There are a significant number of foreigners resident in the UK, many of them are very affluent and able to take advantage of a favourable tax climate. Although the princ iples are relatively well known among specialist lawyers and accountant, the mechanics are often poorly understood by investment managers and trustees. Those who have a full understanding can offer a truly value-added service.
A UK-resident foreigner avoids UK income tax on income which is not from a UK or Republic of Ireland source and is not remitted to the UK (s65(4) Income and Corporation Taxes Act 1988).
To ensure that income is not remitted, it should be kept separate from any account used for remittance to the UK.
Once income and prin-cipal are mixed it is, in practice, impossible to separate them and, to make matters worse, the Inland Revenue takes the view that income from a mixed account is withdrawn first.
The rule for capital gains is different. Although UK-resident foreigners have a remittance basis (Section 12(1) Taxation of Chargeable Gains Act 1992) instead of remittances being treated as capital gain first and pure capital second, each remittance will be treated as proportionately capital and capital gain.
Therefore, to achieve maximum benefit for an individual investor we should construct a portfolio by using three separate custody accounts – a capital account, a growth acc ount and an income account.
As any capital gain will be deemed remitted on a proportionate basis, we can hold low capital gain investments in the capital account to create a low capital gain fund available for remittance to the UK.
Usually, these will be bonds as the bulk of their return will be in the form of income leaving only a small capital gain.
Equity investments will produce the highest long-term return, the bulk of which will be capital gain.
By holding the equities in the growth account, the bulk of the portfolio capital gains will be “trapped” here.
The growth account will initially be wholly equity but will gradually accumulate bonds as the portfolio grows and is periodically rebalanced to maintain the asset allocation. Otherwise, as equities have historically grown faster than bonds and the capital account may be depleted as bonds are sold to finance remittances to the UK, the equity proportion will rise and the portfolio take on more risk than desired.
The income account will hold all the income from the capital and growth accounts. This account can be used to fund portfolio management fees, living expenses outside of the UK and other nonUK expenses.
It is worth remembering there are two types of offshore mutual funds and their taxation characteristics are very different. In a distributor status fund, any gain realised on sale is viewed as a capital gain while in a “roll-up” fund the gain is treated as income.
To benefit from expected market developments, it will be necessary to rebalance the portfolio periodically. If the portfolio consists of individual securities, this will mean selling some individual securities and realising capital gains. This gives distributor funds two big advantages over individual securities:
1: Relief of trading losses
As offshore losses for non-domiciled UK residents are disallowed (Taxation of Char geable Gains Act 1992 s16(4)), the gains on individual sales cannot be netted against the losses. A fund can hold a similar selection of individual securities but the capital gain realised on its sale is derived from its net increase in value and therefore gives relief for these losses.
2: Taper relief
As distributor funds will re-balance within the funds, gains will be deferred until disposal of the individual funds themselves, therefore, they are more likely to be long-term gains reduced by taper relief than the case with individual stocks.
As the gain on the sale of a roll-up fund is income, the benefit of taper relief is unavailable. Additionally, the proceeds are deemed income and principal mixed together; so if the proceeds are placed into an account used for remittance to the UK, the gain will as income be deemed remitted first.
With a distributor status fund, the gain would be treated as remitted on a proportionate basis, thereby spreading the realisation of the tax liability over a period of time.
UK inheritance tax is a major problem for UK-resident foreigners as they may be deemed to acquire UK domicile for inheritance tax purposes and their offshore assets may therefore be taxable.
However, this may be avoided by placing their offshore assets in an offshore trust. Although the tax legislation for such a trust is more complicated than for an individual, for remittances made to the settlor the income tax consequences are effectively the same.
However, the situation regarding capital gains is very different. A UK-resident foreigner may effectively avoid paying capital gains tax on capital distributions received from an offshore trust.
Note how the gain on a distributor fund may be free of tax (being capital gain) but that of aroll-up fund being income would be taxable.
Clearly, the UK continues to attract wealthy foreigners by continuing to offer a substantially better tax climate than is available to British subjects. Despite the political friction this can cause, the ben efits accruing to the UK from this arrangement means it is highly likely to continue.
However, the legislation governing this climate will continue to change and evolve. Staying abreast of changes in the tax environment is crucial.