Shadow Directors - The Belgravia Bombshell

The implications for United Kingdom resident non-domiciliaries occupying property owned by offshore companies in R v Allen are far-reaching, warns ANDREW PENNEY.

THE HOUSE OF Lords has upheld the conviction of Mr Brian Roger Allen for cheating the public revenue of income tax. Why does that matter to the many United Kingdom resident non-domiciliaries who still occupy houses in smart parts of London and elsewhere that are owned by offshore companies? Or, equally, why does it matter to British people who have holiday homes abroad held through corporate entities?

The answer is that one of the grounds for conviction was that Mr Allen had, through the delivery of a false return, concealed the provision of living accommodation and benefits received from an offshore company of which he was a shadow director. The House of Lords has now provided new reasoning as to why this is subject to income tax. The implications are far-reaching.

What was clear before the House of Lords decision was that if a director or shadow director received actual emoluments which were assessed under Schedule E Case I, II or III (because he was United Kingdom resident or performing duties in the United Kingdom), then a benefit in kind was also taxable. This much was clear from the reading of four different statutory provisions:

• 'Where … a person is employed in an employment to which this Chapter applies, and by reason of his employment there is provided to him … any benefit to which this section applies … there is to be treated as emoluments of the employment and accordingly chargeable to income tax under Schedule E, an amount equal to whatever is the cash equivalent of the benefit' (section 154(1), Taxes Act 1988).
• '… "director" … includes any person in accordance with whose directions or instructions the directors of the company … are accustomed to act' (section 168(7), Taxes Act 1988).
• 'This chapter applies – (a) to employment as a director [which includes a shadow director] of a company …' (section 167(1), Taxes Act 1988).
• '… "employment" means an office or employment the emoluments of which fall to be assessed under Schedule E …' (section 168(2), Taxes Act 1988).

This legislation deems a shadow director (one upon whose instructions a director is accustomed to act) to hold an office and therefore be taxable on emoluments. The charge in relation to living accommodation is imposed by section 145(1), Taxes Act 1988:

'Subject to the provisions of this section, where living accommodation is provided for a person in any period by reason of his employment, …, he is to be treated for the purposes of Schedule E as being in receipt of emoluments of an amount equal to the value to him of the accommodation for the period, less so much as is properly attributable to that provision of any sum made good by him to those at whose cost the accommodation is provided.'

When is actual actual?

The principal argument advanced by James Kessler, counsel for the taxpayer on this aspect of the Allen appeal, was that because a shadow director has no 'actual emoluments' and no 'actual duties', it is not possible to determine where they are being performed. Accordingly, it is not possible to determine whether there is an employment which falls within one of the three cases of paragraph 1 of Schedule E, unless it is said that the benefits of every shadow director anywhere in the world are taxable under paragraph 5 of Schedule E with no territorial limitation (for example, a shadow director of a United States company living in a company house in the United States who has never set foot in the United Kingdom). The Special Commissioners' decision in re Taxpayer F1 SC3099/93 supports this.

In his judgment, Lord Hutton dismisses this argument and states that a deemed director is taxable on the benefit of living accommodation under Cases I, II and III in the same way that actual emoluments would have been. In the past, it was not considered that Case I was relevant to a shadow director because it was thought that it only applied to an actual director. Now it is clear that all three cases of paragraph 1 of Schedule E apply to shadows. Case I applies to resident, ordinarily resident and domiciled taxpayers regardless of where the duties are performed. United Kingdom resident domiciliaries occupying houses anywhere that are owned by companies would be taxable under Case I.

This concerns mainly United Kingdom residents and domiciliaries who own houses in Florida through a Delaware LLC or BVI company for protection from United States estate tax; or the same persons owning a house in Spain or Portugal through a locally incorporated (or offshore) company for protection from local inheritance laws; or it could be the same persons owning a house in France through a société civile immoblière as a way of turning realty into personalty to avoid forced heirship.

It may also include United Kingdom homes. London prime estates often insist on houses being owned through a corporate entity so as to prevent enfranchisement rights. If a United Kingdom domiciliary or resident is a director or a person on whose instructions the directors are accustomed to act, then such persons should be declaring the benefit of living accommodation on their self-assessment tax returns. Failure to do so may constitute tax evasion.

Similarly, a United Kingdom resident non-domiciliary, who occupies in the United Kingdom a house owned by an offshore company for inheritance tax protection, risks the civil and criminal sanctions of tax evasion, if he does not declare the benefit of living accommodation as being within the charge under Schedule E, Case III (a benefit received in the United Kingdom). If the United Kingdom resident non-domiciliary has a house abroad, for example in Paris, New York or Geneva, then he would have a liability under Case I, unless he can show that he has a foreign employment all the duties of which are performed outside the United Kingdom (see section 192, Taxes Act 1988). The dilemma for the United Kingdom resident non-domiciliary in this situation is that, if his position as a director is formalised, he risks having a United Kingdom employment that may make the company United Kingdom corporation tax resident. However, if he does not formalise the position, but remains a shadow director, he may inadvertently be performing duties in the United Kingdom.

The only category of persons who are clearly not within the scope of the shadow director charge as clarified by Lord Hutton, are non-residents who have a house in the United Kingdom. It is now clear in the light of the Allen decision that a non-resident deemed director with a house in the United Kingdom is not taxable since it is impossible to determine whether the house is provided in respect of duties performed in the United Kingdom by the non-resident.

Houses and companies

The conclusion from R v Allen can only be that so far as United Kingdom resident non-domiciliaries and United Kingdom resident domiciliaries are concerned, it would be safer if houses are not be owned by companies.

Thought will need to be given to the possible unwinding of various situations involving United Kingdom domiciliaries occupying houses outside the United Kingdom owned through locally incorporated or offshore companies. Each case is likely to be different and will require local advice. Perhaps it will be possible to make it clear that the occupant is not a person on whose instructions the directors are accustomed to act. In the writer's experience, many foreign property owning entities like Delaware LLCs and French SCIs do not have directors but are controlled by their members. Guidance will be needed from the Revenue on how it sees section 145 working in this situation. If it is necessary to liquidate a Delaware LLC, French SCI or Spanish SA, there could be substantial local transfer taxes or stamp duties, and the client will still be left with the problem he was trying to avoid by incorporating the company in the first place, namely local succession laws and inheritance taxes.

One issue which might help, and which remains unresolved, is whether the shadow director can obtain a deduction because he has funded the purchase of a property by way of interest-free loan to the company. The legislation permits the deduction 'for so much as is properly attributable to that provision [the accommodation] of any sum made good by him to those at whose cost the accommodation is provided'. It may be argued that the interest foregone on such a loan is a sum made good. In Stones v Hall [1989] STC 138, the point arose, but there was no evidence linking the interest foregone and the provision of the accommodation.

Belgravia house dilemma

For the non-domiciled United Kingdom resident who occupies a substantial London house owned by an offshore company, which is in turn owned by an offshore trust (typically discretionary), there is a cost-effective solution to the section 145 problem which at the same time preserves protection from inheritance tax.

The directors of the property-owning offshore company need to consider selling the property to a new foreign trust for a promissory note which is in the form of a deed governed by an appropriate law. If the 'specialty debt' is kept outside the United Kingdom, its effect is to strip out the value of the United Kingdom residence and retain it in the form of the foreign situs security. Great care must be taken with the wording of the specialty debt document to avoid English land law operating to make the debt United Kingdom situs. If the non-domiciled occupant remains in the United Kingdom and is coming close to having spent 17 out of the last 20 tax years as a United Kingdom tax resident (such that he will become deemed domiciled for inheritance tax), it is important that the specialty debt is not held in the hands of the United Kingdom resident non-domiciliary himself but (for reasons discussed below) it probably ought not to remain on the balance sheet of the offshore company which originally held the property. It is best if it is assigned to a separate 'clean' discretionary trust, but care is needed in choosing the assignee vehicle.

As with any strategy, there are potential pitfalls to avoid.

Who should hold the debt?

Careful thought needs to be given as to whether the specialty debt should remain in the offshore company which is effectively the vendor of the property. While, as stated below, there should not be income tax implications for the vendor company, before doing anything, consideration should be given to transferring the property back either to trust level or to the ultimate non-domiciled settlor. If this is not done, and the offshore company simply sells the property to the new trust, it will realise a gain on the sale of the property and there is a double-tiered gain in respect to the company shares held in the trust.

It is possible that these double gains will end up being distributed to United Kingdom domiciled children of the settlor at some point in the future, in which case they will be taxed under section 87, Taxation of Chargeable Gains Act 1992, and the supplementary charge provisions at a rate of 64 per cent. If the property is transferred back to trust level before being sold over to the new trust, then there is just one tier of gain potentially subject to section 87.

If the property is transferred back to the non-domiciled settlor, then the gain on distribution from the trust will be free of tax (sections 86 and 87 do not apply to non-domiciliaries). The problem with this latter course, however, is if the rules on reservation of benefit relating to non-domiciliary trusts change in the near future. In that situation, the settlor will be left with a specialty debt which will fall within the inheritance tax charge as and when he becomes deemed domiciled, and any trust he sets up after the change in the law will also be subject to reservation of benefit.

The best solution would seem to be to take action immediately, to unwind the property back to settlor level and for the settlor to put the specialty debt into a new offshore trust at the earliest opportunity, in any event before any change in the law.

Reservation of benefit issue

The Capital Taxes Office is rumoured to be considering applying the inheritance tax reservation of benefit rules to trusts set up by non-United Kingdom domiciliaries. If true, it would mean that the reservation of benefit rules in section 102, Finance Act 1986 will apply to new trusts set up by non-domiciliaries after a date to be announced as and when the settlor becomes deemed domiciled. Thus if new trusts are set up now to acquire the property and, separately, to hold the specialty debt, and if there is a likelihood that the occupier will become deemed domiciled, the trusts need to be set up immediately before any change in the law. While it would not be disastrous for the property holding trust to be caught in the reservation of benefit rules, because the specialty debt will take the value of the property out of the trust fund for inheritance tax purposes, it would be disastrous if the trust which holds the specialty debt was caught within the reservation of benefit rules. (It is important that the specialty debt is drawn to protect not only the current value of the property but also any growth in the value of the property, as otherwise that growth will be in the reservation of benefit rules if the property holding trust is set up after the law has changed. Great care is required in this connection.) If the law did change before the specialty debt could be settled into a new trust, it could be added to any existing trust (such as the one that had the offending property company) but, as stated above, this has trust gains which can potentially be charged on domiciled beneficiaries.

Who should buy the property?

Can an existing offshore trust be used to buy the property? At first sight this would seem sensible provided the existing trust does not contain non-United Kingdom situs assets. If it did, the specialty debt will reduce the value of the non-United Kingdom situs assets rather than the United Kingdom residence, so defeating the object of the exercise (section 162(5), Inheritance Tax Act 1984). To avoid this problem, it is tempting to charge the London property as security for the debt so as to ensure the debt falls on the property in priority to the non-United Kingdom situs assets in the trust. However, if the charge is in the form of a deed which needs to be registered at H M Land Registry, it will defeat the object of the exercise. The simplest approach, therefore, is to sell the property to a trust which contains no other assets of significant value, and which is preferably a new trust. If, for example, it contained accumulated income, the rent-free occupation of the residence may give rise to liability under section 740, Taxes Act 1988.

Stamp duty

The transfer which effects transfer of title from the existing offshore company to the new trust will be liable for stamp duty at four per cent, assuming the value of the property exceeds £500,000. However, the duty can be avoided by the familiar device of resting on contract.

Take action now

Clearly the House of Lords decision in Allen has far-reaching implications for United Kingdom domiciled residents and non-domiciled residents. In relation to London houses occupied by non-United Kingdom domiciled residents there is a solution, but there are traps for the unwary, and in view of the impending change in the law on reservation of benefit in relation to non-domiciliary trusts, action must be taken immediately.

Andrew Penney is a partner of City solicitors Speechly Bircham, and can be contacted on 020 7427 6400 or by email: andrew.penney@speechlys.com

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