Promises, promises

"To end the speculation and uncertainty, and to provide stability, I confirm that I will be making no further changes to the taxation of non-domiciles in this parliament"

Chancellor of the Exchequer, George Osborne, 23 March 2011

When those of us who professionally advise non-domiciled UK resident individuals and their families heard this statement two years ago, following the announcement to increase the remittance basis charge to £50,000 for non-doms resident in the UK for 12 years, it promised a welcome pause to the ever-changing tax regime. How wrong we were?

A surprise announcement in the 2013 Budget will bring to an end a well-trodden and previously entirely legitimate path to inheritance tax (IHT) mitigation. This change has a particularly significant impact on the IHT strategy for non-doms, coming in conjunction with the introduction of the annual tax on enveloped dwellings and extended scope of capital gains tax (CGT).

It has been a long-established principle of inheritance tax that a debt owed by a taxpayer at the time of a taxable event (typically on death) is deducted from the value of the asset on which the debt is secured. Where the asset falls within the scope of IHT (typically for non-doms, UK real estate), a debt secured on that asset reduced its taxable value. This rule applied with little exception, even in cases where borrowed funds were used to invest in assets either outside the scope of or fully relieved from IHT.

For example, a non-dom releases equity from an otherwise unencumbered UK house through a mortgage and invests the borrowed funds offshore, in a 'back-to-back' arrangement with the lender - in this circumstance, the debt would previously have been deducted from the value of the UK property in calculating the UK IHT estate, while the offshore investment is 'excluded property' and therefore outside the charge for the tax.

It should be noted, based on the draft legislation issued in March, that a debt taken on to fund the initial acquisition of a UK residential property (or a subsequent remortgage without any equity release) appears to still be allowed for IHT purposes.

However, this regime will change on the date the Finance Bill receives royal assent (July). After this, the following rules will apply for non-doms and excluded assets:

• Where a liability secured on a UK asset is used to fund the acquisition of 'excluded property' (assets situated outside the UK, such as a non-UK bank account or foreign property), that liability will generally not be allowable for UK IHT purposes.

• There are limited circumstances where an element of the liability may be allowed, for example where the value of the foreign asset is less than the liability outstanding or where the foreign asset has been subsequently disposed of and any proceeds reinvested in a taxable asset.
  However, as expected, there are measures to prevent relief in cases where there has been an artificial manipulation of the value of the asset or debt or where the foreign asset has been disposed of for less than market value, such as by way of a gift.

• The draft legislation contains provisions to trace the use of funds where the acquisition of an asset is not directly funded by borrowed monies. These are designed to identify scenarios where the debt can be said to have indirectly financed the purchase but will undoubtedly lead to potential confusion in their application.

For those affected by the new high value residential property regime, these changes will significantly impact on their capacity to legitimately minimise their exposure to IHT.

For non-doms, it creates an urgent need to take advice. While the rationale for changing the rules governing relief of liabilities may be understandable, it is disappointing that the new rules are retroactive, in that they apply to both existing and new arrangements. This means that people may have incurred costs (including bank charges) by entering into a financing arrangement which, when implemented, was effective under the law at that time and was seen as non-controversial tax efficient estate planning.

While the proposed changes limit relief for debts, there are still circumstances where relief will continue, for example where an individual borrows against UK property and uses the funds to make a gift to their children and/or grandchildren. This may be an attractive strategy to retain ownership of the family home while giving away some of the equity in that.

Tom Elliott is managing director of Crowe Clark Whitehill, Mayfair