What price the  ‘Special Relationship’?

  • Author : Graeme Privett
  • Date : January 2009
ABOUT THE AUTHOR Graeme Privett TEP is a Personal Tax Manager at Frank Hirth & Co LLP

T he US is unique amongst the developed countries insofar as it imposes worldwide taxation on its citizens, residents and ‘green card’ holders (collectively ‘US taxpayers’), irrespective of their actual residence and physical presence in the US. For such a US taxpayer resident in the UK, this presents many challenges, even where they may, in theory, be entitled to a foreign tax credit (FTC) in the US against their US liabilities for UK tax paid on the same income or gains.1

Prior to 6 April 2008, the UK would tax US taxpayers resident in the UK on their UK source income and capital gains, as well as on remittances of non-UK income and capital gains. Where remittances were made to the UK, then the US taxpayer could generally take credit for US tax paid on US source income, and may have been able to take credit for US tax paid on ‘third country’ income received in the UK with a liberal interpretation of the US/UK Treaty situs deeming rules. As such, despite the unique taxation position, it was still possible for US taxpayers to compartmentalise their affairs, especially if neither non-UK source income nor gains were required in the UK.

Under Schedule 7, Finance Act 2008, from 6 April 2008, adult non-UK domiciliaries who have been UK resident for seven of the previous nine tax years who wish to continue to be taxed on the remittance basis will have to pay an additional charge of GBP30,000 per annum. In the final legislation, the taxpayer will now nominate some (or all) of their foreign income or capital gains, so that the tax increase is not more than GBP30,000. If the nomination of overseas income or gains is not sufficient so as to create a tax charge of GBP30,000, then the Revenue will ‘top up’ by treating the taxpayer as having nominated enough extra income to make up the shortfall.

It became apparent following the initial framing of the charge that the US would not readily allow a foreign tax credit for the GBP30,000 and once reframed, a legal opinion was sought from the US law firm as to whether the Remittance Basis Minimum Charge (RBMC) would qualify as creditable under section 901 et seq. of the US Treasury Regulations. Whilst their opinion, which was appended to Budget Note 107, concluded the RBMC was creditable, it was conceded that as the UK has a higher top rate of income and capital gains tax, a proportion of the RBMC would, in many cases, not be credited, but added to an ever increasing pot of excess FTCs. To date, the Internal Revenue Service (IRS) has not commented on whether they feel that the RBMC is allowable. It would be hoped that IRS guidance will be forthcoming in time for the 2008 calendar year US tax return filing season. However, there continues to be significant tension between the current ‘remittance based’ foreign tax credit rules in the 2001 UK/US Treaty, and the likely switch by a number of UK resident US taxpayers to an ‘arising basis’ where they choose not to pay the GBP30,000 charge. A specific issue will be the IRS attitude to the ‘nomination’ process, as it is not at all clear that where a UK resident US taxpayer who does not have sufficient offshore income to ‘frank’ the GBP30,000 charge, but does so for other reasons, whether the excess ‘tax’ will be creditable in the US. Particular care will need to be had to the nomination to ensure that sufficient income and gains are actually nominated to result in a tax charge as close to the GBP30,000 as possible.

Given their position, it is very likely that the majority of US taxpayers with unremitted income and gains over the de minimis level will simply elect to be taxed on a worldwide basis. Due to their unique position, it would not be a surprise if the majority of non-doms electing to be taxed on their worldwide income were, in fact, US taxpayers as compared to non-domiciliaries from other jurisdictions. The reason for this is that the simple economic benefit of retaining the remittance basis will be so much less for them as they will be one of the few groups of foreign domiciliaries having to pay tax in their home country at up to 35 per cent on income and 15 per cent on long-term capital gains on their non-UK source income and gains.

Therefore, for US taxpayers resident in the UK and now taxable here on an arising basis, the 2001 US/UK Double Tax Treaty will play a more important part when considering their tax position in both the UK and US. Typically, UK source income and gains will be taxed in the UK with a FTC for the US tax return, though, as explained above, often the UK tax is higher than the US liability so the excess is carried forward. The IRS will tax US source dividends at 15 per cent, which will be available as a credit in the UK against the higher rate tax charge of 32.5 per cent. Under Articles 11 and 12 of the Treaty, US source interest and royalties respectively will first be taxed in the UK with credit in the US for the UK tax paid under the US ‘re-sourcing’ FTC rules. Gains made on US real property will still be taxed in the US, typically at the longer-term rate of 15 per cent, which will be available for credit in the UK. Due to the impact of the US/UK Treaty ‘savings clause’, US citizens and residents who are resident in the UK are typically taxed in the US as though the Treaty did not exist, subject to very limited relief primarily in the pensions area. Rather, the individual is left to cross credit the tax paid in each jurisdiction and hope that the net result is the higher of the two taxes, and not double taxation.

In this regard, there are a several issues that arise. Exchange rate differences will mean the cross credit will never be a straight 18 per cent or 15 per cent of the amount subject to tax in the other place for capital tax purposes. The UK view of the world may create an ‘income gain’ subject to tax at up to 40 per cent, such as is the case with most US domestic mutual funds, for example, which the US may tax at only a 15 per cent rate. The US may well consider a gain that is exempt in the UK to be fully taxable in the US, and the prime example here is 100 per cent relief for the gain on the sale of a UK principal residence, whereas the US may only relieve the first USD250,000 or USD500,000 of gain depending in the filing status of the US taxpayer.

US grantor trusts

The creation of a US or foreign grantor trust represents typical estate tax planning for US taxpayers, although care does need to be taken to ensure there are no UK tax issues for the UK resident US taxpayer. The creation of the grantor trust does not generally trigger a US tax charge and is broadly tax neutral as the income and gains are still assessed on the grantor. Unless the trust is specifically designed to be a completed gift for the purposes of US estate tax, the assets of the grantor trust remain liable to estate tax as if they were still owned personally, and subject to the particular laws of the US State in which the grantor is domiciled, typically there is no requirement for the trust’s assets to pass through probate. In this regard, on a simplistic level the grantor trust does bear many of the hallmarks of UK settlor interested trusts.

The US positively encourages trustees of a foreign non-grantor trust to operate a full distribution policy with the adoption of a 65 day election

Where a US taxpayer resident in the UK has settled such a trust, they will need to consider the UK income and capital gains tax consequences of the trust income and gains. As the grantor is interested in the trust, then the non-UK income will be treated as part of their worldwide income and should be factored in when considering whether to pay the GBP30,000 charge. The grantor will automatically be assessed on UK source income under section 720, Income Tax Act (ITA) 2007 regardless of whether they receive any distribution. If the non-UK income is not taxed on the grantor in the UK it can be taxed on him if distributed to him either as income or if he receives (or is entitled to receive) a capital sum. This still creates a problem as if the income is not taxed on the grantor in the UK, it will fall into the pool of income to be accounted for under section 731, ITA 2007. The US tax can be reimbursed to the grantor without an issue, though it would only appear to reduce the pool of relevant income.

From a capital gains tax perspective, things are markedly simpler. The exemption for non-UK domiciliaries from the anti-avoidance provisions in section 86 Taxation of Chargeable Gains Act (TCGA) 1992, which taxes gains realised by non-UK trusts on a UK resident settlor prevail. Happily, non-UK domiciled settlors are not chargeable to tax regardless of whether they choose to be remittance basis users. Therefore, all gains made by non-UK trusts (including those made on UK situs assets) will fall into the deferred gains pool under section 87 TCGA 1992, which is covered below.

Domestic (US) and foreign (non-US) non-grantor trusts and their beneficiaries

When the grantor has died, then the trust will be taxed as a separate person for US tax purposes. If the trust is a US trust, the trust itself pays tax on income and gains and receives a distribution deduction for amounts paid out to beneficiaries, who are taxed again on the receipt of an income distribution. If the trust is a foreign trust, it is taxed as a non-resident alien in the US and US taxpayers receiving distributions from the trust will be taxed on the basis of the distributions of income and gains received. There are penal charges that make the rolling up of income and gains within a foreign non-grantor trust very unattractive. When payments are made out of a foreign non-grantor trust, it is matched to current income first before accumulated income. Therefore, where there has been an accumulation in the foreign non-grantor trust, the rates can be so penal so as to make the distribution effectively taxed at 100 per cent.

In this regard, the US tax system positively encourages trustees of a foreign non-grantor trust to operate a full distribution policy with the adoption of a ‘65 day election’. This allows the trustees to calculate income and capital gains arising in the trust shortly after the year end and as long as these are paid out to the beneficiary within the first 65 days following the close of the calendar year, then they elect to have the distribution treated as if it were made in the previous tax year.

The UK treatment is not wholly dissimilar to the US, though there are some notable differences. In the UK, accumulations of income and gains are pooled under the mechanisms of section 721, ITA 2007 and section 87, TCGA 1992 with provision to match firstly income and then gains to distributions or benefits from the trust to beneficiaries. We do have a penalty regime, though this only applies to distributions matched to capital gains made in the tax year before last. However, with the reduction of the headline rate of capital gains tax, the charge at its highest will now be 28.8 per cent.

For the US taxpayer, the receipt of a distribution or a benefit from the trust would be assessable to UK tax unless they were claiming the remittance basis of taxation and the distribution or benefit was received offshore. Where the US person pays tax on the arising basis in the UK and they have received income from the trust, then they will pay tax on that distribution at their highest marginal rate in either jurisdiction, which is likely to be the 40 per cent rate in the UK.

Section 87 – credit crunch?

As it has been noted, the rolling up of income and capital gains in a non-grantor trust is not desirable from a US perspective, so often trustees will avoid this. Therefore, it is conceivable that the trustees will pay out the income and ‘something’ more. From a UK perspective, this ‘something’ could well be capital gains matched under section 87, TCGA 1992.

Although it has been noted above that section 86, TCGA 1992 was not extended to non-UK domiciled individuals, the US will still tax the grantor on gains realised in a grantor trust. When the gain is chargeable in the UK on the beneficiary, there are difficulties in claiming a credit in the UK for any US tax paid (for example, by the grantor or in the case of a non-grantor trust, on the realisation of capital gains by a non-grantor trust) as the UK will typically consider the income and the distribution to be ‘unmatched’. Any UK tax paid will fall back into the various pools of foreign tax available for credit in the US, and the US taxpayer is left with the ‘resourcing’ provisions of the UK/US Treaty to provide any relief. This now leaves the same gain open to double taxation. For example on the disposal of US real estate by a US trust, where the trust makes a USD100 gain, the grantor or trustees could typically pay USD15 US tax. The net USD85 would then be distributed and potentially subject to tax in the UK under section 87 TCGA 1992, creating a further tax charge of USD15.30. Therefore, using this simple example, the tax rate is just over 30 per cent if the rebasing election is not considered.A solution to the credit matching may be available in limited circumstances whereby the trust is imported to the UK. If, for example, the trustees are going to be subject to US taxes on the disposal of a significant asset, say a US property, then by importing the trust to the UK, the trustees would be able to take advantage of the US tax credit of 15 per cent on longer-term gains in the UK2. To do this, one must be careful not to offend the US rules so as to export the trust from the scope of US tax, though ensure that the trust is resident in the UK under the new unified rules introduced in Finance Act 2006. This can be achieved by the retirement of the existing trustees for an appointment of a US person resident in the UK as trustee. This works best when the intention is to wind up the trust shortly after realisation of the asset and does avoid a double tax charge.

However, as both the above example and the article as a whole demonstrates, the new rules in Finance Act 2008 will provide particular issues for US taxpayers resident in the UK. Given that the US/UK Treaty is due its five-year review by the US and UK Treaty negotiators, one can only hope that both sides reach a sensible agreement on some of these issues, but given past performance, that may take some time.

To obtain credit in the US and avoid a mis-match, it is common for US persons to settle their balancing payment in the UK by 31 December preceding. The US does permit the matching credits on an accruals basis.
The right for individual States to charge taxes on the disposal of real property has not been considered here.

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