Update: tax and trusts

The taxpayer's appeal against the High Court decision in the case of Lyle Dicker Grace v Revenue & Customs Commissioners [2009] EWCA Civ 1082 was heard in the Court of Appeal in October.

In this case, a long haul pilot, Mr Grace, had been UK resident for tax purposes from 1986 to 1997. In August 1997, he rented a flat in Cape Town and later bought a house there. He retained his house near Gatwick Airport, but spent as much of his time as possible in South Africa and intended to retire there in the future. Mr Grace had to spend time in the UK to perform his contract of employment as a pilot. That involved staying in the UK for a few days before flights out of the UK, and also required him to be in the UK between inward and outward flights.

In the original appeal, the Special Commissioner decided that Mr Grace had become resident in South Africa and had ceased to be resident in the UK, despite retaining his house there. The Special Commissioner said that Mr Grace's time spent in the UK was only for a temporary purpose. That was relevant because section 336 ICTA 1988 (as then applied) provided that if a person is in the UK for less than six months (as Mr Grace was) and was only here for a temporary purpose, he would not be treated as UK resident.

HMRC appealed that decision to the High Court and won. The High Court decided that Mr Grace did not spend time in the UK for a temporary purpose and that he had not ceased to be UK resident.

The judgment of the Court of Appeal contains a useful summary of the law relating to UK residence and ordinary residence, which is contained mainly in case law. Numerous cases have a bearing upon Mr Grace's position, but the following principles are particularly relevant:

(a) All of the relevant facts need to be taken into account. Therefore, the existence of a house in another country needs to be considered, but is not decisive in determining the residence status of an individual because a person can be resident in more than one country at the same time in a single tax year.

(b) If a person is compelled to visit the UK to perform the duties of his employment, or if he resides in the UK against his will, the nature, length and regularity of his visits to the UK may still be sufficient to amount to residence (the Lysaght case).

The Court of Appeal found that the Special Commissioner had misdirected herself on the issue of Mr Grace being in the UK for a temporary purpose. The court tended towards a view that Mr Grace was UK resident, because he was in the UK for more than merely a temporary purpose, but thought that more than one result was possible, based upon all of the relevant facts. The ultimate decision as to whether Mr Grace was resident in the UK or not was not a decision which the Court of Appeal should make, but was a decision which needed to be made by the Special Commissioners after they had corrected themselves on the error in law.

The Court of Appeal therefore allowed the appeal by Mr Grace, but only so that the issue of residence could be remitted to the First-tier Tribunal (Tax Chamber) for reconsideration. Although the appellant, Mr Grace, was successful in having the case remitted to the First-tier Tribunal, he did not show that the Special Commissioner had not made an error, so costs were not awarded in favour of either party.

This case demonstrates the difficulty in establishing whether a person who has previously been resident in the UK has ceased to be so resident for tax purposes. The cases on which the law is based each turn on their own particular circumstances and, as Lloyd LJ said in this case, the previous decided cases 'illustrate a great variety of examples, and the result of one case cannot normally be used as a guide to how another should be decided, even if the two have some factors in common'.

This case is also a useful reminder of when a decision of the Special Commissioners (which has now become the First-tier Tribunal (Tax Chamber)) can be overturned. An appeal against such a decision can only be successful if either:

(a) the decision is one which 'no person acting judicially and properly instructed as to the relevant law could have come'; or

(b) the reasoning for the decision contains bad law, which affects the decision (from Edwards v Bairstow (1956)).

The question of residence on the facts of this case therefore remains to be decided by the First-tier Tribunal.

Employer funded retirement benefit schemes (EFRBS)

EFRBSs have been the subject of much discussion recently as a tax efficient way for a company to provide benefits to its directors and employees and their families without the restrictions associated with exempt approved pension schemes (known as registered pension schemes).

EFRBSs are similar to employee benefit trusts, in that a contribution is made by the employing company to trustees who have discretion in the way in which they can invest that contribution and in the way in which they can apply the invested funds for the benefit of employees or their families.

(a) Tax treatment

An EFRBS is not as tax efficient as a traditional registered pension scheme, under which the contribution by the company is not a benefit in kind and is deductable for corporation tax purposes and the pension fund grows in a tax exempt environment. However, the EFRBS is more tax efficient than simply paying benefits directly from the company to the employee, and additional tax benefits can be achieved by having non-UK resident trustees.

The contribution by the company to the trustees will not be deductable from the company's profit for corporation tax purposes (currently at the lower rate of 21 per cent and 22 per cent from 1 April 2010) unless and until an employee receives a taxable benefit from the trust. The contributions will not be subject to income tax on employees and will not attract national insurance contributions.

If the trustees are resident in the UK, the investment income received by them will be subject to UK income tax (currently at a rate of 40 per cent, but at a rate of 50 per cent from 6 April 2010) and any disposals of assets will be chargeable to capital gains tax (currently at 18 per cent, but widely expected to increase in the near future).

However, if the trustees are not UK resident, any gains can be realised free of UK capital gains tax (but will still be subject to UK income tax on UK source income).

So far as the employees are concerned, the value of the EFRBS fund will be outside of the estate of the employees or directors for inheritance tax purposes.

Payments out of the EFRBS to an employee will attract a charge to income tax on the employee, but no national insurance contribution charge will arise if the benefit which is paid is of the same type which a registered pension scheme is permitted to make and is paid after the employee's employment has ended. Other conditions also need to be met.

Some tax advisers believe that there is an error in the legislation which inadvertently allows a corporation tax deduction to be achieved on contributions by a company to an EFRBS, but the purpose of the legislation is clear and it is a high-risk strategy to create an EFRBS on the basis of the corporation tax deduction alone.

(b) Benefits payable to employees

Most benefits from an EFRBS are paid as a cash lump sum, but benefits may be paid as a pension or annual payment or as a non-cash benefit (for example, by the transfer of assets to an employee). Alternatively, the trustees may make loans to the employee, which will give rise to an income tax liability on the employee if the rate of interest is less than a commercial rate.

The trustees can, rather than actually paying benefits out to an employee, earmark the fund or a particular part of it for the benefit of a particular employee and his family without giving rise to an income tax charge.

(c) Investment

The trustees have greater flexibility than the trustees of a registered pension scheme and can essentially invest in whatever they wish, including shares in the sponsoring company or residential property.

(d) Lifetime allowance

The lifetime allowance which restricts the size of a pension fund will not apply to an EFRBS. The current lifetime allowance is £1.75m and will increase to £1.8m in 2010. The government has announced that the £1.8m limit will be frozen from 2010 to 2016.

Funds within an EFRBS can exceed that threshold and therefore such an arrangement may be appropriate as a supplementary pension arrangement, alongside a registered pension scheme.

(e) Associated companies

One of the additional benefits of an EFRBS is that it can establish and own shares in a separate UK company. That company will not be associated with the sponsoring company and therefore the threshold for the small companies rate of corporation tax (currently £300,000, below which corporation tax is payable at 21 per cent) will not be reduced. If two companies are associated, the corporation tax thresholds must be divided by the number of associated companies, so that a higher rate of corporation tax is payable by each company on a lower level of profit.

Treading carefully

EFRBSs are a useful way of extracting funds from a company without any income tax or national insurance charge on employees at that stage. However, when benefits are given to employees from the scheme, a tax liability on the employee will arise (as with a registered pension scheme) as well as the possibility of a capital gains tax charge arising.

Careful advice is required before implementing such an arrangement. The costs of establishing the scheme and the annual administration costs of the trustees can be high. In the right circumstances, an EFRBS can be useful in supplementing normal pension provision and providing a lump sum benefit to the family of an employee on his death (free of inheritance tax).