Offshore investments and non-domiciles: what to look out for

TaxTalk December 2022

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Last month we reported on the Offshore Funds Regime, its rules and their traps. This time we focus on the particular issues for non-domiciled remittance basis taxpayers and settlors of offshore trusts.

So what do ‘non-domiciled’ and ‘remittance basis’ mean? UK residents who have their permanent home (domicile) outside the UK are able to claim the remittance basis.

Those claiming the remittance basis will be subject to UK tax only on UK-sourced income and gains, together with foreign income and gains which have been remitted (brought into) the UK.

A decision on whether to make a claim for the remittance basis can be made annually.

When someone has been resident in the UK for 15 of the last 20 years, they are no longer able to claim the remittance basis and are considered domiciled in the UK. However, before becoming ‘deemed domiciled’ (the term used for tax purposes) they can set up an Excluded Property Trust. This allows a non-domicile to ring fence their foreign assets and keep them outside the UK tax net, even once they become deemed domiciled.

What is the issue for non-domiciles?

By definition, offshore funds are foreign assets. This means non-domiciles claiming the remittance basis may be less worried about whether a fund has reporting fund status (on the basis that the income and gains are outside the scope of UK tax).

But whether a fund is a reporting fund or not can be significant. The treatment will depend on the individual’s status throughout the life of the investment and at the time of disposal.

Depending on the investor’s circumstances, the status of the investment can be important:

  • If the investment is in a non-reporting fund that doesn’t distribute income, the investor needn’t make any claim to remittance basis throughout the life of the investment. They can make a claim in the year of disposal to shelter the gain. All of the gain would be treated as income on the disposal and taxable if remitted to the UK.

  • If the investor is deemed domiciled (has been a UK resident for 15 of the past 20 years) at the time of disposal, it may be best to invest in a reporting fund. They could use the remittance basis to shield any excess reporting income from UK taxation, but still benefit from Capital Gains Tax on disposal.

In the case of income that is reported by a reporting fund but is not distributed, that income has not been remitted to the UK.

For a non-domiciled remittance basis taxpayer who has invested in a reporting fund, the disposal proceeds will represent a ‘mixed fund’. This means that it is made up of income, gains and the original investment. Special rules determine which order these amounts are deemed to be brought into the UK.

When a remittance basis taxpayer is considering their investments, it’s vital they look at their long-term UK tax position. Where a non-domicile is planning for long-term UK tax residence, they must structure their investments carefully. Trusts can form an important part of this.

Trusts with traps

As we’ve said, non-domiciles can set up Excluded Property Trusts for their benefit before becoming deemed domiciled. Usually the income and gains arising in these trusts are not subject to UK tax and are not taxable on the individual, as they arise within the trust. They would only be taxable on a distribution from the trust. But there is a significant exemption to this rule.

There is a particularly tricky trap for non-domiciles with trusts, which can lead to significant dry tax charges. This may happen if the trust invests into offshore funds and assets producing accrued income (which is beyond the scope of this article).

If the trust holds offshore funds that do not have reporting fund status, and the individual is UK deemed domiciled (so can no longer claim the remittance basis) at the time of disposal, then beware. The gain on disposal of the non-reporting fund is taxable directly on the settlor as income, regardless of whether the proceeds have been distributed from the trust. This can create a substantial dry tax charge on the settlor.

To put it another way, if the trust disposes of a non-reporting offshore fund, realising a gain of £1m, this would trigger a tax charge of up to £450k on the settlor of the trust.

As there has been no distribution from the trust, the settlor may have to pay a considerable dry tax charge from other funds. If the trust makes a distribution to offset this liability, it could create a further tax problem. That’s because there are complex rules to determine which income has been distributed by a trust.

This problem can be made worse if the trustees invest in offshore funds that trigger a liability without the settlor’s knowledge. So it’s important settlors give clear instructions to their trustees to prevent accidental tax charges. This might be, for example, to exclude investment in a non-reporting offshore fund.

Due to the complexity of both the non-domicile regime and the Offshore Funds Regime, it’s crucial that non-domiciles consider their holdings and long-term plans carefully when structuring their investments.

If you have any questions about the issues raised in this article, please contact Stephen Kenny or your usual PKF contact, who would be happy to help.