The proposed changes to the deemed domicile rule announced in the Summer Budget on 8 July 2015 will have a detrimental effect on longer-term UK residents who continue to be domiciled outside the UK as a matter of general law and take advantage of the remittance basis of taxation.
There are two rules in UK inheritance tax (‘IHT’) legislation relating to deemed domicile. The first is for foreign domiciled individuals who have taken up residence in the UK, the second for UK domiciliaries who have moved abroad. The first case is the focus here.
The rule is expressed in terms of years of tax residence over a period of 20 tax years. At the point when a person’s deemed domicile position is considered, tax years are counted back, including the current tax year, and if the individual has been tax resident in 17 or more of those 20 years, he or she is deemed domiciled.
The rule does not disregard split years of tax residence, so an individual could move to the UK on the very last day of a tax year and be treated as resident for that year, the single day being counted as a year in the calculation, in effect. Deemed domicile status begins at the start of the seventeenth year of tax residence. In the example here, the individual would become deemed domicile after 15 years and two days of tax residence.
The deemed domicile rule currently applies for IHT purposes only. For a fixed annual charge, the remittance basis of taxation is still available in respect of certain foreign income and proceeds from capital gains on the disposal of foreign situated assets. The IHT advantage is lost from the seventeenth year, but for those wealthy individuals, UK tax on overseas income and gains can still be mitigated.
With effect from April 2017, the deemed domicile rule will be modified in two key respects:
- the 17 year rule will become the ‘15 year rule’; and
- this rule will apply for all UK tax purposes, and not just IHT.
HM Revenue & Customs’ (‘HMRC’) technical briefing describes the proposal as the ’15 year rule’, although this is something of a misnomer as deemed domicile applies from the start of the sixteenth year of tax residence.
The Consultation Document issued on 30 September clarifies how split years of tax residence will be treated when the new rule takes effect. Under current legislation, split years are included, as illustrated above where a single day is counted as a year of tax residence in the calculation and this treatment above will continue under the new rules.
With effect from April 2017 deemed domiciled individuals who continue to be domiciled outside the UK as a matter of general law will be in the same tax position as UK domiciled individuals in respect of personal assets. The remittance basis of taxation will no longer be available and their worldwide assets will be exposed to IHT.
Practical Effect of the Proposed Changes
So what should long term non-domiciliaries do if a permanent move to a low or zero tax jurisdiction is not an option?
The deemed domicile rule for new arrivers into the UK is expressed in terms of years of tax residence over a 20 year period. It may be simpler to illustrate how it operates with an example before identifying any opportunities before the modified rule impacts:
Mr Kallis, a South African national, arrived in the UK on 1 April 2003, intent on taking up residence and setting up businesses. His ultimate intention is to retire to his homeland. Over the years, he accumulates significant wealth, holding it in foreign assets in order to take advantage of the remittance basis of taxation.
Regardless of only having spent a few days in the UK in 2002/03, his first year of UK tax residence is 2002/2003. Under the current rule, he would be deemed domiciled in the UK for IHT purposes with effect from 6 April 2018, at the start of his seventeenth year of tax residence, 2018/19.
The proposed change in April 2017 means that he will be deemed domiciled for all UK tax purposes with effect from 6 April 2017.
So what can Mr Kallis do in advance of the rule change? There are broadly two options:
- Re-set the residence clock, or
- Settle assets onto an ‘excluded property settlement’.
Re-Setting the Residence Clock
Re-setting the residence clock requires a break in UK residence for a period, so that the calculation of tax years under the deemed domicile rule effectively starts afresh again. If Mr Kallis is able to leave the UK on 31 March 2017, for example, and cease UK residence for six consecutive tax years, returning during the tax year 2023/24, the deemed domicile clock would effectively be completely reset. It would take a further 16 years of tax residence to become deemed domiciled and he could continue to make use of the remittance basis of taxation during those years.
However, this requires six tax years of non-residence and this may be too much for Mr Kallis. He may need to be involved directly in his businesses on a day to day basis. If he stays, then he no longer has the ability to use the remittance basis in respect of the assets he holds offshore. But he can still make tax effective plans ahead of 6 April 2017.
Excluded Property Settlements
Mr Kallis could transfer the wealth that he has accumulated overseas onto trust, in order to take advantage of the significant IHT benefits of an excluded property settlement. Any assets he holds personally will be exposed to IHT with effect from 6 April 2017, regardless of where they are situated, but if he were to transfer the foreign assets onto trust prior to that date, with careful management by the trustees they would be permanently outside the scope of IHT during the life of the trust.
Providing the settlor of a trust is both domiciled outside the UK as a matter of general law and not deemed domiciled, the IHT benefits of settling a trust are clear, both now and after the changes proposed for April 2017. A change of policy in relation to income and capital gains arising within a settlement will improve the tax position for settlors who can benefit under the terms of a trust and do not claim the remittance basis. This makes an even more compelling argument for creating a trust prior to becoming deemed domiciled.
As things stand under current legislation, the settlor in this case (one who does not claim the remittance basis) would be taxable on all income and capital gains arising within the settlement, regardless of their source. From 6 April 2017 if a non-domiciliary has settled a trust before he becomes deemed domiciled, he will not be taxed on trust income and capital gains, providing they are retained in the trust. But with effect from April 2017 when the changes come into force the non-domiciliary “will be taxable on the value of benefits received … without reference to the income and gains arising in the offshore [trust]”. And this will be the case whether the benefit is received in the UK or overseas.
This amounts to a fundamental change in the tax law in this area. Although a deemed domiciled individual will be within the charge to tax on worldwide income and gains and unable to avail of the remittance basis of taxation, he will still benefit by retaining funds in a trust.
However the sting in the tail will be that all benefits taken from the trust will be taxable and not linked to historic income and gains as under the current system and so probably penalise those who have maintained good trust records and can demonstrate benefits have been funded from trust capital (and so would have been non-taxable under current rules) and those who enjoy the benefits outside the UK.