An interview with international tax advisers, Dominic Lawrance and Alice Martin from Charles Russell Speechlys
Estate planning is all about protecting your loved ones and part of this is transferring assets to your heirs in a way which is tax efficient.
Taking advice on estate planning can enable couples to reduce the tax burden on their estate, but the issues for international families connected to the UK are complex.
There are many challenges when preparing an estate plan, one of them is understanding the concept of “domicile”, which under English law is not just determined by citizenship or residence.
I had the great pleasure discussing this with Dominic Lawrance and Alice Martin, both partners at the law firm Charles Russell Speechlys LLP, who are experts in UK estate planning for international families.
During our interview we covered:
- What is domicile and what are the tax advantages for a non-UK domiciliary?
- The impact of being UK resident for 15 out of 20 years (deemed domicile)
- The potential relevance of double tax treaties
- Domicile mismatches between spouses
- Keeping non-UK assets out of the scope of inheritance tax
- What the future holds for non-doms in the UK.
Dominic and Alice, thank you for discussing these important issues with us. To begin with, can you explain what it means to be a ‘non-domiciliary’?
A non-UK domiciliary (sometimes called a “non-dom”) is an individual who is domiciled outside the UK for the purposes of English common law.
“Domicile” is a concept in law which is different from the tax concept of residence. It is also unrelated to nationality. It is perfectly possible for an individual to be resident in one country, domiciled (for English law purposes) in a second country, and a national of a third.
Non-UK domiciled status can persist for a long time after an individual has become resident in the UK. Under English common law, an individual may have been UK resident for decades, and may even have acquired British nationality, and yet have a domicile outside the UK. This will be the case if the individual had a “domicile of origin” outside the UK and he or she has never acquired a “domicile of choice” in any part of the UK.
What is a domicile of origin?
Every individual is born with a “domicile of origin”. If his parents were married at the time of his birth, his domicile of origin will have been the domicile of his father at that time. An individual can however acquire a “domicile of choice” in a different country, if he moves to that country and forms an intention to reside there permanently or indefinitely.
An individual with a non-UK domicile of origin will remain non-UK domiciled for as long as he can credibly say that he intends to cease residing in the UK at some point in the future. For example, it is common for individuals with foreign domiciles of origin to intend to leave the UK when their children cease to be in full-time education in the UK, on the termination of a particular job with a UK employer, on the sale of a particular UK company, on their retirement, etc. If the intention to leave the UK is realistic, the domicile of origin will be retained in these scenarios. However, if an individual moves to the UK late in life, an assertion of a foreign domicile may be more susceptible to challenge.
It is also possible for an individual with a domicile of origin in the UK to become a non-UK domiciliary, by residing in another country and forming the intention to reside there permanently or indefinitely. This will result in the acquisition of a domicile of choice in the other country. However, it’s unusual for a person with a UK domicile to acquire a domicile of choice elsewhere as soon as they leave the UK. A domicile of origin has an adhesive quality and it is difficult to cast off. There is a heavy evidential burden to show that a domicile of origin has been displaced with a new domicile of choice, and keeping connections with the UK (like owning UK real estate) can undermine the claim to have acquire a domicile of choice elsewhere.
In principle, a domicile of choice in another country may be retained if the individual ceases to reside in that other country, and even if he begins to reside again in the UK. However, if an individual who has a UK domicile of origin and was born in the UK becomes UK resident, they will be deemed domiciled and therefore ineligible for the tax benefits that normally attach to non-UK domiciled status.
Determining an individual’s domicile is not necessarily straightforward, but where an individual was born abroad, or his parents lived abroad, or he himself has lived abroad for a long period, it is likely to be worth investigating his domicile further to see whether he may be a “non-dom”.
Why is domicile so important?
The significance of domicile goes beyond tax. In particular, a foreign domicile can affect succession to “movable” assets such as bank accounts and shares. The way such assets pass on the individual’s death may be affected by the succession law of his country of domicile. That law may contain “forced heirship” provisions which prevent the individual from disposing of his assets on death in the way that he wishes.
However, it is probably fair to say that the most immediate impact of a foreign domicile is in relation to tax. Non-doms (who aren’t deemed domiciled) have a reduced exposure to UK taxation, in recognition of the fact that they are less closely connected to the UK than individuals who are domiciled within the UK. The tax advantages of being a non-dom are essentially threefold:
- the remittance basis of taxation;
- the restriction of inheritance tax to UK assets; and
- the scope to create a non-resident trust from which the individual can benefit, without the creation of the trust giving rise to inheritance tax, and without various anti-avoidance rules applying to the trust’s assets and income/gains generated within the trust.
What is the advantage of being a non–dom where inheritance tax is concerned?
When a UK domiciliary dies, his or her estate is subject to inheritance tax on a worldwide basis. Inheritance tax applies at 40% to assets both within and outside the UK, except to the extent that they are protected by the exemption for assets passing to a surviving spouse or fall within the individual’s “nil rate band”. At £325,000, the latter is not exactly generous.
By contrast, when a non-dom dies, then provided that he or she is not deemed domiciled in the UK for inheritance tax, the tax generally applies only to UK assets; generally, there is no inheritance tax on assets situated outside the UK.
The only notable exception to this relates to non-UK assets which derive their value from UK residential property or have been provided as collateral for a loan used to acquire or improve such property. This means that the value of a non-UK company which holds UK residential property will still be within the scope of inheritance tax, and that the value of the benefit of a loan can also be subject to inheritance tax, if the funds were used to buy UK residential property. Such assets are effectively deemed to be UK assets for IHT purposes.
The same principles apply if a non-dom (who is not deemed domiciled) makes a lifetime gift of non-UK assets. Absent any connection with UK residential property, there is no inheritance tax on such a gift, even if the gift is one which would potentially give rise to an immediate inheritance tax charge for a UK domiciliary. Examples are gifts to trusts, gifts to trust-like entities such as private foundations and gifts to charitable entities outside the EU.
Dominic and Alice, can you explain the “deemed domicile” concept?
The concept of deemed domicile limits the length of time for which the tax benefits of non-UK domiciled status are available. A deemed domicile in the UK is typically acquired by a non-UK domiciled individual once he has been UK resident in 15 of the 20 preceding tax years. It follows that an individual with a foreign domicile typically becomes deemed domiciled for UK tax purposes at the beginning of his 16th tax year of residence in the UK.
It is important to count tax years of residence correctly for these purposes. Under the rules which applied before the UK introduced its current statutory residence test, it was not uncommon for an individual moving to the UK to become taxable as a resident in a given tax year even if he only started spending time in the UK towards the end of the tax year; and indeed, an unlucky or ill-advised individual might become tax resident a matter of days before the end of the tax year in which he “arrived” in the UK.
This can also happen under the statutory resident test, for example if the individual becomes UK resident on commencing full-time work in the UK. There is no doubt that, where an individual became UK resident partway through a tax year, that whole tax year must “go onto the clock” for the purposes of the deemed domicile test (even if he was taxable as a resident, in that tax year, for just a few days). Deemed domicile can therefore arrive sooner than expected, sometimes little more than 14 years after the individual’s “arrival” in the UK.
The effect of being deemed domiciled in the UK is that the remittance basis of taxation ceases to be available and the scope of inheritance tax extends from UK assets to all assets on a worldwide basis. This is relevant not only in the event of the individual’s death, but also if the individual makes lifetime gifts, especially gifts to trusts or trust-like entities.
However, where an individual has not yet become deemed domiciled, these effects can be countered by putting non-UK assets into what is known as an excluded property settlement. This is a trust, usually in discretionary form, of which the non-dom himself can be a beneficiary. The trust must be created and funded before the non-dom becomes deemed domiciled. If so, it can function as an indefinite shelter from inheritance tax, not just in the non-dom’s lifetime but potentially for many generations after his or her death. It can also provide significant tax deferral benefits with respect to income and gains generated by the trust assets.
How can a person get out of the “deemed domicile” rules?
Where an individual has already become deemed domiciled for inheritance tax purposes, his deemed domicile can in principle be “broken” by a period of non-UK residence. In a typical case, six entire tax years of non-UK residence are required if the individual plans to resume residence in the UK after the non-resident period.
Are there any treaties that are relevant for inheritance tax?
Generally, an individual who has become deemed domiciled in the UK for inheritance tax purposes has the same status, where inheritance tax is concerned, as someone who is domiciled in part of the UK. However, in certain scenarios the position is modified by a double taxation treaty.
There are a few treaties that the UK has entered with other countries, which can affect the scope of inheritance tax in relation to individuals who are domiciled outside the UK but are deemed domiciled for inheritance tax purposes. The effect of one of these treaties applying is that, on the individual’s death, inheritance tax may not apply to non-UK assets, notwithstanding the individual’s deemed domicile. Generally, these treaties only have effect in relation to transfers on death, and they do not (for example) affect the inheritance tax position if the individual makes a lifetime gift of non-UK assets to a trust.
Dominic and Alice, what are the domicile mismatch traps?
Non-dom status is generally beneficial, but there is one situation in which it can have unwelcome inheritance tax consequences – where there is a “domicile mismatch”. This occurs when:
- a UK domiciled spouse dies leaving his or her estate to a non-dom spouse who is not yet deemed domiciled; or
- a non-dom spouse who is deemed domiciled for inheritance tax purposes dies leaving his or her estate to a non-dom spouse who is not yet deemed domiciled.
Normally, assets passing from one spouse to another are free of inheritance tax, by virtue of the spouse exemption. However, in the scenarios mentioned above, the spouse exemption is limited to £325,000 – unless the surviving spouse makes an election to be treated for inheritance tax purposes as domiciled in the UK. If so, the spouse exemption is unlimited, but the worldwide assets of the surviving spouse will be within the scope of inheritance tax on his or her own death (unless the surviving spouse then spends sufficient time outside the UK to shed his or her deemed domiciled status).
Mixed domicile couples, and non-dom couples who became UK resident at different times, should consider putting special Wills in place to cater for the possibility of a domicile mismatch on the first death. Consideration should also be given to transferring non-UK assets of the non-UK domiciled and non-deemed domiciled spouse into an excluded property settlement, to forestall the acquisition of deemed domiciled status if an election is required to avoid inheritance tax on the first death.
Can you explain how establishing an excluded property settlement can work for a family?
As mentioned above, non-doms generally lose their favored inheritance tax status once they become deemed domiciled, when their non-UK assets fall within the scope of inheritance tax.
However, if a non-dom gives non-UK assets to an excluded property settlement before he becomes deemed domiciled, these assets will remain ring-fenced from inheritance tax even after the individual becomes deemed domiciled and beyond his death, so that the assets are protected from inheritance tax for future generations. The individual can, and normally should, be a beneficiary of the trust. It is also possible for the trust to be revocable, so that the individual can bring it to an end at any time. These features of the trust do not affect its efficacy as a shelter from inheritance tax.
If the trust has non-UK resident trustees, it offers an additional advantage, because (provided that certain conditions are met) neither the non-UK domiciled settlor nor any other UK resident beneficiary will be liable to capital gains tax realized by the trustees, or liable to income tax in respect of non-UK income received by the trustees, until a benefit is received from the trust. This means that income and gains can, in principle, roll up inside the trust without tax being paid on them.
Although an excluded property settlement will save inheritance tax at 40% of the value of the assets on the settlor’s death, there will be ongoing trustee fees. Prospective settlors should compare these costs against the cost of life assurance.
Where a non-dom might be interested in establishing such a trust, to ring-fence assets from inheritance tax, it is strongly recommended that advice is taken at the earliest opportunity. Ideally, an adviser should be consulted more than a year before the anticipated date of acquisition of a deemed domicile in the UK.
There are two reasons for this. One reason is that it can take some time to choose a trustee and establish and fund a trust, and it is not sensible to leave it to the last minute.
In addition, it is very common for individuals to have poor records and recollection of when they first became UK resident. Very often, it transpires that the individual became UK resident earlier than he or she had remembered, and/or that the totting up of years of UK residence has been done incorrectly. In either case, a surprisingly common outcome is that the professional adviser is consulted about establishing an excluded property settlement after the individual has already become deemed domiciled! This is deeply disappointing for the individual and adviser alike.
What other issues should non-doms consider in their estate planning?
Other important issues for non-doms to consider include:
- The possibility of (in effect) converting foreign income or gains into clean capital through gifts to family members.
- The possible use of “wrappers” or structures and how foreign structures might be treated for UK tax purposes
- Estate planning for foreign assets – whether local Wills are necessary, and the impact of local succession laws (for example, forced heirship rules may apply);
- Whether steps are needed to prevent any companies that the non-dom manages from becoming UK resident for tax purposes;
- Specific issues which may arise due to an individual’s domicile or nationality, or where his assets are situated (in particular, we work with a lot of US citizens, who are subject to US taxes on a worldwide basis and need specific advice to achieve the best result from the interplay of the International and US tax regimes); and
- What would happen in the event of incapacity, as opposed to death. The UK has ‘lasting powers of attorney’ whereby you can nominate who should make decisions for you if you became unable to do so for yourself. Similar provisions may be needed for each jurisdiction in which there are substantial assets.
Dominic and Alice, what does the future hold for non-doms in the UK?
The tax rules for non-doms are very complex and specialist advice is almost always needed when moving to or from the UK, and to keep abreast of developments. It is quite possible that the rules on domicile will be subject to further changes in the future and so any planning should be as ‘future-proof’ as it can be.
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