Editor: Anthony S. Bakale, CPA, MT
There have recently been some radical changes in the taxation of certain taxpayers in the United Kingdom. The purpose of this item is to explain the old rules, the new rules, and the perceived impact of these legislative changes on U.S. taxpayers living in the United Kingdom.
The extent of U.K. tax liability is determined by a person’s residence and domicile statuses. As a general rule, most U.K. nationals who are resident and domiciled in the United Kingdom will be subject to U.K. tax on their worldwide income, similar to the situation of a U.S. citizen or permanent resident in the United States. Double tax relief is generally provided via a foreign tax credit, also similar to the United States. However, under the pre–April 6, 2008, rules, individuals who were U.K. residents but not ordinarily resident or not domiciled in the United Kingdom were not taxed on their worldwide income in the United Kingdom. Instead, those persons were able to benefit from the remittance basis of taxation in the United Kingdom. Under the remittance basis, the foreign-source income of such residents is subject to U.K. tax only if it is remitted to the United Kingdom.
For tax years beginning on April 6, 2008, under §809 of the 2008 Finance Bill, a major change has been made to the remittance basis taxation system. Under the new rules, to use the remittance basis system, certain long-term residents of the United Kingdom who are not ordinarily resident and/or domiciled in the United Kingdom will be required to pay a £30,000 charge in addition to any tax due on U.K. income and gains or foreign income and gains remitted to the United Kingdom.
In order to determine how a taxpayer will be treated for tax purposes in the United Kingdom, it is necessary to understand U.S. and U.K. residency rules. From a U.S. perspective, the residency rules are statutorily defined and consist of a substantial presence test and a “green card” test (Sec. 7701(b)). In comparison, the United Kingdom uses the concepts of “resident” and “ordinarily resident.” There is no full statutory definition or technical meaning of these terms, although there are certain statutory provisions that apply in limited circumstances.
Guidance on residency can be gleaned from case law and HM Revenue and Customs (HMRC) practice booklet IR20, Residents and Non-Residents: Liability to Tax in the United Kingdom (April 2008). Residency is a question of fact, not intention. In general, if an individual is in the United Kingdom for 183 days during the tax year, that individual will be considered a U.K. resident. Before April 6, 2008, the days of arrival and departure were ignored. After April 5, 2008, any day the individual is present in the United Kingdom at midnight will be counted as a day of presence for residence test purposes (HMRC, 2008 Budget Note 102 (3/12/08)).
Can an individual still be resident in the United Kingdom if he or she does not spend 183 days in the country in a tax year? The answer is yes—but under what circumstances? If a person intended to spend on average at least 91 days per tax year over a four-year period in the United Kingdom, that person would be considered resident from April 6 of the first year he or she arrived or April 6 of the tax year that his or her intentions changed to meet the 91-day test (IR20 at ¶3.3). If an individual did not intend to spend this amount of time in the United Kingdom but in reality did—i.e., averaged 91 days or more per year over a four-year period—that person would become a U.K. resident beginning on April 6 of the fifth tax year he or she was in the country.
Resident or Ordinary Resident?
If someone is resident, is he or she ordinarily resident? Not necessarily. An individual can be resident without being ordinarily resident or vice versa. “Ordinary residence” is broadly equivalent to habitual residence. So, for example, if P normally lives in the United Kingdom but decides to travel around the world for an entire tax year (e.g., April 6, 2007–April 5, 2008) before returning to the United Kingdom, P will be a nonresident for the 2007–8 tax year but will remain ordinarily resident. For employees coming to the United Kingdom on temporary assignments, if it is obvious that they intend to stay for at least three years, they will be ordinarily resident from the date of arrival.
Some evidence that indicates an individual’s intention to stay for three years includes purchasing a home or signing a lease agreement for at least three years. But if an individual signs a two-year lease (with the intention of returning to his or her home country after that), then at the beginning of year 3 buys an apartment, that person becomes ordinarily resident from April 6 in the tax year of the apartment purchase. If the individual signs a one-year lease every year, will he or she then avoid becoming ordinarily resident? Possibly, but the individual will become ordinarily resident from April 6 of the tax year after the third anniversary of the date of arrival in the United Kingdom (IR20 at ¶3.9).
The concept of domicile is more important than ordinary residence in terms of the effect it has on an individual’s U.K. tax liability. There are three types of domicile (IR20 at ¶¶4.3–4.5):
- Domicile of origin (which usually is acquired at birth based on the father’s domicile);
- Domicile of dependency (a child will have a domicile of dependency until he or she is legally capable of changing it on reaching the age of 16); or
- Domicile of choice (to lose one’s U.K. domicile of origin, the individual would have to sever all ties with the United Kingdom and settle permanently in another country).
Although it is possible to be resident in more than one country at the same time, an individual can have only one domicile. Therefore, most U.S. citizens who come to work in the United Kingdom on a short-term basis are not domiciled in the United Kingdom.
What Constitutes a U.K. Remittance?
The definition of “remittance” is an amount of money “paid, used or enjoyed” in the United Kingdom or an amount “transmitted to or brought to” the United Kingdom (Income Tax (Earnings and Pensions) Act, 2003, c. 1, §33(2))—e.g., a transfer of money from a U.S. bank account to a U.K. bank account is considered a remittance. After April 5, 2008, any money, property, and services brought into the United Kingdom will be deemed to be remittances and subject to U.K. tax. There are some exemptions—e.g., personal items costing less than £1,000. (See HMRC, 2008 Budget Note 104, for more details.)
Note: Payment made on a U.K. credit card used to purchase goods or services in the United Kingdom from a U.S. bank account is deemed to be a remittance.
Efficient Tax Planning Under the Pre–April 6 Rules
Under the old rules, there were several tax-efficient ways to remit funds to the United Kingdom without triggering a U.K. tax liability. One of the most common was that before a U.S. citizen came to the United Kingdom, he or she would set up a capital and an interest bank account so that all the interest earned on the capital account would be credited to the interest account. The U.S. citizen would only take money out of the capital sum account, thereby resulting in no tax liability on the remittance in the United Kingdom. However, if no separate account was set up for interest, the U.K. tax authorities deemed any monies paid out to first be from the income earned and thus subject to tax in the United Kingdom.
Tax Planning After April 6, 2008
Effective for the 2008–9 tax year and onward, individuals who have been resident in the United Kingdom for at least seven of the previous nine tax years prior to the 2008–9 tax year but were either not domiciled or not ordinarily resident in the United Kingdom will be taxed on their worldwide income unless they pay a £30,000 tax charge to remain on a remittance basis (2008 Finance Bill, §809G). (Note that there is a lookback provision that counts years prior to the new legislation toward the seven-out-of-nine-year test.) This £30,000 charge is in addition to the tax liability for the year on any income or gain remitted to the United Kingdom.
Individuals may elect in and out of the remittance basis instead of being taxed on worldwide income on a tax-year-by-tax-year basis.
Under the new remittance basis rules, a U.S. citizen resident in the United Kingdom is eligible for neither a personal allowance nor a capital gain annual exemption. Individuals are eligible for those exemptions only if they are taxed in the United Kingdom on their worldwide income. However, there is a safe harbor that allows a U.S. citizen who is resident (but not domiciled) in the United Kingdom and has unremitted foreign income and gains of less than £2,000 a year to be eligible for a personal allowance and an annual exemption for capital gain tax purposes (2008 Finance Bill, §809C).
Is the U.K. Tax Charge Creditable in the United States?
Under draft legislation published on January 18, 2008, it appeared that the £30,000 charge/tax would not have been a creditable tax under the U.S.-U.K. income tax treaty. Following protests, the HMRC announced that “the £30,000 charge will be an income tax or capital gains tax and should be treated as such for the purposes of Double Taxation Agreements” (HMRC, 2008 Budget Note 107, ¶10). However, since treaties are bilateral, both parties must agree to the HMRC’s interpretation. There are ongoing discussions between the U.S. and U.K. governments as to how this charge/tax will be dealt with under the treaty.
U.K.-U.S. Tax Issues and Considerations
Unlike many countries, the United States taxes on a citizenship basis, and U.S. tax treaties have a “savings” clause in them. In effect that means U.S. citizens are always subject to U.S. tax on their worldwide income even if they are resident in another country. Assuming the IRS agrees that the £30,000 charge is a creditable tax, the U.S. foreign tax credit is limited to the amount of U.S. taxes imposed on foreign-source income. The highest U.S. federal income tax rate on ordinary income is 35%, and the highest rate for capital gains and qualified dividends is 15%, compared with U.K. tax rates of 40% and 18%, respectively.
There are likely to be scenarios in which there will be “wasted” foreign tax credits (i.e., U.S. tax imposed on foreign-source income is substantially less than the foreign taxes paid on such income). In effect, the worldwide effective tax rate for a U.S. citizen resident in the United Kingdom will be higher than if he or she were a resident of only the United States. This means that for U.S. employers providing tax equalization to their foreign-stationed employees, it will cost more to send those employees to the United Kingdom on long-term assignments.
Another factor to consider is that the United States has a calendar tax year for individuals, whereas the United Kingdom’s tax year runs from April 6 to April 5, so there may be a matching issue for reporting income and claiming foreign tax credits on a cash basis. In addition, because of how the new U.K. rules have been drafted, tax paid on U.S. source income that a taxpayer has elected to tax on a remitted-to-the-U.K. basis will be netted against the £30,000 tax charge to reduce the U.K. tax charge. Under the U.K.-U.S. income tax treaty, in this situation certain types of income would be deemed to be re-sourced as U.K. sourced income. Thus, when U.S. citizens file their U.S. tax returns, their foreign-source income would be increased to allow them to take a foreign tax credit on their U.S. tax returns.
However, some forms of income—e.g., business profits attributable to a U.S. permanent establishment—will not be re-sourced and therefore reduce the foreign-source income base on which the foreign tax credit is calculated, even though this income is subjected to tax in the United Kingdom. So taxpayers should be careful about which sources of U.S. income they elect to have taxed on a remitted income basis in the United Kingdom to minimize the possibility of “wasted” foreign tax credits.
Final Sting in the Tail
If §809G of the 2008 Finance Bill receives Royal Assent as written and is interpreted literally, U.S. taxes paid on U.S.-source remitted income could be netted against the £30,000 tax charge. However, to the extent that the £30,000 charge is reduced, §809G reinstates this reduction, in effect ensuring that the £30,000 charge is paid in full. For example, assuming the income that is remitted has the equivalent of £10,000 of U.S. tax attached to it, the £30,000 tax charge is reduced to £20,000, but the £10,000 is then reinstated; thus, the U.S. citizen electing the remittance basis of U.K. taxation is going to pay the full £30,000. Obviously, this is not advantageous from an international tax relationship perspective, so it will be interesting to see where the dust settles and what is the final interpretation of the new section.
U.S. citizens and long-term residents of the United Kingdom need to be aware of the new and evolving rules. Those citizens’ worldwide tax bills could increase significantly unless they understand the new rules and take whatever steps possible to mitigate the situation.
Anthony S. Bakale is with Cohen & Company, Ltd. Baker Tilly International in Cleveland, OH
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
If you would like additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.