How best to manage assets after the Budget

The UK Government's Finance Bill 2008 shifted the landscape of offshore and onshore tax planning. The offshore world is waiting for the final publication of the Finance Act 2008, to be retroactive to 6 April 2008. Until then, it continues to consider the draft legislation, in light of the clarifications issued by HM Revenue & Customs and Mr Darling's adjustments in the 2008 Budget.

Residence

Residence plays a key role in determining whether or not an individual will be liable to pay tax on income or gains on assets both

inside and outside the UK. A UK resident will be subject to tax on their entire worldwide income and gains ('the arising basis') whilst a non-UK resident will only be subject to UK taxes when they remit income and capital to the UK ('the remittance basis').

Since 6 April 2008, determination of residence is based on the number of times that the individual is present in the UK at midnight in each tax year.

Individuals present in the UK for 183 midnights or more in any tax year (or for an average of 90 midnights over any four-year period) are treated as UK resident. Non-UK-residents who visited the UK frequently in the past 10 years might also automatically be regarded as UK-resident for the 2008/9 tax year.

Day-counting rules for non-domiciled individuals were merely the tip of an iceberg of changes intended to be implemented by the retroactive Act this summer.

(a) Capital Gains Tax (CGT)

As of 6 April 2008, the rate of CGT has been fixed at 18 per cent for UK-resident individuals, trustees and personal representatives, whilst offshore trustees will be subject to CGT at a rate of up to 28.8 per cent on payments out of trust capital where gains have been held for a period of up to six years but only limited CGT exemptions will be available. It is likely that capital distributions will now be preferred over income by UK resident non-domiciled beneficiaries of offshore trusts in order to achieve reduced tax rates. Further, as detailed below, there are more opportunities to reduce CGT liability than income tax.

(b) The £30,000 remittance charge

Since 6 April 2008, non-UK domiciled but UK resident individuals are required to pay a charge of £30,000 in every tax year if they wish to continue to be taxed on the remittance basis. The Bill has not only revoked taper and indexation reliefs (except where it applies to companies) but it has also removed the right of taxable individuals to claim personal allowances while using the remittance basis.

When a UK resident individual decides not to use the remittance basis, and therefore not to pay the £30,000, he will be automatically taxed on the arising basis. It is up to the individual to assess his annual earnings to determine whether or not it is beneficial to pay the charge in each tax year.

(c) 'Remittance'

The definition of 'remittance' was expanded under the Bill to include assets purchased with offshore funds or offshore funds that are brought into the UK. The

Budget confirmed that not all items funded in this way will be taxable; for example, assets taken into the UK for less than 9 months will not be treated as remitted.

Where exemptions are unavailable, non-domiciled UK resident individuals who wish to (a) purchase assets in the UK with offshore funds (that is real estate), (b) borrow funds offshore for use in the UK (that is offshore mortgages) or (c) move currently offshore-situs assets into the UK will be required to pay tax on the value of those assets, or their benefit, as soon as they are remitted.

(d) Alienation

UK resident individuals can no longer escape CGT by gifting assets to their spouse or child, who later remit those assets to the UK tax-free. The Bill treats the UK resident as liable for tax whenever a member of the taxpayer's 'immediate family' remits assets received offshore into the UK.

'Immediate family' refers to the UK resident individual's spouse, minor children, offshore trusts of which he is a settlor and close companies of which he is one of five or fewer shareholders.

Settlors, trustees and protectors may consider adding non-UK resident or more distant family members to the class of beneficiaries in their trusts, thus distributions can be made without attracting UK tax.

(e) Offshore gains distributed to UK resident beneficiaries

The Budget confirmed that pre-6 April 2008 offshore gains will not be taxable at the hands of UK resident non-domiciled beneficiaries; however, those beneficiaries will be subject to tax on offshore gains realised after 6 April on the remittance basis. The calculation of tax will be based on the gain at the time it is distributed rather than when remitted. Given that both UK- and non-UK-situs assets held within offshore trusts will be subject to CGT, offshore trusts are still useful for sheltering gains.

(f) Entrepreneurs' Relief

Entrepreneurs' Relief has been introduced and is available to all UK tax payers on 'qualifying gains' of up to an aggregated £1m during their lifetime. 'Qualifying gains' are broadly defined as gains realised on (a) the sale of any trade, profession or vocation carried on by the tax payer for at least one year or (b) the sale of shares that have been held for over one year in a trading company of which the taxpayer is an officer or employee and he owns a minimum of 5 per cent of the share capital giving him over 5 per cent of the voting control.

UK resident beneficiaries are permitted to deduct from their own £1m limit the value of a gain realised by offshore trustees and distributed to them.

(g) Capital Losses

Offshore losses are to be permitted to be set off against capital gains arising offshore but only if all unremitted offshore gains are disclosed to HMRC. This provision will be very unwelcome by many settlors, given that one of the benefits of establishing an offshore trust is the privacy that it affords.

Effects on the offshore industry

It is still very much hoped that further softening and clarifications of the provisions of the Bill will be issued and incorporated into the Act. Accordingly, many taxpayers have opted not to take any extreme measures - thereby accepting that they may pay the new taxes in the current tax year 2008/9 '“ until after the Act is published.

Going forward, capital vs. income considerations will be required each time distributions are requested from trustees. Additionally, new structures will be developed to enable more effective funding of UK-situs assets, such as real estate. One very real benefit of the Bill and Budget has been the encouragement of more frequent and open dialogue between offshore trustees, settlors, beneficiaries and onshore advisors in order to minimise the risks of falling foul of the new rules. Aside from the far reaching effects of the Bill, a number of cases have recently caused a stir amongst offshore trustees.

Dual residence and 'effective management'

Smallwood and Smallwood, Trustees of The Trevor Smallwood Trust v Commissioners for HM Revenue & Customs '“ Spc 00669 (2008) was an appeal brought by the trustees of The Trevor Smallwood Trust against a closure notice issued by HM Revenue & Customs to include CGT of £2,727,356 and the ruling that double taxation relief would be disallowed on that amount. It was brought following the sale of shares by a Mauritius-based trustee, resulting in substantial gains, and the subsequent appointment of UK-resident trustees.

The UK trustees claimed to be entitled to double taxation relief under a double taxation agreement between the UK and Mauritius, which provided that gains from alienated property would be taxable only in the contracting state of which the trustee was resident. Where the trustee was resident in both of the contracting states, it would be deemed resident in the state in which its effective place of management was located.

The Special Commissioners distinguished 'management' from 'effective management' and decided that the effective management had remained in the UK and consequently, they accepted that the trustee was dual resident during the period that the trustee was resident in Mauritius. Under English law, part residency in the UK during any given tax year resulted in UK residency for tax purposes and therefore double taxation relief was not applicable and the full amount of CGT was payable.

Despite the decision, the commissioners commented that had the trustees been solely resident in Mauritius when the gains were made the treaty would have prevented UK capital gains tax becoming payable. The trust had originally been established for tax efficient purposes and had the settlor and his wife not continued to be actively involved in the trust, or, indeed, not been appointed as a trustees within the same tax year as the shares were sold, it appears, that the goal of the trust would have been fulfilled.

Sham trusts

The case of A v A and St George's Trustees Limited [2007] EWHC 99 (fam) followed hot on the heels of the Charman v Charman [2005] and CI Law Trustees & Folio Trust Company Limited v Minwalla [2005] cases regarding sham. As part of divorce proceedings the wife submitted that the husband had complete control of a number of trusts and treated shares within one of them as his own, thereby demonstrating that the trusts were a sham established only to put the shares out of reach of the husband's first wife during their divorce.

Mumby J found that the trust was not a sham and further ruled that provided that the original or subsequently appointed trustees were not party to the settlor's thought process when establishing the trust or party to any sham actions since the establishment, the trust would not be a sham. Mumby J referred to the cases of Shalson v Russo [2003], Thomas v Thomas [1995] and Charman and Minwalla and held that trustees had taken on the trusteeship and had administered the trust in a bona fide manner and, therefore, there was no sham. He further expressed dismay that the case in point 'probably should never have been brought' and it was symptomatic of the current trend for high value divorce proceedings to involve claims of sham. From an offshore trust prospective, this is certainly helpful but it remains to be seen whether this approach will be followed in future.

Letters of Wishes

Finally, Breakspear v Ackland [2008] All ER 260 involved three discretionary beneficiaries of a testamentary trust who sought an order for disclosure of a Letter of Wishes in order that they might better temper their expectations of the trust. The application was part of wider contentious probate proceedings following the death of the settlor.

Briggs J tried to balance the trustees' right to keep decision making confidential and the settlor's right to correspond with his trustees on the same basis with the need for transparency and the right of the beneficiaries' to hold the trustees accountable. Referring to Re Wilkes Charity (1851) and Re Londonderry Settlement [1965] Briggs J commented that 'the defining characteristic of a wish letter is that it contains material which the settlor desires that the trustees should take into account when exercising their. . . discretionary powers. It is therefore brought into existence for the sole purpose of serving and facilitating an inherently confidential process'. Accordingly, beneficiaries should not think that disclosure is their right and trustees should properly exercise their discretion as to whether to disclose a Letter of Wishes.