Tony Foreman of PKF, co-author of the Zurich Tax Handbook, highlights some unusual tax considerations arising from increased global mobility...

Tony Foreman of PKF, co-author of the Zurich Tax Handbook, highlights some unusual tax considerations arising from increased global mobility. Increasingly, UK resident individuals find themselves spending significant amounts of time working in another country and may even become resident in that country as well as in the UK. There are also people who are subject to two tax regimes because their country of origin will not let them go. An example of this is the USA. A UK resident who is a US citizen or who has a “green card” is still required to file a US tax return and pay US tax. Another common situation is for a UK resident to have a second home in another country. Some people even have a foot in three tax jurisdictions; for example, someone might be UK resident, of French or Swedish domicile and have a second home in Portugal. If his wife is a US national, they could end up reporting to four different Revenue Authorities! And it is not at all uncommon for such people to be beneficiaries of trusts that are administered in yet another country. As will become apparent, part of the art of managing all this is to recognise that there are aspects where no general rules apply. Don’t Make Assumptions It is important to bear in mind that each country can have a tax system that is internally coherent but does not fit together with another country’s set of tax rules. Below are some examples comparing the UK system with rules applied in other countries: · Domicile We have the concept of domicile. Other countries either do not use this term or, if they do, mean something akin to ordinary residence. · Income The UK draws a distinction between employment income and self-employment income. Directors are taxed on the basis that they have employment income. But in some countries the dividing line would be drawn at a different point and directors who are not full-time officers may be treated as independent contractors (i.e. as if they were self-employed). Our system gives a tax credit for UK dividends but a Jersey or Guernsey resident may have to pay 20 per cent tax on the dividend. · Capital gains Some countries do not tax capital gains unless they are closely connected with a business (countries as diverse as Belgium, New Zealand and Singapore fall into this category). Other countries are like the UK in having a comprehensive capital gains tax regime but calculate the gain very differently – if you were to take up residence in Australia or Canada the value of an asset at the date of your arrival is treated as your “cost” for their CGT purposes. Our legislation does not normally tax non-residents’ capital gains (unless they arise from a permanent establishment in the UK), many other countries charge CGT on gains from real estate realised by non-residents. Australia has reserved the right to assess non-residents on capital gains from sales of shares in Australian companies and actually does this in practice. · Inheritance tax Everywhere else in the EU, Inheritance Tax means a tax charged on a person who receives an inheritance rather than, as in the UK, a tax based on the circumstances of the person who leaves a legacy to someone else. And in these EU countries, the rate of Inheritance Tax payable generally depends on how closely you are related to the deceased. Many EU countries also have forced heirship rules, i.e. legislation that governs the way in which property must pass on death. Wills that do not accord with these rules are effectively overridden. Our IHT gives a complete exemption where an individual leaves property to his wife (unless he is domiciled in the UK and she is domiciled elsewhere). The USA does not give an exemption for outright bequests by a US national to an alien spouse. Exemption is available only if the property is put into a Qualifying Domestic Trust. Other taxes A number of EU countries also have taxes which are completely different from our taxes. For example, France and Spain have an annual net wealth tax. Most other EU countries have a much higher rate of stamp duty on property purchases. Some countries’ legal systems do not recognise the concept of a trust, let alone provide for the way in which trusts will be taxed. To sum up, tax is often charged very differently in other countries. You need to ascertain the principles which apply in any other country with which your client may be connected and (equally important) the way in which their taxes are administered. You will also need expert advice on how the two tax regimes interact, (i.e. which country has primary taxing rights) and the consequences of a given transaction or series of transactions in each country. If your client is the beneficiary of a trust in the foreign country, you need to find out how this will affect his taxable income in the UK. One Country Will Not Recognise Another’s Tax Incentives Bear in mind that if you become subject to Australian or US tax, you will not be entitled there to exemption for interest earned within your ISA. In fact, tax exempt investments such as life policies or pension schemes may not attract any special tax treatment, especially if the framework in which such investments are set up is unfamiliar to the overseas tax authorities. A stock option may qualify for tax-exempt status in the USA but this treatment does not govern the UK treatment. The boot can just as easily be on the other foot. A profit realised from the exercise of an EMI option by a US national working in the UK will be taxable in the USA without any special relief. The IRS may tax a UK resident US national on the sale of his London home even though it is exempt for UK CGT purposes. The US system does not have a main residence exemption as such. Instead it has an exclusion from charge on gains of $250,000 ($500,000 for joint filers) where the property qualifies as the taxpayer’s private residence for two of the last five years. UK house price inflation coupled with a strong pound could easily make this exemption seem woefully inadequate. Donations to overseas charities which are not registered in the UK will not normally attract giftaid relief in the UK. Gifts and legacies to such charities will be potentially subject to IHT. Likewise gifts to non-US charities will not qualify as a deduction in the US tax return. Surprising Consequences From Double Taxation Agreements (DTA) Firstly, it is worth bearing in mind when the benefit of a DTA may be claimed. The sequence is as follows: 1. establish the residence status of the individual or company (the person) under domestic law – if the person is resident in a country, then 2. establish if there is a liability to tax under that country’s domestic law – if there is, then 3. establish if that income is also liable to tax in another country (with which a DTA exists) – if it is, then 4. determine the person’s residence status for the purposes of the DTA – if the DTA applies, then 5. the person can claim relief or credit under the DTA rules (these may override domestic legislation). If, at stage four, the person is resident in both countries, most DTAs contain a tiebreaker provision whereby fiscal residence is determined as follows: a) if the individual has a permanent home in only one country, he is deemed to be resident there b) if the position has not been resolved by (1), he is treated as resident where he has the centre of his personal and economic interests c) if the above tests do not resolve the position, he is treated as resident in the country where he has an ‘habitual abode’ d) if he has an habitual abode in both countries, he is deemed to be a resident of the country of which he is a national e) if he is a national of both countries, or he is not a national of either country, the tax authorities of the UK and the foreign country may settle the matter by mutual agreement. In summary, the person may be regarded as resident in several countries for the purposes of each country’s domestic tax legislation and be taxed locally on income arising in each. However, only the country in which the person is resident for the purposes of the DTA can impose tax on his worldwide income (subject to relief or credit tax paid elsewhere). The UK also has some DTAs that cover IHT. These can also have some unexpected results, for example, an individual who dies domiciled in India is not subject to our normal rule which deems an individual to be UK domiciled for IHT purposes if he has been resident here for 17 of the last 20 years. The EU Dimension There are very few articles in the EC Treaty (the most important source of EU law) which cover direct taxes. Each member state has responsibility for setting its own domestic direct tax rules. However, these rules must not contravene fundamental principles of EU law. The EU is meant to be one large single market and any tax provisions that act as a disproportionate obstacle to the movement of workers, capital and the right for companies and individuals to establish themselves in different EU states, have been held to contravene these principles. Over the past ten years the European Court of Justice (ECJ) has heard a number of cases where aggrieved taxpayers have argued that legislation in particular member states does not accord with EU law. Provisions which treat non-residents less favourably than residents have been struck down by the ECJ as contrary to the EC Treaty. A recent ECJ case has raised questions over the validity of exit charges imposed by UK domestic tax legislation. In the case of Hughes du Lasteyrie du Saillant v Ministere de L’Ecomomie de Finances et de L’ Industrie, a French individual emigrated to Belgium and was subject to French tax on the unrealised gains on shares in a French company that he took with him. On 11 March 2004, the ECJ stated that such a charge was an impediment to the “freedom of establishment” enshrined within the EU Treaty. It ruled that France could have asked the Belgian tax authorities for assistance in collecting the tax on any gains once the shares were sold and hence the exit charge was a disproportionate measure for collecting tax. The UK applies an exit charge in a number of situations: · when a UK individual emigrates and in the prior six years he had received an asset by way of gift on which the donor’s capital gain has been held-over · when a UK resident trust becomes non-resident · when a company ceases to be UK resident. It is arguable that the ECJ decision means that these exit charges are contrary to EU law. The Dutch and German tax authorities have already announced changes to their own exit charge rules as a result of this case. It may be that tax repayment claims should now be made for individuals who have suffered UK exit charges. Enforcement of Foreign Taxes Until recently, our courts have not been prepared to enforce taxes imposed by other countries (see Taylor-v-Government of India HL 1955 (34 ATC 10). Section 134 FA 2002 allows the UK tax authorities to bring proceedings to collect unpaid taxes in the UK on behalf of authorities in other EU countries. Other countries have a more practical approach in that you may not be permitted to leave the country unless you have a “tax clearance” certificate. Interaction of UK and USA Regimes The USA is one of the most extreme cases of a tax regime which will not let go, and it is therefore instructive to look at the treatment of US nationals who come within the UK tax net. The rest of this article looks at the way that US and UK tax may interact and some situations where UK and US tax planning may diverge. Liability to make US returns A US citizen or green card holder is liable to US taxation on a worldwide basis regardless of where this income is paid, earned or received, so it can be said that a US citizen continues to be taxed on their passport. Reliefs are available in respect of foreign earned income and housing credits. Foreign earnings exclusion A US citizen or green card holder living outside the US may elect to exclude up to $80,000, for the 2003 US tax year, of foreign earned income and certain housing allowances. The exclusion can only be claimed if the tax home is outside the US and the individual meets either the foreign residence or physical presence test. If only part of the qualifying period falls within the tax year, the amount of exclusion available is scaled down proportionally. The foreign residence and physical presence test The bona fide foreign residence test applies to US citizens only and requires that a US citizen is physically present in any one or more foreign countries for a period that includes a complete US tax year. The physical presence test extends to resident aliens as well as US citizens and to qualify the individual must be physically present in any one or more foreign countries for 330 days during any consecutive 12-month period. Foreign tax credit A US citizen can elect to claim relief for tax paid on his non-US earnings as a credit as opposed to a deduction. The credit is limited to the ratio of foreign source taxable income to worldwide taxable income multiplied by the US tax payable on worldwide income. The foreign tax credit available will also be scaled down if he uses the foreign earned income exclusion. Excess credits may be carried back two years and carried forward five years. Alternative minimum tax (AMT) To counteract the tax savings that legislative changes have created over the years, the US Congress enacted the Alternative Minimum Tax (AMT) legislation. In brief, the AMT ensures that where a taxpayer takes legitimate advantage of the several tax reliefs available to him in the Internal Revenue Code, he still pays a stutorily defined minimum amount of tax. Overseas, taxpayers who offset their US income tax with a substantial foreign tax credit often become liable for AMT, and the resulting calculations can be extremely complex. In effect, individuals with incomes that are offset by large deductions have those deductions and exemptions either reduced or eliminated. The remaining income is taxed at 28 per cent. If an individual has foreign tax credits equal to or greater than 90 per cent of the AMT figure, the credit is reduced to 90 per cent of the AMT. This makes all of the income over the limit effectively taxed at a rate of approximately 2.8 per cent. This commonly applies to US taxpayers who are claiming the foreign earnings exclusion. UK Tax Considerations in Relation to Earned Income A US individual coming to work in the UK should review his residence position. If he is on secondment to the UK for less than two years, all reasonable subsistence accommodation expenses can be paid tax-free. The reciprocal agreement may provide exemption from NIC. If the individual is not ordinarily resident and is performing employment duties overseas, the relevant emoluments will only be taxed in the UK on the remittance basis. If he becomes ordinarily resident, the remittance basis will apply only to remuneration from a non-UK resident employer where all the duties are performed abroad. Therefore, split contracts for non-UK duties are still a possible way of mitigating UK tax. The position of a self-employed individual is more problematic. Earnings of a UK resident sole trader are taxable in full under Schedule D Case 1 even where he is foreign domiciled and most of the work is undertaken abroad (see Ogilvie-v-Kitton 5 TC 338). Such an individual would generally be more favourably treated for UK tax if he were employed by a non-UK resident company. Death Duties Under nomal circumstances, the estate of a US citizen will be subject to US Federal estate taxes, based on the value of the worldwide assets held on the date of death. The estate may also be chargeable to US state estate taxes, depending on the deceased’s connections with, and the property held in, that state. However, UK situs assets may also be chargeable to UK Inheritance Tax. Indeed, if the indivdual concerned had acquired a “deemed domicile” in the UK at the date of death the potential charge to IHT is extended to the value of his worldwide assets. For IHT purposes only, a deemed UK domicile can be acquired if the deceased had been resident in the UK for at least 17 out of the last 20 years prior to his death. This can lead to some quite complicated situations but, fortunately, the double taxation estate treaty between the UK and the USA goes some way towards solving some of the problems arising. In particular, the treaty restricts the charge on the value of moveable assets to the country of domicile, and where the deceased was domiciled in both countries under domestic rules, a series of tie-breaker clauses set out to determine the country of domicile which is to be used for the purposes of applying the treaty. Unfortunately, the treaty does not prevent a double charge on any immoveable real estate, and this will be subject to tax both in the country of domicile, and the country where the property is located. In these circumstances, credit for tax payable in the country where the property is located will be given in the country of domicile. However, this credit will be limited if the rate of tax is more than in the country of domicile, and the overall rate of tax payable on real property will therefore always be at the highest rate of the two countries. Potential Conflict of Laws Further difficulties can arise where inter-spouse transfers take place, due to the slightly different way in which the usual inter-spouse exemption is applied in the UK and the US. In the US, the exemption is based on citizenship, whereas in the UK it is based on domicile, or deemed domicile. For example, the estate of a US citizen husband, who has a deemed UK domicile because of his period of UK residence, will qualify for the full IHT inter-spouse exemption in the UK if it passes to his UK domiciled British citizen wife. However because the estate will not be passing to a US citizen spouse, it will not qualify for the surviving spouse marital deduction in the US. Similarly, the estate of a US citizen husband (who has a deemed UK domicile because of his period of UK residence) which passes to a US citizen wife (who does not) will only qualify for a £55,000 IHT inter-spouse exemption - even though the full surviving spouse marital deduction will be available in the US. In Summary It is vital to establish the precise residence, domicile and family status of clients and their connected businesses and trusts before you can start advising them on tax compliance and planning issues. It is also essential to test the outcomes of any activity against the legislation and practice of each tax jurisdiction with a local expert: plans that are only tax-effcient in one jurisdiction are unlikely to impress. Tony Foreman is a tax partner at accountants and business advisors PKF who specialises in advising high net wealth clients. Tony can be contacted on 020 7065 0495, e-mail tony.foreman@uk.pkf.com