TAX: PRIVATE CLIENT: An Introduction

Introduction 

This article discusses two issues arising in connection with the protected foreign source income (PFSI) regime, enacted in 2017 in conjunction with the introduction of new rules deeming certain individuals to be domiciled in the UK.

Suppose that P, a UK resident individual, is the settlor and a beneficiary of an offshore settlement, and income arises to the non-UK resident trustees or to underlying non-UK resident companies. Under Section 721 of the Income Tax Act 2007 (ITA 2007), that income may be deemed to be P’s income, even if she does not receive any benefits from the trust.

But if P has a non-UK domicile of origin and has not acquired a UK domicile of choice, until the enactment of the new deemed UK domicile rules in 2017, P could claim the remittance basis of taxation, so as not to be taxable in respect of unremitted foreign-source income.

But the effect of the new deemed UK domicile rules is that if P has been UK resident for at least 15 out of the past 20 tax years, she is deemed to be UK domiciled, and therefore she can no longer claim the remittance basis. The PFSI regime was introduced at the same time. Provided that P made the settlement before she became deemed UK domiciled, Section 721 does not apply to income which if it were P’s would be “relevant foreign income” as defined by Section 830 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005), with the result that P is not taxable under Section 721 in respect of such income, even after she becomes deemed UK domiciled, and so she can only be taxable under Section 732 of the ITA 2007, that is, if she receives benefits from the settlement.

Tainting 

The first issue I want to discuss in connection with the PFSI regime concerns the fact that the regime ceases to operate if the settlement is “tainted”, that is, if “property or income is provided directly or indirectly for the purposes of the settlement” by P or by the trustees of any other settlement of which P is a beneficiary or settlor, at a time when P is domiciled or deemed domiciled in the UK – Section 721A(3)(e) and (4)(g). For certain tax purposes, the concept of property being “provided for the purposes of a settlement” is regarded as importing an element of bounty, that is, gratuitous intent – see, for example, Jones v Garnett. But does that meaning apply in the present context?

Arguably not, given that Section 721B tells us that for the purposes of Section 721A(3)(e) and (4)(g) we must ignore “property or income provided under a transaction, other than a loan, where the transaction is entered into on arm’s length terms”, and also “property or income provided, otherwise than under a loan, without any intention by the person providing it to confer a gratuitous benefit on any person”. Arguably, these provisions indicate that property can be “provided” even though the transaction is on arm’s length terms and even though there is no gratuitous intent. If that is right, then it would appear to follow that the word “provided” in this context simply means supplied, irrespective of the terms of supply or the supplier’s intention.

Although Section 721B also tells us to ignore the principal of a loan which is made to the trustees of the settlement on arm’s length terms, there is no equivalent exception for a loan made to an underlying company. Arguably, therefore, if P makes a loan to an underlying company, she has necessarily provided property or income directly or indirectly for the purposes of the settlement, and accordingly has tainted the settlement, even though the loan is on arm’s length terms and there is no gratuitous intent.

A tribunal or court may be reluctant to accept that argument. After all, the PFSI legislation must be construed purposively, and it is difficult to see why Parliament would have intended that the settlement should be tainted when P makes a loan to an underlying company on arm’s length terms, given that it is not tainted when P makes a loan on precisely the same terms to the trustees of the settlement.

An alternative argument is that Section 721B merely requires certain specified transactions to be ignored, without casting light on the interpretation of Section 721A(3)(e) and (4)(g). According to that argument, the making of a loan by P does not necessarily involve property being “provided…for the purposes of the settlement”, and in particular the making of a loan to an underlying company will not taint the settlement if it is on arm’s length terms and does not otherwise involve any gratuitous intent.

In any event, if P is, or will shortly become, deemed UK domiciled, it would be prudent to ensure that there is an “umbrella agreement” in place between the trustees of the settlement and all underlying companies on the one hand, and P and the trustees of all other settlements of which P is a settlor or beneficiary on the other, so as to govern all dealings and other legal relations between them, whether formal or informal, so that they are automatically on arm’s length terms and therefore minimise the risk of the settlement becoming accidentally tainted.

Suppose, for example, that by virtue of Section 624 of the ITTOIA 2005 P is liable to income tax in respect of UK source income arising to the trustees of the settlement; if P pays the income tax then under Section 646 she is entitled to recover an amount equal to the tax paid from the trustees. In the absence of an umbrella agreement, P’s omission to recover the debt may cause the settlement to be tainted; but if there is an umbrella agreement in place, the debt will carry compound interest at a commercial rate and therefore there should be no tainting.

Offshore Income Gains 

The second issue I wish to discuss is whether the PFSI regime applies to offshore income gains (OIGs), that is, capital gains which arise from the disposal of an interest in a “non-reporting” offshore fund and which are deemed to be income by the Offshore Funds (Tax) Regulations 2009 (the “OFT Regs”). HMRC’s published view is that if P is deemed UK domiciled the PFSI regime does not apply to OIGs arising to the trustees of the settlement or to underlying companies, because if the OIGs were P’s income they would not be her “relevant foreign income” as defined by Section 830 of the ITTOIA 2005. If HMRC are right, then once P becomes deemed UK domiciled she will be liable to income tax under Section 720 of the ITA 2007 in respect of such OIGs, even if she receives no benefits from the settlement. In my view, however, HMRC are wrong, because the OIGs would be P’s “relevant foreign income” as defined by Section 830.

That is, Section 830(1) defines “relevant foreign income” as income which (i) arises from a source outside the UK, and (ii) is chargeable under any of the provisions specified in Section 830(2).

Condition (ii) is clearly met, because Section 830(2)(o) specifies income chargeable under Chapter 8 of Part 5 of the ITTOIA, and by virtue of Regulation 18 of the OFT Regs OIGs are charged to income tax under Chapter 8 of Part 5.

As for condition (i), following the recent decision of the Court of Appeal in Bluecrest v HMRC, it is now clear that in order for income to be charged under Chapter 8 of Part 5 it must have a source. In my view, by treating OIGs as income charged under Chapter 8 of Part 5, Regulation 18 also treats the OIGs as having a source.

The fact that OIGs are only “treated” as income does not mean they cannot have a source. On the contrary, Section 830 recognises that deemed income can have a source. See for example Section 830(2)(i), which applies to the capital proceeds of foreign dividend coupons which are “treated” as income by Chapter 13 of Part 4 of the ITTOIA.

As for whether the source of the OIGs is outside the UK, that is a question of fact in each case. But it is reasonable to suppose that the source of OIGs is the offshore fund in question, and if that fund consists of non-UK assets the source of the OIGs is likely to be outside the UK.

This analysis is consistent with Section 830(4)(aa) of the ITTOIA, which directs one to Regulation 19 for the treatment of “other income” as relevant foreign income. Regulation 19 provides that OIGs arising to a non-UK domiciled individual are “treated” as relevant foreign income. In other words, Regulation 19 deems a non-UK domiciled individual’s OIGs to be relevant foreign income without needing to show that they arise from a source outside the UK. That treatment is consistent with OIGs arising to a deemed UK domiciled individual also being relevant foreign income where they can be shown to arise from a source outside the UK.