Taxation

1. Rental Income

Investment income from UK properties and even that owned by non-resident individuals or their nominees is subject to taxation in the UK . Since 6th April, 1996 , letting agents, or tenants where there is no letting agent are required to pay basic rate tax each quarter on the UK property income of the non-resident. Non-residents will be able to set-off the tax suffered by deduction from rent their UK income tax liability. Non-residents may apply to the Inland Revenue for approval to receive their UK property income gross provided:-

1. their UK tax affairs are up to date, or

2. they have never had any obligations in relation to UK tax, or

3. they do not expect to be liable to UK tax, and

4. they undertake to comply with all their UK tax obligations in the future.

The restrictions on obtaining a deduction for interest paid in respect of the funding of a property acquisition have been relaxed with effect from 6th April, 1994 . Prior to thatdate, for a non-UK resident, to ensure that the interest paid in respect of the funding of the acquisition was deductible, the following conditions had to be satisfied:-

1. the interest had to be "annual" interest chargeable to tax under Case III of Schedule D; ("annual" meaning basically that the loan had to be capable of exceeding one years duration and "chargeable to tax under Case III of Schedule D" meant that the "source" of interest payments had to be in the UK .

2. the interest, whether ‘annual’ or ‘short’ was payable in the UK or Eire on an advance from a bank or discount house carrying on bona fide a banking business or the business of a discount house, in the UK or Eire; and

3. the payment of interest was in respect of a loan and not an overdraft; and

4. at the time the interest was paid the property was used as the only or main residence of the person by whom it was paid or was, in any period of 52 weeks comprising the time at which the interest was payable, let at a commercial rent for more than 26 weeks, and when not so let was either available for letting at such rent or was used as the main residence of the borrower.

From a practical point of view, it was normally recommended that, to avoid any problems concerning deductibility of interest and concerning payment of withholding tax in the UK on interest paid to an offshore lender, any non-resident wishing to purchase UK land borrowed from a UK bank or a foreign bank carrying on a bona fide UK business so as not to have to consider the nature and source of the payments of interest in determining the deductibility for UK tax purposes or the question of withholding taxes.

From 6th April, 1994, interest paid on a loan to fund a property acquisition, will be deductible regardless of where the borrower resides and regardless of whether the interest is short or annual.

Yearly interest derived from a UK source paid to another person whose place of abode is outside the UK must still be paid under deduction of tax at the basic rate although the non-resident recipient may be able to claim a reduction of tax at the basic rate of withholding under the terms of the relevant double tax treaty.

2. Gains and Inheritance

The operation of the domicile rules, particularly as they apply to tax income and capital gains (on a remittance basis only) to a large extent make those taxes voluntary, which means that the UK is a popular place for non-domiciled people to establish residence, possibly on a long term basis. The domicile rules were under review as of April 2003 to be replaced by taxation of foreign income and gains based on a residence test. The possibility of a review of the “domicile rule” has been abandoned by the Chancellor according to the 2003 December pre-budget report so it may be a useful basis for planning for the foreseeable future.

If an individual who normally resides outside the UK buys a property, it may be bought in the name of a company. UK building societies may be reluctant to lend domestic mortgage finance to a non-resident company or individual but it is possible to obtain 60-70% finance from a UK or Channel Islands bank for a Channel Islands company or specialised UK lenders who will lend to lower cost companies such as those in the British Virgin Islands companies to buy a UK property if the property itself is offered as security. In some cases personal guarantees of the beneficial owner will be required.

The advantage to using a company incorporated in a low-tax jurisdiction to be the registered owner of the property is that, if the property comes to be sold and it has accrued a capital gain, and the owner of the company does not live in the UK , the capital gains will not be subject to taxation in the UK . The use of an offshore company will also enable inheritance tax to be avoided.

If the property is used to establish a residence in the UK, the revenue’s view is that such a structure may give rise to an income tax charge on the grounds that the benefit of living accommodation is being provided to a person (i.e. the non-domiciled individual) by reason of his (deemed) employment as a by the offshore company. In the revenue’s view, the deemed employment may make the individual a "shadow director": that is, the individual, although not formally a director, is a person in accordance with whose directions or instructions the (actual) directors of the company are accustomed to act. The revenue would seek to charge tax on the benefit calculated with reference to the official rate of interest.

The existence of a discretionary trust holding the shares of the company, actively managed by professional offshore trustees and controlling the holding company, should diminish the force of an argument that it is the individual in the UK who controls the situation in reality, but this factual situation is not always easy to achieve. The revenue’s view is that the existence of a trust is may be immaterial if it is “controlled” by the beneficial owner in occupation. So the best IHT planning strategy - to have the UK property owned by an offshore company to change its tax location to the place where the where the company is incorporated - remains consistent with good CGT planning but may bring about a serious income tax problem without property thought on the management and organisation of the ownership structure.

If the individual purchases the property in his own name, the CGT main residence exemption may be available, however the property will be subject to IHT on his death as real property is taxed mainly where it is situated. It should be assumed that any relevant double tax treaty would only operate to stop the property being taxed in the country of domicile at a higher rate than the rate that applies in the UK .

The potential tax can be mitigated, or avoided, in several ways:

• a strategy often employed is to have the property held by a professionally managed trust rather than a company per se and have the trust lease or rent the property to the beneficial owner at low rent.
   
• the property can be purchased with a loan and serviced from UK income or remitted foreign capital, although if purchased in the beneficiaries own name, any increase in value of the property over the original purchase price is unprotected from IHT in the event of death.
   
• an individual’s widow/widower may be given the subsequent right to occupy the property, the IHT spouse exemption will probably apply on the individual’s death. IHT would then be postponed but not eliminated.
   
• ownership could be split between several family members:- for example a flat worth £500,000 owned equally by husband, wife and three children gives each a UK estate worth£100,000 each - well below the IHT threshold being 255,000 GBP in 2003/4. Beneficial ownership of minor children may be established by a declaration of trust while legal ownershipremains. This may not be acceptable to a mortgagee and the transfer by trust may be chargeable to tax.
   
• the IHT liability could be insured against by a policy on the individual’s life, written on the trust at the outset for the intended heirs so as to be outside his estate for IHT purposes at his death.

The practical advantages of direct ownership of the property by an individual are apparent but the disadvantages are:-

• CGT will be payable on disposal of the property during the individuals lifetime if it is not his main residence or otherwise exempt.
   
• The Land Registry is open to public inspection and is therefore not consistent with confidentiality.
   
• Probate in the UK will have to obtained on the death of the sole legal owner for the property to be sold or for the legal title to devolve to the heirs of the deceased. It will be the duty the deceased’s personal representatives to submit financial accounts of the deceased’s assets and liabilities. Individuals who are not UK domiciled are still potentially in the charge to IHT in respect of transfers of UK situated property, which includes UK land and buildings.

Michael Reason International Business Lawyers, 8 Moorgate, London EC2R 6DA

Ph: +44(0)207-600-3111

Fx: +44(0)207-600-4111

mreason@michael-reason.com

Sources

Tolleys Tax Planning 2003-04

Tolley’s International Tax Planning, Third Edition, MJ Finney and J Dixon, October, 1996

Liquid History, To commemorate Fifty Years of the Port of London Authority, 1909-1959, Arthur Bruant, Privately Printed, London 1960

The Groundwork of British History, Part II, George Townsend Warner, M.A. and C.H.K. Marten,M.A. Blackie & Son Limited Glasgow , 1926.