Articles
Notes re 2007 Pre-Budget Report (PBR)
I would like to hear from any staunch supporter of the Labour party what elements of the Chancellor’s pre-budget report are designed to make the tax system in the UK fairer to its residents, or designed to make the UK a more attractive jurisdiction in which to conduct business activities. If we look at the individual items that were covered by the PBR, we can identify the following:-
Investment Manager Exemption
I have started off with this to give readers the opportunity to fire this salvo at the outset in defence of the Chancellor and his colleagues. The IME as it is known is designed to enable offshore funds and individuals to operate in the UK through investment managers without exposing themselves to UK taxation. Because certain activities are treated as a trade rather than an investment, these trading activities may indeed create a tax liability for the offshore fund. Happily, the Chancellor has now announced that there will be a proportionate approach to the situation where the IME is denied in respect of specific transactions, and tax will only be levied on those items which are considered trading, rather than on the entire income of the fund or individual (i.e. trading as opposed to investment activities). This proportionate approach is no less than is fair and reasonable, but it is good that the Chancellor has specifically stated that those investment activities specifically covered by the IME will continue to be covered by the IME! It would be really good to have absolute clarity as to what activities are considered investment and what trading activities, and the Chancellor has promised to let us know this in due course.
Offshore Funds
A discussion paper was issued at the time of announcing the PBR in respect of offshore funds. Although running to 25 pages, the essential element is that the Distributor Fund status is no longer going to be relevant, but instead there will be a facility for an advanced election as a ‘Reporting Fund’. Currently, Distributor Fund status enables an individual investor to be taxed on profits derived from his investment in an offshore fund to capital gains tax rather than income tax, provided that the income from the fund is subject to income tax on an arising basis. This requires the Distributor Fund to distribute 85% minimum of its annual income to investors who will then be subject to personal income tax on such distributions. In this way, if the offshore fund has investments which yield capital growth, those profits will be subject to capital gain rather than income tax. If business asset taper relief applied to the investments, then the tax rate would then have been just 10% as opposed to 40%.
The Chancellor now has decided to eliminate Distributor Funds and replace them by Reporting Funds. So the good news is that the offshore fund does not have to distribute its income and can retain it for further investments; the bad news is that the investor does not receive the income but has to pay the relevant proportion of the tax due on such income. Hardly fair on those who do not have other income from which to meet these tax liabilities.
Moreover, HMRC can recompute the annual income of offshore funds so that certain deductions may end up by being disallowed. But the main issue seems to be that the Government is replacing the notion of the offshore fund as being a collective investment scheme under which property is held on trust for the participants, but instead the definition seems to be wide enough to encompass many offshore companies as well as trusts which invest funds by virtue of a pooling of monies by shareholders. Thus although shareholders may consider that they own foreign companies and will eventually enjoy a capital gain derived on the sale of the shares in the company unless the company elects to be a Reporting Fund (if indeed it is covered by the legislation), the individual may instead be subject to income tax on the gain rather than capital gains tax, in the same way as any non-Reporting Fund as they will now be known.
So in summary, the beneficial 18% tax rate applying across the board for capital gains may not actually be enjoyed by certain investors in offshore companies that hope to make a profit by way of ultimate sale of their respective shares. Perhaps this is the intended benefit: to show a simplified capital gains tax system with one of the lowest capital gains tax rates in developed countries, but on the other hand to restrict the items of profits which may be subject to such rate of tax.
Capital Gains Tax
Much has been written in the Press about the effect of increasing the capital gains tax rate on business assets by effectively 80%, from 10% taper relief to 18% standard rate. The furore concerning fund managers and their carried interests seems to have been the trigger for the Chancellor to review the entire capital gains tax regime and, in his infinite wisdom, to prejudice the business community at large to achieve the higher taxation on carried interests. Fund managers themselves are absolutely delighted, since they feared that their carried interests could be re-characterised as income earned from their activities as fund managers, and therefore taxed at 40%. Strangely enough, that is exactly what carried interests are, income from their activities in running investment funds. Surely a re-characterisation of carried interests would have been fairer, whilst maintaining the status quo for the business community at large.
Indeed, if certain items of capital gain are now reclassified as income (investments in offshore funds as above) then there really is a double whammy; letting a small section of the community who may well have accepted a higher tax charge on what is clearly income, whilst penalising the investment community in respect of investments which clearly are not as a result of an individual’s activities to earn profits for himself.
Non-Domiciles
And so we come to the non-domicile community, those individuals who are resident in the UK but whose domicile follows that of a foreign jurisdiction. No one denies that individuals who have been resident in the UK for more than 20 years should pay taxation on a similar basis as those whose country of birth is the UK. And indeed for inheritance tax rules, an individual is deemed domicile in the UK if he has spent the last 17 out of 20 years in the UK. So it is not unreasonable to extended deemed domicile provisions for income and capital gains tax purposes. Indeed the Government have tightened these rules by stating that anyone who is resident in the UK for 7 out of 10 years will be subject to full taxation on income and capital gains, but presumably not for inheritance tax where the 17 out of 20 years rule may still apply (yet to be ascertained).
But then the Government gave an opt-out for wealthy tax-payers by offering them the opportunity of paying a flat rate of £30,000 per annum and thereby avoiding taxation on income and capital gains throughout that particular year. Moreover, those wealthy tax-payers probably have homes abroad and can easily leave the UK as a tax resident for say a 3 year period to return in the 4th year and start an entire new period of 7 out of 10 years. So in this respect, the Government have clearly stated that it accepts that there can be an unfair treatment between the wealthy and the poorer non-domiciled resident individuals. Those that are wealthy can arrange their affairs and pay a nominal amount of tax (for them) without any real penalty, whereas those who are poorer may have to pay UK tax on the very small amounts of foreign income that they can accumulate without remitting to the UK.
The PBR also mentions the proposal to tighten up “anomalies” in the remittance rules and source ceasing provisions. This will mean that fewer planning opportunities will be available to non-doms in order to minimize their UK tax liability when bringing funds into the UK. Exactly what the anomalies are is not clear at this stage, and we will have to wait for guidance notes to be published before any positive action can be taken.
Additionally, there is also the proposed extension of certain anti-avoidance measures to non-doms. Nobody knows until the draft legislation is published exactly how the Government intend to implement this, but it is likely to have a knock-on effect in those offshore jurisdictions in which offshore income and gains are housed.
Inheritance Tax
We started with an apparently benign measure, and can end with one, namely the rules that 2 spouses can aggregate their nil-rate band of £300,000 and on 2nd death, the exemption that can apply for inheritees will be £600,000. Certainly good news, but one that has been covered in virtually all wills prepared by lawyers where the first nil-rate band is applied to individual inheritees on the 1st death with the 2nd nil-rate band only applicable on the 2nd death. The example given in the PBRN 16 is where an entire estate has been left to a surviving spouse, and indeed their must be many situations where this happens so the new rules are certainly welcome. However in reality, they do not address the vast increase in capital values of properties owned by individuals in the UK. If the £300,000 nil-rate band was considered say a few years ago to enable a principal private residence to pass to inheritees without the imposition of inheritance tax, isn’t it unfair that a tripling of property values over the past few years does not entitle the principal private residence still to be left to inheritees without inheritance tax charges.
Summary
It is not that I have been against many of the budgetary changes over the last 10 years. However, the objectives of the Government in creating a tax system is that it should be certain, fair and simple. Yes, taper relief is more complex than paying a single standard rate, but it is designed to stimulate the business environment in the UK. It was introduced 10 years ago when the UK economy needed the fillip of budgetary measures to encourage entrepreneurs to remain in the UK. How bizarre that it is now ended at a time when equally the economic outlook is viewed by most economists as entering into a downward phase, so to discourage the business community at this stage seems perverse to say the least.
And if certain individuals (middle-earners) are badly affected by the new non-domicile rules, their option is to leave the UK for places like Switzerland, and this is likely to occur as well. Yes investment fund managers may feel let off by having their carried interests taxed at 18% rather than 40%, but there are still uncertainties in the Investment Manager Exemption which could potentially jeopardise the status of offshore funds. And definitely, the Reporting Fund legislation needs to be very carefully reviewed throughout the consultation process to make sure that investors do not suddenly find that capital gains are subject to full income tax rates, rather than the reduced simplified 18% tax rate that they may otherwise have welcomed.
As I questioned at the beginning, what is there in this PBR that encourages the business community, investors or middle-earning individuals who are resident in this sceptred isle of ours?
Prepared 24 October 2007
