be challenged.

So called ‘Hawala’ (informal funds transfer) schemes are also believed to be in operation where an individual may deposit funds with a broker in an overseas location and the broker’s associate in this country would release funds to the individual in the United Kingdom after deducting commission. Such schemes are often associated with a lack of documentation, being based upon trust between the broker and their associate; this is no doubt designed to circumvent the detailed conditions of section 65(8), Taxes Act 1988.

Conclusion

The April 2003 background paper (whilst providing a useful summary of the current United Kingdom tax rules) does not threaten any immediate reform to the remittance basis of charge and, until such reform becomes effective, there will remain many opportunities for the estimated 65,000 foreign domiciliaries in this country to remit income and gains here with minimal United Kingdom tax consequences.

Successful modernisation of the legislation may require a discussion of whether it would be more effective to eliminate current tax efficient remittance methods such as source ceasing, or whether to target the detection of tax avoidance remittance methods and informal funds transfers.