Alien entanglements: extended

THIS IS A LONGER VERSION OF THE ARTICLE FROM TAXATION #4171

KEY POINTS

• The new remittance basis — complex and opaque?
• A practical example.
• The capital payments charge.
• Computing the liability on remitted income and gains.
• Don't overlook deemed remittances.

Finance Act 2008, Sch 7 introduces the new remittance basis rules. For the first time that the author can recall, the Government published a substantial tranche of new legislation in the Finance Bill of fundamental importance to the UK economy affecting a large group of taxpayers which it acknowledged at the time of publication to be inadequate and to require substantial revision.

The legislation runs to seventy one pages and even for taxpayers with quite straightforward affairs, it is monstrously complex and opaque.

This article examines the new provisions by applying them to a non-domicillary — Caspian — whose affairs, by comparison to most, are quite simple; he has interests in property in only two countries and in only three classes of assets.

Yet the reader who follows the calculation of his tax liability under the new rules to its end deserves to reward himself with a large glass of best Somersetshire cider.

Caspian and his domicile

Caspian's circumstances are set out in the Example below. He is domiciled in Narnia. Narnia charges income tax on all Narnian source income and gains except on the interest income of non-residents. Capital gains are charged at 16%. Narnia's general income tax rate is a flat 18% on income above the sterling equivalent of £6,000.

Narnia has a double taxation treaty with the UK conforming to the OECD model treaty, (adopting the credit method under Article 23B) except that under the Narnian treaty a contracting state may tax capital gains arising in respect of any assets situated in that state and the other contracting state must give credit for that tax.

Under the treaty, rent on Narnian property, dividends from Narnian companies and Narnian source interest may be taxed in Narnia.

Except in the case of holdings in Narnian companies of 25% or more (which Caspian does not own), the double tax treaty restricts Narnian tax on dividends paid to a UK resident to 15% and Narnian tax on interest paid to a UK resident to 10%.

Anti-avoidance provisions without application

Because Caspian had not set up the Caspian Trust (see Example available at the foot of this article as a PDF document) by reference to UK taxation, the transfer of assets abroad provisions in ITA 2007, Part 13, Ch 2, do not apply to its income.

The trustees had the power to benefit Caspian under the terms of the Caspian Trust so the income arising under the settlement is treated as the income of Caspian under ITTOIA 2005, s 624.
Because Caspian is not domiciled in a country of the UK in any relevant tax year, TCGA 1992, s 86 (the 'offshore settlor charge') will not apply to the settlement in any relevant year (TCGA 1992, s 86(1).

The capital payments charge

TCGA 1992, s 87, however, had applied to the settlement since 1998-99 when s 87(1) was amended. But until the changes made by the FA 2008, Sch 7 came into effect, the application of s 87 did not result in any gains becoming chargeable because only Caspian had received capital payments under the settlement and s 87(7) provided that a beneficiary was not to be charged to tax on chargeable gains treated under the capital payments charge as accruing to him in any year unless he was domiciled in the UK at some time in that year.

However, Finance Bill 2008, Sch 7 repeals the previous s 87 and inserts a new s 87C and new s 90 and amends various other relevant sections of TCGA 1992. It is not entirely clear that these amendments do not create charges in relation to 2007-08 and previous years, but HMRC claim that they do not do so and in applying them to the Example (available at the foot of this article as a PDF document) we shall assume that that is correct.

Calculating the s 2(2) amounts

The first step is to determine the TCGA 1992, s 2(2) amounts for each tax year of the settlement and the capital payments received by beneficiaries of the settlement. The s 2(2) amount for a tax year is the amount upon which the trustees would have been chargeable to tax under s 2(2) for that year if they were resident and ordinarily resident in the UK less any amounts treated as accruing under s 86 for the year. (TCGA 2007, s 87(4).)

Before any adjustments the amounts on which the trustees should have been assessable under s 2(2) and the capital payments of the Caspian Trust were as shown in Table 1.

FA 2008, Sch 7 para 122(2) provides that one reduces to nil any capital payment which would have been left out of account by virtue of TCGA 1992, s 87(6) as originally enacted. Section 87(6) provided that a capital payment was to be left out of account to the extent that chargeable gains had been treated as accruing in an earlier year by reason of the payment.

The capital payments to Caspian in 2005-06 to 2007-08 would have resulted in gains of £25,000 per year being deemed to accrue to Caspian although those gains would not have been chargeable to capital gains tax. (TCGA 1992, s 87(7). N.B this is before amendment by Finance Bill 2008.) They are therefore left out of account for the purposes of the new rules.

Where, as here, TCGA 1992, s 87 and s 89(2) applied to a settlement for the tax year 2007-08 or any earlier year, Sch 7 para 120 applies to the settlement to determine the s 2(2) amounts for the settlement for 2007-08 and previous years.

Step 1

Calculate (in accordance with s 87 and, where appropriate, s 88) the s 2(2) amount for each tax year (not later than the tax year 2007-08) for which s 87 applied to the settlement.

For this purpose, references in TCGA 1992, s 87(4) and (5) (as substituted) to s 87 applying to a settlement for a tax year are to be read as references to s 87 (as it had effect before that substitution) applying to a settlement for a tax year.

That is done above.

Step 2

Find the total amount of chargeable gains treated under s 87 or s 89(2) as accruing to beneficiaries of the settlement in the tax year 2007-08 or any earlier tax year ('total deemed gains').

Under s 87, before its amendment by FA 2008, Sch 7, chargeable gains equal to the aggregate capital payments of £75,000 in the years 2005-06 would have been treated as accruing to Caspian even though by virtue of s 87(7) (before amendment) the accrual of those chargeable gains did not give rise to a charge to tax if the recipient was not domiciled in a country of the UK.

So the total deemed gains were £75,000.

Step 3

Find the earliest tax year for which the s 2(2) amount is not nil. If the s 2(2) amount for that year is less than or equal to the total deemed gains, reduce that s 2(2) amount to nil. Otherwise, reduce that s 2(2) amount by the amount of the total deemed gains.

The earliest tax year for which the s 2(2) amount is not nil is 2000-01. The s 2(2) amount for that year is greater than the total deemed gains so it is reduced by those total deemed gains to £125,000 (£200,000 - £75,000).

Step 4

Reduce the total deemed gains by the amount by which the s 2(2) amount was reduced under Step 3.

The s 2(2) amount for 2000-01 was reduced by £75,000 so the total deemed gains are reduced by a similar amount to nil.

Step 5

If the total deemed gains are not nil, start again in Step 3. For this purpose, read references to the earliest tax year for which the s 2(2) amount is not nil as references to the earliest tax year:

(a) which is after the last tax year for which Steps 3 and 4 have been undertaken; and
(b) for which the s 2(2) amount is not nil.

Because the total deemed gains are now nil, under Step 5 the process comes to an end. Having applied FA 2008, Sch 7 para 120, therefore, the s 2(2) amount for 2001-02 is £125,000 and for 2008-09 remains at £200,000.

Matching the s 2(2) amounts to the capital payments

Now one applies the matching rules of TCGA 1992, s 87A(2).

Step 1

Find the s 2(2) amount for the relevant tax year.

The relevant tax year is the year for which one wishes to determine whether chargeable gains accrue under s 87. In relation to our computation that is 2008-09.

Step 2

Find the total amount of capital payments received by the beneficiaries from the trustees in the relevant tax year.

The capital payments in the year, which were received by Caspian and Rilian, were £31,000 in total.

Step 3

The s 2(2) amount for the relevant tax year is matched with:

(a)  if the total amount of capital payments received in the relevant tax year does not exceed the s 2(2) amount for the relevant tax year, each capital payment so received; and
(b)  otherwise, the relevant proportion of each of those capital payments.

'The relevant proportion' is the s 2(2) amount for the relevant tax year divided by the total amount of capital payments received in the relevant tax year.

The total amount of capital payments does not exceed the s 2(2) amount for the year so the s 2(2) amount is matched with the capital payments made to Caspian and Rilian in 2008-09.

Step 4

If paragraph (a) of Step 3 applies:

(a) reduce the s 2(2) amount for the relevant tax year by the total amount of capital payments referred to there; and
(b)  reduce the amount of those capital payments to nil.

If paragraph (b) of that Step applies:

(a)  reduce the section 2(2) amount for the relevant tax year to nil; and
(b)  reduce the amount of each of the capital payments referred to there by the relevant proportion of that capital payment.

Paragraph (a) of Step 3 applies so the s 2(2) amount for 2008-09 is reduced to £969,000 (£1,000,000 - £31,000) and the capital payments are reduced to nil. It is these amounts which are used in the calculations in following years.

Step 5

Start again at Step 1 (unless s 87A (3) applies).

Section 87A(3) applies, inter alia, if all of the capital payments received by beneficiaries from the trustees in the relevant tax year or any earlier tax year have been reduced to nil. That condition is satisfied because the capital payments have been take out of account by FA 2008, Sch 7 para 122.

The capital payments of 2008-09 have therefore been matched on a LIFO basis with the gains made in 2008-09 and not with the gains of 2000-01 and 2007-08. Being neither resident nor ordinarily resident in the UK, Rilian is not chargeable to capital gains tax on the gains treated as accruing to him. Caspian is chargeable on the gains treated as accruing to him, but he is assessable on the remittance basis so we now have to apply the remittance basis to these gains.

Remittance basis and capital payments charge

ITA 2007, s 809L(1) provides that:

(1)  An individual's income is, or chargeable gains are, 'remitted to the United Kingdom' if:

(a)  Conditions A and B are met;
(b)  Condition C is met; or
(c)  Condition D is met.

Conditions C and D contain complex provisions relating to transactions involving persons who are not relevant persons and those provisions are not relevant to our example. Conditions A and B are given in s 809L(2) and (3).

They are as follows.

'(2)  Condition A is that:

(a)  money or other property is brought to, or received or used in, the UK by or for the benefit of a relevant person; or
(b)  a service is provided in the UK to or for the benefit of a relevant person.

'(3)  Condition B is that:

(a)  the property, service or consideration for the service, is (wholly or in part) the income or chargeable gains;
(b)  the property, service or consideration:

(i)  derives (wholly or in part, and directly or indirectly) from the income or the chargeable gains; and
(ii)  in the case of property or consideration, is property of or consideration given by a relevant person;

(c)  the income or chargeable gains are used outside the UK (directly or indirectly) in respect of a relevant debt; or
(d)  anything deriving (wholly or in part, and directly or indirectly) from the income or chargeable gains is used as mentioned in paragraph (c).'

Relevant persons are defined in ITA 2007, s 809M. The definition includes the taxpayer himself, a minor child of the taxpayer and a close company in which the taxpayer is a participator.

TCGA 1992, s 87B provides that gains treated as accruing to an individual under s 87 are foreign chargeable gains within the meaning of TCGA 1992, s 12 and that for the purposes of new ITA 2007, Part 14 Ch A1 ('remittance basis') relevant property and relevant benefits are to be treated as deriving from these chargeable gains. For these purposes property or a benefit is relevant if the capital payment by reason of which the chargeable gains are treated as accruing consists of:

(a) the payment or transfer of the property or its becoming property to which s 60 [nominees and bare trustees] apply; or
(b) the conferring of the benefit.

Condition A is satisfied by virtue of s 809L(2)(a) in relation to the transfer of moneys by way of loan to Rilian because 'money… has been… brought… to the UK… for the benefit of a relevant person'.

It is assumed that Condition A cannot be satisfied in relation to the transfer of moneys by way of loan to Caspian because although the definition of 'remitted' in s 809K is comprehensive it is not necessarily exhaustive and it is difficult to see how a thing can be remitted by virtue of a transaction taking place three years before it existed and without any reference to it.

Is Condition A satisfied by virtue of s 809L(2)(b) in relation to the trustees' conferring of a benefit on Caspian and Rilian through their continued omission to call in the loan? Refraining from calling in a loan is not aptly described as a service.

Even if that were not the case, and sub-paragraph (2)(b) were satisfied, Condition B does not appear to be satisfied.

That is because under Condition B the service (in this case the continuance of the loan) must either be the income or gains or derive from the income or gains. It is difficult to see how the continuance of a loan, as opposed to the making of the loan itself, can satisfy either of these two conditions.

Can it be said that the transfer of moneys to Rilian is (wholly or in part) the income or chargeable gains? We first need to consider which gains are referred to in new ITA 2007, s 809L(3)(a).

They are the gains which are deemed to accrue to Caspian under s 87. The gains which accrue to him are not the trustees' gains themselves, but an amount calculated by reference to those gains. So it is not true that 'the property [the moneys lent to Rilian]… is (wholly or in part) the… chargeable gains [the gains treated as accruing to Caspian in 2008-09]'.

Is s 809L(3)(b) of Condition B satisfied? Is the condition satisfied that '[the moneys advanced to Rilian are]… property of a relevant person… that derives (wholly or in part, and directly or indirectly) from the… chargeable gains [the gains deemed to accrue to Caspian]'?

The moneys certainly became the property of a relevant person; that is Rilian. But do they derive from the chargeable gain which is deemed to accrue to Caspian? New TCGA 1992, s 87B(3) does not help with this question because the capital payment by which the chargeable gains accrue to Caspian (see s 87B(4)) was not the making of a loan to Rilian, but rather the continuance of the loan to Caspian.

The moneys lent to Caspian surely do not derive from the chargeable gains deemed to accrue to Caspian under s 87. Rather, both the moneys and the gain derive from the actual gains realised by the trustees.

In summary, Condition A is not satisfied in relation to the advance of moneys to Caspian or to the continuance of the loans to Caspian and Rilian. Condition A is satisfied in relation to the advance of moneys to Rilian, but Condition B is not satisfied in relation to that advance.

Therefore, perhaps unexpectedly, the gains treated as accruing to Caspian have not been remitted to the UK. So it appears that even though a gain is deemed to accrue to Caspian by virtue of the capital payment being the benefit of the continuance of a loan to him which has been utilised in the UK there has been no remittance of this gain. It seems unlikely that this is how HMRC intended the legislation to work.

Trust income

The income of the settlement has been segregated outside the UK and has not been used in any way in relation to purchases of assets, the provision of services or in respect of a debt. Therefore, it does not fulfil either Condition (A) or Condition (B) in ITA 2007, s 809L(2) and (3) and has not been remitted to the UK.

Personal gains

New ITA 2007, s 809Q(6) defines a mixed fund as:

'money or other property which immediately before the transfer, contains or derives from:

(a) more than one of the kinds of income and capital mentioned in s 809Q(4); or
(b) income or capital from more than one tax year.'

There is a strange circularity in this definition. In order to know whether a fund is a mixed fund you must know whether it contains, or derives from, the various sorts of income set out in s 809Q(4). One determines the composition of the fund from ITA 2007, s 809R.

That section, however, only applies for the purposes of Step 1 in new ITA 2007, s 809Q(3). In turn, the application of new s 809Q is determined from whether various circumstances involving mixed funds exist.

To make sense of the provisions one has to cut the circle somewhere. So we shall start by assuming that Caspian's Narnian original capital bank account was a mixed fund and then applying the various provisions to determine of what that mixed fund was composed.

Section 809R(2) treats property which derives wholly or in part from an individual's income or capital for a tax year as consisting of or containing that income or capital.

As the account consists of capital other than the proceeds of capital disposals and the proceeds of Caspian's disposal on 30 April 2008 which has borne Narnian capital gains tax at 16%, it contains foreign chargeable gains of £1 million arising from Caspian's disposal on 30 April 2008 (which fall within the category of ITA 2007, s 809Q(4)(h) 'foreign chargeable gains subject to a foreign tax') with the remaining balance falling into the category of s 809Q(4)(i) 'income or capital not within another paragraph [of sub-section (4) ibid]'.

One then applies the provisions of s 809Q(3) to determine the nature of the money transferred on 1 May 2008. The result of doing so is that the foreign chargeable gains which have borne Narnian tax are matched first with the transfer of £500,000 on 1 May 2008.

So the whole of the £500,000 is treated as being a transfer of the gains arising on the disposal on 30 April 2008.

Under ITA 2007, s 809X, property which is brought to, or received or used in, the UK in circumstances in which s 809L(2)(a) applies (the first limb of Condition (A) for determining a remittance) is to be treated as not remitted to the UK if it is exempt property. The money transferred from the Narnian original capital bank account was not exempt property.

Caspian is a relevant person for the purposes of determining whether there has been a remittance.

Caspian has remitted the chargeable gain arising on his disposal because the transfer on May 1, 2008 satisfied the condition of TA 2007 s.809L(2)(a) that:

'money… [was]… brought to… the UK by… a relevant person.'

Condition B was satisfied because that 'property… [was] the… chargeable gain…'.

Therefore, £500,000 of Caspian's capital gain of £1 million realised on 30 April 2008 was remitted to the UK.

Personal income

Like the trust income, all of Caspian's relevant foreign income for the year which arose on his personal assets had been segregated in his Narnian accumulated income account and had remained outside the UK. It had not been dealt with in any way which satisfied any of the remittance conditions (A) to (D) set out in ITA 2007, s 809L. So none of this income had been remitted.

Summary of remittances of income and capital gain

So the only parts of Caspian's foreign income and capital gains which have been remitted in 2008-09 were the capital gains of £500,000 arising on 30 April 2008.

Deemed remittances under new ITA 2007, s 809H

However, where ITA 2007, s 809I applies:

'Income tax and capital gains tax are charged, for that year and subsequent tax years, as if the income and chargeable gains treated under [new s 809J ibid] as remitted to the UK by the individual in that tax year had been so remitted (and income and chargeable gains of the individual that were actually remitted in that tax year had not been).'

So, where s 809I applies, the actual remittances of income and gains determined under the complex remittance rules of new s 809L — S 809S are ignored except to the extent of determining the total remittances and the income and gains treated as remitted are identified under s 809J.

Section 809I applies if:

'(a) any of an individual's nominated income and gains is remitted to the UK in a tax year; and
(b) any of the individual's remittance basis income and gains has not been remitted to the UK in or before that year.'

An individual's nominated income and gains are the total income and chargeable gains nominated by him for the purposes of the remittance basis charge in any year up to and including the year concerned and an individual's remittance basis income and gains are his foreign income and gains for all tax years up to the year concerned to which the new rules apply, less the nominated income and gains.

Thus, Caspian's nominated income and gains and remittance basis income and gains are as set out in Table 2.

The computation is made simpler by the fact that this is the first year to which the new rules apply. It can be seen that part of the nominated income and gains have been remitted to the UK in 2008-09 and that the only part of the remittance basis income and gains which has been remitted to the UK is that part of the personal gains which has not been nominated.

The conditions for ITA 2007, s 809I to apply, therefore, are satisfied.

To determine which of the remittance basis income and gains are deemed to have been remitted under s 809I we have to apply the steps set out in s 809J in the following way.

Step 1

Find the total amount of:

(a)  the individual's nominated income and gains; and
(b)  the individual's remittance basis income and gains;

that have been remitted to the United Kingdom in the relevant tax year. This amount is 'the relevant amount'.

This total is £500,000 being the amount remitted of the personal gains.

Step 2

Find the amount of foreign income and gains of the individual for the relevant tax year (other than income and chargeable gains nominated under s 809C) that is within each of the categories of income and gains in paragraphs (a) to (h) of subsection (2). If none of ss 809B, 809D and 809E apply to the individual for that year, treat those amounts as nil (and accordingly go to Step 6).

The amount of the foreign income and gains for 2008-09 within each of the categories of income are as shown in Table 3.

Step 3

Find the earliest paragraph for which the amount determined under Step 2 is not nil. If that amount does not exceed the relevant amount, treat the individual as having remitted the income or gains within that paragraph (and for that tax year).

Otherwise, treat the individual as having remitted the relevant proportion of each kind of income or gains within that paragraph (and for that tax year). 'The relevant proportion' is the relevant amount divided by the amount determined under Step 2 for that paragraph.

The earliest paragraph under which there is an amount determined under Step 2 is paragraph (c). That amount does not exceed the relevant amount of £500,000 and so Caspian is treated as having remitted this income.

Step 4

Reduce the relevant amount by the amount taken into account under Step 3.

The relevant amount is therefore reduced to £290,000.

Step 5

If the relevant amount (as reduced under Step 4) is not nil, start again at Step 3. In Step 3, read the reference to the earliest paragraph of the kind mentioned there as a reference to the earliest such paragraph which has not previously been taken into account under that step.

As the relevant amount is not nil one starts again at Step 3 ignoring the relevant foreign income (other than income subject to a foreign tax) and applies Step 3 to Caspian's foreign income of £430,000 which has borne tax. £290,000 of this income, being the remaining balance of the relevant amount, is treated as having been remitted and this amount is apportioned amongst its constituent parts as shown in Table 4.

Caspian's income tax and capital gains tax self-assessment for the year was, therefore, as shown in Table 5.

The detailed computation was as follows:

New ITA 2007, s 809H(4) treats the taxpayer as having nominated an amount of unspecified income sufficient to give an additional income tax liability equal to the difference between £30,000 and the increase in tax payable due to the income and/or gains assessable under s 809H(2).

The effect of this provision is that where double tax relief is available on the income nominated to be taxed under s 809H(2) the liability will be increased by s 809H(4) by the same amount. It is doubtful whether the courts would accept that the purpose of the double taxation relief provisions can be defeated in this way, but in this article we have applied a literal construction of the legislation.

An unpleasant shock

Caspian's accountant had been expecting a liability of £11,000 ((£500,000 at (18% - 16%)) plus (£5,000 at 20%)). After such a hard journey to find that the actual liability was £175,630 (£3,320 + £172,310) was no doubt something of a shock.

He had overlooked the deemed remittance rules in new ITA 2007, s 809I and the interaction of s 809H(4) with double tax relief.

Caspian had also suffered from the fact that personal and annual capital gains tax allowances are not available when the remittance basis is claimed and the dividend upper rate does not apply to dividend income taxable on the remittance basis.

Don't confuse the customers

Caspian's affairs are simpler than one is likely to find in real life. This review has shown that calculating a tax liability under the new remittance basis rules is extremely complicated. Even so, it has skated over a number of uncertainties in the construction of the legislation.

The logic of providing a special privilege to those with weak connections to the UK is to place a price on the privilege of residence here which balances the benefits of residence to the individual non-domiciliary and the advantages to this country of his residing here (which we should lose if he were to move to another jurisdiction).

The first rule of effective pricing is that one's pricing structure should be understood by one's customers.

Otherwise, they will deduct a risk premium from the price they are willing to pay to take account of the risk that they may be charged more than they think.

The second rule of effective pricing is not to divert profits away from yourself to third parties by making your pricing structure so complex that the customer has to pay for advice on the best course of action in relation to it. The new remittance basis transgresses both of these rules. We are used to stealth taxes — the Government has given us a stealth dis-incentive.

Simon McKie is the chairman of McKie & Co (Advisory Services) LLP, telephone: 01373 830956, email: simon@mckieandco.com. This article is based on an article written for publication in Private Client Business.

Issue Extract

tax_4171_comment_p213_0.pdf

Categories: Comment & Analysis