The overriding theme of the conference is commerciality. Nowadays, unless a structure demonstrates a clear business purpose for its existence, no amount of clever planning will remove it from the sword of Damocles in the form of a tax investigation. This is the topic that I am exploring in this month’s article “The Offshore Nightmare”, which in fact I wrote nearly 20 years ago. Entrepreneurial clients have always been the lifeblood of IFS’ practice, and have provided me with practical illustrations of why planning their business ventures at the outset is an invaluable asset for their future sanity. Mr Washington in the article below rues the day he took advice from Bodgit & Scarper.

With kind regards

Roy Saunders

THE OFFSHORE NIGHTMARE

How many times has a Special Office Tax Inspector gleefully exclaimed “Oh what a tangled web we weave …” whilst the tax practitioner defensively declares “Well, the best laid plans of mice and men …”. At IFS Consultants, we are not mice afraid to assist clients imaginatively in creating sound commercial structures which have tax mitigation as one of their objectives, but our forty five years of experience purely in international tax planning have demonstrated time and again that arachnidan structures are best studied by anthropologists than tax planners. This comic strip is designed to highlight some of the problems that can be encountered with a very common ‘offshore’ structure involving a Trust, a holding company and a tax haven company. The fictional characters are exactly that but I wonder whether readers recognise anybody!

The ‘offshore’ structure

George Washington had for a long time been known as a maverick inventor within the food and beverage industry and had after many years invented the unique ‘onion glasses’ so that there will “no longer be tears before mealtimes”. He had sought the advice from ‘Bodgit & Scarper’ as to how he could best exploit this invention with as little tax exposure as possible.

The Washington Family Settlement was formed in 1994 on the advice of Arthur Bodgit, the settlor being Mrs Golightly who is an elderly spinster friend of the Washington family who now resides in Monaco. Although Mr Washington is not named as the settlor, he did arrange with the trustees, B&S Trustees Ltd of Jersey, for the rights to the patent for the onion glasses to be registered in the name of a British Virgin Islands company, Dry Eyes Inc. However, in order to allow Mr Washington some degree of control over the trustees’ actions, Mr Washington was named as the Protector and has also presented to the trustees a Letter of Wishes to be acted on in the event of his death.

Having successfully exploited the Dry Eyes Onion Glasses at home, Mr Washington sought advice as to a suitable corporate structure for overseas sales. Eventually, he accepted that the Trustees would transfer the shares of Dry Eyes Inc to a Netherlands Antilles company which would then further transfer the shares to a Dutch company. The Dutch company would then form subsidiaries in various high tax jurisdictions which would be licensed by the BVI company Dry Eyes Inc to sell the glasses subject to a substantial royalty payment which would reduce taxable profits. Thus the Washington Family Trust would own Dry Eyes Corporation NV of the Antilles which in turn would own Dry Eyes Holdings BV in Holland. The Dutch company would own Dry Eyes Inc of the BVI owning the rights, as well as subsidiaries in several European countries and the US.

Mr Washington has now sought the assistance of Maurice Brightman at IFS to comment on the structure in place.

The Trust

MB “The first thing to consider here Mr Washington is the fact that the trust was formed in 1994 and as such, if you are considered the settlor, any capital gains which arise in the trust or any underlying subsidiary, say from the sale of the shares in the BVI company, will be liable to tax in the beneficiaries hands. I suspect that Bodgit did not inform you of this?”

GW “Quite right Mr Brightman, but you see, I’m not the settlor, Mrs Golightly is” George said with a satisfied smile.

MB “Well, let’s look at the facts. Mrs Golightly did indeed pay the £100 settled sum for the Trust’s initial funds, but you allowed very valuable rights to vest in a subsidiary company of the Trust, so creating the opportunity for the Trust to make significant profits. You would therefore be regarded as the ‘deemed’ settlor. I expect Mr Bodgit didn’t explain this to you ”.

GW “No he didn’t”, as a worried expression crossed George’s face.

MB “Moreover, the tax authorities may assess you on the value of the rights transferred to Dry Eyes Inc, since there is no doubt that you made a disposal for capital gains tax purposes. Can I get you a stiff drink Mr Washington?”

On hearing this news Mr Washington lets out a gasp and turns a shade of grey Maurice had never seen before, letting out expletives that are best left unprinted. Mr Washington accepts the offer and decides to have a whiskey and water; after all it is late morning already.

GW “Carry on Maurice” Mr Washington prompts after letting the first mouthful of whiskey warm his throat, “I’m sure this is not the only bad news you have for me this afternoon.”

MB “Well, assuming that you are the deemed settlor, and because you have not been specifically excluded as a beneficiary of the trust, the entire income of the trust is taxed in your hands on an arising basis. Moreover, this extends to income of an underlying company, such as Dry Eyes Inc, even though the income left in the other subsidiaries may be protected under relevant double tax treaty arrangements. The anti-avoidance provisions, which are designed to stop taxpayers like you from avoiding tax through the creation of offshore trusts, have caught you. I also see that you have been named as a Protector to the trust which is fine, but I recall you told me that you have been sending instructions to the trustees for the last 3 years and they have been complying with these instructions without comment. This is interesting because there has been quite a lot of case law recently which tends to suggest that an over-zealous Protector could indeed assume the responsibilities shouldered by trustees, and in fact become a “quasi trustee”. Thus the management of the trust could be said to be taking place where you are resident, bringing the trust under the remit of domestic tax law.”

GW “Is there anything else you want to scare me with now or is that it for the Trust”, said Mr Washington now in a very disgruntled mood.

MB “Probably if I look more closely at the trust deed, which appears amazingly short at three pages, but now let’s move on to the BVI company”

The BVI company

Maurice then takes a sip of iced water and looks through some notes he made before meeting Mr Washington.

MB “This company seems to have been formed properly, however I see that Mr Rossi and Mr Bianco are the two directors, and they are resident in Lugano, Switzerland. Are you familiar with the tax concept of management and control?”

Mr Washington looks blankly at Maurice, indication enough that this basic rule is unfamiliar to Mr Washington and enough reason for Maurice to continue.

MB “Management and control is the test for a company’s residence, and although a company may well be incorporated in the British Virgin Islands, if the day-to-day management of the company is exercised by directors who are resident in Switzerland, the Swiss authorities may consider that Dry Eyes Inc is de facto a Swiss company. As such, they would be more than within their rights were they to assess the BVI company for Swiss taxation.”

GW “But I thought Switzerland was an offshore centre” Mr Washington exclaimed with a look of bemusement spreading across his face.

MB “Technically the word offshore applies to all non-domestic companies, but I know what you mean. The Swiss have for many years offered various incentives for companies and individuals alike, however it is not a no-tax jurisdiction. If on the other hand say Jersey directors are used, and board meetings are held and the decisions of the company are made in Jersey, then this company would be run properly as an ‘offshore’ company in your understanding.”

GW “Well that’s all right then, I’ll kick the Swiss directors off the Board and appoint Jersey directors – can you recommend any?”

MB “It’s not quite as simple as that. I understand that Dry Eyes Inc has a bank account in Switzerland and that you have sole authority to sign on the account. Moreover, I would guess without too much difficulty that the Swiss directors listen rather obediently to your suggestions as to contracts they need to enter into for the licensing arrangements,” asked Maurice tactfully.

GW “Well, who else knows the business”, asked George.

MB “Precisely,” and after allowing the notion to sink in during the pause, continued, “I have no problems with you being a director of Dry Eyes Inc since you clearly are the business provider, but as long as the other directors perform clear functions of management and that you are present for the board meetings in Jersey where all decisions affecting the company are taken, then the company should be considered to be resident ‘offshore’. However, if you are seen to be exercising control in your country of residence, then you might just as well have formed the company as a domestic company and paid full domestic taxation”

GW “Oh dear, I assume that what you have just said also applies to the Dutch company.”

The Dutch BV

MB “Unfortunately yes, that is correct Mr Washington”, Maurice sighs knowing that he is the bearer of bad tidings, a position he would rather not be in. “The Dutch company was set up as a holding company to own the overseas subsidiaries, which in itself is good advice given the excellent double tax treaties Holland has concluded and the Dutch tax advantages for holding companies. However, again the fundamental principles do not seem to have been explained to you by Bodgit. Whilst one of the directors is resident in Holland, the other two, yourself and your wife, are resident in the UK, and I can find no records of any board meetings having been held in Holland during the past two years. Even if you had a majority of non-resident directors, unless they were really involved in the management of Dry Eyes Holdings BV, the UK Revenue would presume that you and your wife controlled the Dutch company.”

GW “But what sort of management can people do in my own company which would have any credibility”, asked George.

MB “Well, a suitably qualified accountant can control the finances of the company and its underlying subsidiaries, taking some of the financial control off your shoulders including dealing with group auditors. Similarly, a lawyer can prepare the contractual arrangements which govern the relationship between Dry Eyes group companies. Local administrative personnel in Holland can liaise with foreign tax authorities to ensure that royalties are received by Dry Eyes Inc with the minimum of withholding tax, and they can also assist with local employee problems when the group expands, such as ensuring proper contracts of employment comply with local legislation. And so on, and so on.”

Maurice was feeling jaded now and was looking forward to a relaxing swim at the club just five minutes from the office. He was thinking the floatation tank might be even better. However he hadn’t concluded his consultation yet.

MB “Oh, and incidentally, although I am sure Mr Bodgit chose a Dutch holding company because dividends and capital gains from subsidiaries can be received tax free under the participation exemption, you ought to know that they won’t”, added Maurice pausing for maximum effect, “since Dry Eyes Inc is a BVI company which is not subject to tax on its profits, which is one of the three fundamental requirements for subsidiaries of Dutch companies to come within the participation exemption”.

The US Problem

Mr Washington had on the advice of Bodgit established a small warehousing facility in New Jersey, which was used in the first instance simply to house boxes of the onion glasses before distribution to the various American wholesalers who had been interested in the new idea.

MB “Can you tell me the reasons, if any, why the BVI company opened the warehouse in New Jersey before you formed the US subsidiary, Mr Washington?”

GW “Well, I took the advice of Bodgit who told me that under US law, a warehouse would not amount to a permanent establishment, whatever one of those is, and as such I would not be liable to US tax. The US company could then act as a sort of promotional company only with the sales to the wholesalers being done direct from the BVI company. Seemed like good advice to me at the time”

MB “Hmm. I’m not too sure about that. The first problem you are faced with is that the BVI company does not benefit from a double tax treaty with the US. This means that a permanent establishment does not have to exist for the US authorities to assess a foreign company which is trading in the US, which you are clearly doing. It is true that under the terms of a double tax treaty, it is quite often possible for a foreign company to have a warehouse or showroom without it amounting to a taxable presence, and this is in order to attract foreign business. Therefore I would have understood it more if the Dutch company had opened the warehouse in New Jersey, although the new US/Dutch treaty now prevents the treaty from applying at all to Dutch companies such as yours. But I will not dwell on that.”

“The main problem is that the US corporation will be attributed with the profits earned by Dry Eyes Inc on its sales to US wholesalers under the “force of attraction” principle. You cannot artificially separate the source of profits merely by using separate corporate entities.”

“And of course, the perennial problem of ‘transfer pricing’ has not even been discussed with you. I understand that Dry Eyes Inc is buying the onion glasses from a third party manufacturer and selling them to group subsidiaries, presumably at a profit. If so, this profit of the BVI company could be attacked under the transfer pricing rules as it reduces the income subject to tax in the high tax subsidiaries.”

GW “But surely that’s the idea isn’t it?”

MB “Not as far as the tax authorities are concerned. And incidentally, transfer pricing also affects the amount of royalties you are extracting from group companies, interest charges you are levying on inter-company loans, management fees and all other related party payments”.

GW “There doesn’t seem much point in having set up the whole operation, which incidentally has cost me a huge amount in administration fees, if I can’t avoid the taxman. I might just as well have operated from the outset as a UK company throughout the world”.

MB “Quite. I am afraid that besides my modest fee for this consultation, you do have significant tax assessments to look forward to. And the fact that you may be susceptible to double taxation on the same income should not be overlooked, so perhaps I can help by arranging a meeting with the tax authorities and discuss a voluntary settlement”.

The above comic strip was written by Roy Saunders in January 1998

The post November 2017 (167) – THE OFFSHORE NIGHTMARE appeared first on IFS Consultants Ltd.

The Swiss lump sum tax regime, or ‘forfait’ as it is known in the French speaking part, has been in existence for decades, and used to be the best alternative to the non-dom regime of the UK. However, left wing pressure in certain cantons like Zurich led to a withdrawal of the cantonal regime (although noticeably not in Geneva and Vaud), and to an anticipated cliff edge vote at a federal referendum which retained it at federal level with a 60% vote. Nevertheless, one wonders how long the regime will continue. In any event, it isn’t cheap! Although foreign source income may be exempt, the ‘forfait’ calculates tax on a figure of seven times the rental value of Swiss property (itself not cheap) and according to one’s level of expenditure to support their lifestyle. In other words, one should reckon on the annual tax exposure of between CHF 125,000 to CHF 250,000 depending upon which canton is chosen.

Off to warmer climes in Spain, its ‘impatriate’ regime offers a six-year tax free period in respect of foreign source income and gains, charging just 24% tax on the first €600,000 of Spanish source income. This was known as the Beckham rule, introduced by the government in 2003 at the same time as Real Madrid were incentivising David Beckham to sign for Real Madrid from Manchester United. Were members of the government Real Madrid supporters?!! But the beneficial legislation has now been withdrawn for sportsmen (but not entertainers). The disadvantage of the system is that the ‘impatriate’ must move to Spain as a result of a genuine employment contract, a requirement which is not therefore available to pensioners or those with a high net worth who only wish to enjoy the warmth of the Spanish Riviera.

As an alternative, Cyprus welcomes all sorts, and with its own non-domicile legislation, allows foreign income and gains not only to be untaxed on an arising basis, but allows the income and gains to be remitted to Cyprus without further taxation. There are also significant allowances available in domestic taxation which may benefit those who enjoy the ‘meze’ of the island, as well as an unusual residence programme for individuals carrying on business or who are employed in Cyprus. The programme allows such individuals to become tax resident in Cyprus after only spending 60 days in its territory provided they are not resident elsewhere — a saviour for those who spend their life travelling the world and strugging to meet residence requirements to appease their bankers.

Another alternative, and a country with a history of encouraging foreigners to enjoy the local sunshine, is Portugal. The regime there is called the “Non-Habitual Resident” regime and does not require an employment relationship to exist for those wishing to benefit from this provision. And unlike its Spanish equivalent, the regime lasts for 10 consecutive years. So foreign income, which includes pension income, is exempt from tax, thereby attracting many retirees. However, there is a catch; capital gains on foreign assets will still be taxable at 28% and the benefits do not extend to distributions received from certain offshore territories, so a degree of restructuring of assets will be necessary before taking advantage of this programme (which should not be too difficult to arrange!).

Not wishing to lose out on the beauty parade, Italy is the latest country to introduce beneficial legislation aimed at encouraging foreign individuals to take up Italian residence. Unlike the absence of an annual payment in Portugal, the new Italian legislation does however require a €100,000 tax payment each year to allow foreign income and gains to be exempt from Italian tax – but does so for a 15-year continuous period. There is an anti-avoidance provision in respect of non-portfolio capital gains, allowing exemption only if the individual has been resident in Italy for at least five years, discouraging those wishing to come to Italy just to avoid a capital gains tax charge in their “home” country. For such persons, Portuguese and Spanish regimes may be more appropriate.

Perhaps one should consider a country like the United Arab Emirates, where there is actually no income tax or capital gains tax, and the sun shines for even longer and hotter than the other countries mentioned. And Dubai, part of the UAE, can benefit from over 100 double tax treaties entered into by the country. As a resident of Dubai, an individual may therefore be able to reduce foreign taxation whilst at the same time enjoying zero domestic taxation.

But here’s the rub. As with all the other countries mentioned, yes, the incoming residents may be able to benefit from the double tax treaties entered into by these jurisdictions. So for example, pension income received by a non-habitual resident of Portugal from say the UK may be receivable without UK taxation, since the UK cedes the normal source rules over to the country of residence. Yet the individual doesn’t pay Portuguese tax on the pension income. Or a Dubai resident able to avoid capital gains tax on the sale of shares in say a German company where the treaty cedes taxing rights to the state of residence, will not pay any tax in Dubai.

The relatively recent initiative of the OECD with its Base Erosion and Profit Shifting (BEPS) proposals have recommended in Action 6 that double tax treaties should include a clear statement that they are not designed for double non-taxation or reduction of appropriate taxation through evasion or avoidance. I am not suggesting that the above countries are encouraging any element of evasion or avoidance, but the consequence of these beneficial provisions is that an individual may enjoy double non-taxation as a result of reliance on the relevant treaty provisions. More than 70 countries have signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (known as the MLI) including all of the above countries other than the UAE. When the MLI enters into force, it will be interesting to see if countries like the UK and Germany allow its treaties to be used by non-habitual residents of Portugal, impatriates of Spain, ‘forfait’ beneficiaries in Switzerland (who are already excluded from many of Switzerland’s double tax treaties for this reason), Italian and Cypriot residents enjoying zero taxation, and those resident in Dubai who pay no tax whatsoever. Maybe it won’t be quite so sunny then!

These issues, and many more, are discussed in the forthcoming IBSA Annual Conference on November 16th, based on a case study of a family owned entrepreneurial company and the issues it experiences throughout its growth. Our IFS regular newsletter readers are invited to attend at the IBSA Members’ rate of £450 plus VAT, with my compliments – please register quoting ‘IFS’. For more information about the conference, please go to the IBSA website.

With kind regards

Roy Saunders

The post October 2017 (166) – TAX RESIDENCE IN THE SUN! appeared first on IFS Consultants Ltd.

Who really owns the right to income? And are they declaring it? These are the obvious two questions that tax authorities around the world want to ask. And a third question is, are intermediary entities within a group structure entitled to be separately treated as if they own the income rather than the ultimate beneficial owner?

United States
It all started many years ago in 1971 with the Aikens Industries case, where an intermediary Honduran recipient of interest was disregarded by the tax court. To enable a conduit entity to benefit from withholding tax exemption, or other US tax benefits, it was stated that there should be sufficient business reasons for the existence of the (Honduran) company. Reasons put forward as acceptable were access to foreign financial markets and presumably shareholders’ funds, and the desire to avoid the burdensome requirement of compliance with US corporate or tax law!

The concept of ‘dominion and control’ follows closely the theme of the Aikens Industries case and implies that not only is a mere interest rate differential required to validate the commerciality of any intermediate finance company, but such companies should have a commercial reason to exist other than merely being used for reducing US withholding taxes.

Strategies were then developed by tax payers to capitalise intermediary finance subsidiaries by way of equity, thus eliminating the question of whether the finance company had ‘dominion and control’ over the interest receivable, so that no legal obligation existed to remit interest to the financing parent company. Clearly the thinking was that the use of an ‘equity wall’ in the international finance company together with providing it with actual substance would be sufficient to overcome the conduit argument established in 1984 Revenue rulings.

In August 1991 the IRS dealt a blow to the equity wall practice by release of Technical Advice Memorandum (TAM) 9133004 which stated that in respect of the facts presented in the Memorandum, the double tax treaty provisions between the United States and the country of residence of the international finance subsidiary, which was presumably the Netherlands, did not apply even though the finance subsidiary paid the interest it received from the US subsidiary to its parent by way of a dividend rather than as interest.

In considering the facts, the IRS stated that the international finance subsidiary, notwithstanding its equity base, was merely a conduit for passing interest from the US subsidiary to its parent company, and therefore tax should have been withheld on the interest payment from the US subsidiary to the international finance subsidiary. It was found that the international finance subsidiary was “no less of a conduit of funds because payments to [its parent company] were in the form of dividends rather than interest”. In view of the fact that it was “clear” that the effective purpose of the international finance subsidiary was to avoid withholding tax on interest payments from the US subsidiary to its parent company, the fact that the international finance subsidiary in fact had some substance or that it had substantial shareholders’ equity capital was irrelevant. This approach by the IRS certainly exposes financing strategies which have been developed by taxpayers.

Against this background, tax practitioners in the US and elsewhere waited with bated breath for conduit financing regulations which were promised by the IRS to support Code §7701(1) enacted in 1993 to provide statutory provisions against multi-party conduit financing arrangements. Final regulations were published by the IRS in August 1995 to take effect in respect of payments made after September 10, 1995. These final regulations served to disregard treaty-based intermediary financing companies for US withholding tax purposes where the intermediary’s participation in the arrangement is pursuant to a plan of which one of the principal purposes (see the Principal Purpose Test later in this article) is the avoidance of US withholding tax, and otherwise lacks a legitimate business purpose.

Tax avoidance must be the motive, and this is generally indicated if the intermediary could not have funded the US recipient without the initial loan from the financing entity, and moreover if the intermediary requires interest receipts in order to meet its interest paying obligations to the financier. Tax avoidance will be deemed to exist where the receipt of funds in the intermediary and the onward transmission of these funds to the US company both take place within a relatively short period, considered 12 months in this instance. However, tax avoidance will not be deemed to arise if the intermediary is engaged in an active business, or if it undertakes significant activities in respect of the financing arrangements, which will involve the intermediary in having employees in the country of its residence who perform significant activities.

If an intermediary is unrelated to the financier and the financed US entity, it may nevertheless be caught within the conduit regulations provisions if the avoidance of US withholding tax is one of the principal purposes of its involvement in the financing arrangements, and if it is established that the intermediary company would not have participated in the arrangement on substantially the same terms unless the financier guaranteed the debt of the financed entity, e.g. by way of back-to-back arrangements or parent company guarantees.

Israel
Many treaties have ‘beneficial ownership’ conditions that restrict tax treaty benefits to residents of the treaty country who are beneficially entitled to income received; the Israeli Tax Administration interprets this to mean they are not mere ‘conduits’ that pass the income on to others (for example Israel’s tax treaties with the Netherlands, Switzerland and Singapore).

The ITA published guidance on its views about beneficial ownership in its Circular 22/2004 of August 26, 2004, where it indicated that although most tax treaties don’t define the term ‘beneficial owner’, the ITA regard this as referring to whoever:

enjoys, in practice, the rights relating to control and ownership of an asset or a right; enjoys any appreciation and risks any loss or erosion of value of such asset or right; has the “final word” regarding anything to do with determining the method and extent of use of an asset or right, including the fruits or yield from them.

The onus is on the applicant (i.e. taxpayer) to prove who is the beneficial owner. In the absence of such proof, no treaty relief need be granted, according to the ITA. The ITA goes on to say that an entity is not a beneficial owner if it is merely a conduit for transferring payments to the beneficial owner. Factors indicating that a conduit entity exists include (according to the ITA):

• minimal business activity;
• minimal assets;
• officer has a limited minor role (sometimes just an external lawyer);
• passing or temporary ownership of receipts;
• no justification for a corporate structure other than tax saving;
• grant of “back to back” loans at identical interest rates, terms, and parallel redemption arrangements, etc.;
• assets collateralized by another party against loans, or provision of a guarantee of another party in some other way;
• another entity bears the economic risks;
• another entity controls the amounts transferred and can decide how they are used;
• contractual or other commitment exists to transfer receipts to another party;
• systematic continuous transfer of receipts to another party, even if no formal obligation exists.

These factors were discussed by the Tel Aviv District Court in the case of Yanko-Weiss Holdings (1996) Ltd. vs. Assessing Officer of Holon in a judgement issued December 30, 2007 (Income Tax Appeal 1090/06).

In this case, a company was incorporated in Israel, but in 1999 its shareholders met in Belgium and resolved to make it a Belgian resident company by moving the registered office, management and activity to Brussels. The company also obtained confirmation of Belgian residence from the Belgian tax authorities. Subsequently, the company claimed a reduced rate of withholding tax (apparently 5 per cent) under the Israel-Belgium Tax Treaty on a dividend from an Israeli resident subsidiary company. Presumably, the dividend may have qualified for a “participation exemption” in Belgium, although the judgement does not discuss Belgian tax, only Israeli tax.

The District Court made reference to Article 31 of the Vienna Convention on the Law of Treaties of May 23, 1969, which states: “A treaty shall be interpreted in good faith in accordance with the ordinary meaning of the treaty in their context and in the light of its objects and purpose.”

The court clarified that tax treaties are intended first and foremost to create a situation in which a taxpayer trapped in the tax system of two countries will not be exposed to double taxation. Tax treaties are not intended and cannot be construed as intended to be used in an abusive way, only in good faith and in the usual way, whether or not they contain express rules in this regard. Therefore, the court ruled that the ITA was allowed to raise a claim of artificiality, notwithstanding the applicability of a tax treaty.

United Kingdom
We can compare this case to a 2006 civil law case in the UK High Court, Indofood International Finance Limited v JPMorgan Chase Bank NA London Branch. This case caused quite a stir amongst the tax fraternity and is the forerunner of the current level of uncertainty in adopting double tax treaty provisions in themselves as gospel. The High Court ruled that the term ‘beneficial owner’ means the actual owner of the interest income who truly has the full right to enjoy directly the benefits of that interest income. A nominee or a conduit company is not regarded as a beneficial owner of the interest, according to the High Court. The decision was not appealed and HMRC has since scrutinised special purpose finance vehicles, particularly those based in Luxembourg.

In this case, an Indonesian company, Indofood, sought to issue loan notes in 2002 with a view to raising capital. Indonesia imposes a 20 per cent withholding tax on interest payments, and to reduce this, Indofood established a wholly owned subsidiary (“IIF”) in Mauritius to take advantage of the reduced rate of withholding tax (10 per cent) under the Mauritius/Indonesia double tax treaty. Indonesia then abrogated its treaty with Mauritius as of January 1, 2005, thus increasing the withholding tax back to 20 per cent. IIF claimed it had the right to redeem the notes. The note trustee, JP Morgan Chase, was opposed to redemption on the basis that the increased withholding tax could be avoided by inserting a Dutch Special Purpose Vehicle (SPV) in place of the Mauritius company in order to take advantage of the reduced rate of withholding tax under the Indonesia/Netherlands treaty.

Indofood claimed that the structure would not work on the basis that the Dutch SPV was not in fact the beneficial owner of the interest. Most double tax treaties have evolved over time in such a way that the recipient of certain types of income, notably dividends, interest and royalties, must be the beneficial owner of such income if treaty benefits (that is reduced rates of withholding tax) are to be availed of. The court found in favour of Indofood on the basis that the Dutch SPV was unlikely to be regarded under Indonesian law as the beneficial owner of the interest. The reason the court came to this decision was not simply that the Dutch company was being interposed purely to take advantage of the treaty. In addition to this the proposal would have resulted in:

• no spread of interest being paid to the Dutch SPV;
• interest was to be paid directly to the noteholders, i.e. would bypass the Dutch SPV.

Even prior to BEPS, many modern double tax treaties, such as the Netherlands/UK treaty, contain limitation on benefits clauses which seek to limit the benefits of the treaty in specific circumstances, for example if the only reason for inserting a Dutch company in a particular structure is to take advantage of the treaty itself. Some treaties, on the other hand, do not contain a specific limitation on benefits provision and it would appear that HMRC regards Indofood as being a fundamentally important case, especially in structured finance deals.

Canada
In the leading Canadian case of 2008, Prévost Car Inc. v The Queen, Swedish and UK parent corporations owned a Dutch holding corporation which in turn held 100 per cent of the shares of Prévost (Canada). The purpose of the Dutch holding corporation was to benefit from the reduced withholding rate of 5-6 per cent compared to the UK rate of 10 per cent. CRA’s case to apply the higher withholding tax rate turned on whether or not the Dutch company was the beneficial owner of the dividends.

The lower court stated: “In my view the ‘beneficial owner’ of dividends is the person who receives the dividends for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received. The person who is beneficial owner of the dividend is the person who enjoys and assumes all the attributes of ownership. In short, the dividend is for the owner’s own benefit and this person is not accountable to anyone for how he or she deals with the dividend income. When the Supreme Court in Jodrey stated that the ‘beneficial owner’ is one who can ‘ultimately’ exercise the rights of ownership in the property, I am confident that the Court did not mean, in using the word ‘ultimately’, to strip away the corporate veil so that the shareholders of a corporation are the beneficial owners of its assets, including income earned by the corporation. The word ‘ultimately’ refers to the recipient of the dividend who is the true owner of the dividend, a person who could do with the dividend what he or she desires. It is the true owner of property who is the ‘beneficial owner’ of the property. Where an agency or mandate exists or the property is in the name of a nominee, one looks to find on whose behalf the agent or mandatory is acting or for whom the nominee has lent his or her name. When corporate entities are concerned, one does not pierce the corporate veil unless the corporation is a conduit for another person and has absolutely no discretion as to the use or application of funds put through it as a conduit, or has agreed to act on someone else’s behalf pursuant to that person’s instructions without any right to do other than what that person instructs it, for example, a stockbroker who is the registered owner of the shares it holds for clients. This is not the relationship between PHB.V. [the Dutch corporation] and its shareholders.”

The Federal Court of Appeal said that the lower court made no palpable or overriding error in its findings. Thus, the Dutch Holdco was not an agent, mandatory, nominee, or conduit that had “absolutely no discretion as to the use or application of funds” and that had “agreed to act on some else’s behalf [and their] instructions without any right to do” otherwise. The corporate veil should not be pierced. There was no evidence of a predetermined or automatic flow of funds to the shareholders.

Revenue Canada’s interpretation of the Federal Court of Appeal’s confirmation of the findings is currently: “In the decision, the Federal Court of Appeal confirmed the Tax Court’s finding that the ‘beneficial owner’ of a dividend is the person who receives the dividend for his or her own use and enjoyment and assumes the risk and control of the dividend. In interpreting the meaning of the term ‘beneficial owner’ as it applies to Canada’s income tax conventions, the Court referred to the OECD Conduit Companies Report, and the 2003 amendments to the OECD Commentary, both of which support the position that the term ‘beneficial owner’ requires something more than strict legal title. In this respect, the Court implied that where an intermediary acts as a mere conduit or funnel in respect of an item of income, the intermediary would not have sufficient economic entitlement to the income to be considered the ‘beneficial owner’. The CRA will examine future back-to-back dividend, interest and royalty cases that it encounters with a view to whether an intermediary could, on the facts, be considered a mere conduit or funnel.”

The Prévost Car case in Canada reviewed whether the beneficial owner should have the meaning under domestic law or international fiscal law. The Dutch holding company acted as an intermediary between UK and Swedish shareholders and the Canadian operating company, and was admittedly introduced in order to avoid most of the dividend withholding tax in Canada. Although there was a shareholders’ agreement regulating the onward dividend flow from the Dutch company, it was held that the company itself was not a party to it and therefore was not bound by an agreement of its shareholders. Therefore, it was not considered to be acting purely in a fiduciary capacity and it was indeed the beneficial owner of the dividend income and entitled to treaty benefits.

In another Canadian case of 2007, the MIL Investments case, a Cayman Island company moved its residence to Luxembourg in order to be able to avoid Canadian capital gains tax on the sale of a Canadian company, which would have been levied if the owner were not resident in a tax treaty jurisdiction. There is in fact no beneficial ownership requirement for the capital gains article to apply, but nevertheless it was held that the concept is implied in treaties. In the absence of any substance in Luxembourg, the true residence of the Cayman Island company would have been questioned. In the MIL case however, the Cayman Island company rented an office and had two employees, and was therefore considered to have the degree of substance to be considered resident in Luxembourg for the purposes of the treaty.

In summary, at this stage of the development of so-called treaty shopping, the use of conduit companies could generally be defensible unless the company were acting merely in a fiduciary capacity for the ‘true’ beneficial owner. However, even at this stage, the French concept of ‘abus de droits’ as it relates to treaty shopping was clearly a warning that abusive treaty shopping is unacceptable, and the conduit company must have a proper degree of substance to benefit from double tax treaty arrangements.

Germany
As a forerunner to the BEPS initiative of the OECD, the Bundeszentralamt für Steuern in Germany argued that, in relation to obtaining double tax treaty benefits and ensuring the recipient is indeed the beneficial owner of the relevant income:

• Holding companies do not qualify for treaty benefits unless they exercise some degree of management and control over their subsidiaries, which denotes the holding company having several employees and its own business premises (although at present only extreme cases are pursued).
• The provisions apply not only to withholding taxes but also to any other kind of treaty benefits or provisions under the EU Parent/Subsidiaries Directive.
• The Bundeszentralamt may look through a chain of tiered companies to the ultimate individual shareholder in order to determine whether he would be entitled to similar benefits if he received the income directly.
• The Bundeszentralamt will not entertain request for advanced rulings on structures.

Of course, prior to Action 6 of the BEPS project, it could have been contended that these provisions cannot override Germany’s double tax treaty obligations, and that where for example withholding tax exemptions should be made available under the terms of the treaty, then unless the treaty itself comprises similar provisions to those enacted under its double tax treaties, these anti-abuse provisions should not be applicable.

However, there have been a number of cases in Germany where treaty benefits have been denied. In one such case a Dutch BV entered into a contract with a German company which held the rights to a sporting event in Germany, the Dutch BV offering expertise and know-how in organising such events, as well as providing the sportsmen taking part. The BV applied for the relevant royalties received to be exempt under arts 15 and 20 of the German/Netherlands’ double tax treaty, such articles providing for royalties only to be taxable in the recipient’s state of residence. The court ruled that in instances where the insertion of a company or other such undertaking achieved no economic goal and served no purpose other than that of avoiding tax, then the treaty provisions should not be applicable. The fact that the BV took no business risks compounded the court’s decision. In this case the court confirmed the German stance on tax avoidance: the deciding factor for the German anti-avoidance legislation is whether the avoidance of German tax is the motive.

The argument that is put forward by the German tax administration is that double tax treaties are not designed to create abusive structures, and therefore the provisions explained above are in accordance with the intentions behind the treaties.

The more persuasive argument, however, is that, if this is the case, there should be provisions in the treaties themselves acknowledging the possibility of introducing such laws, or including specific anti-treaty shopping provisions (as for example the US anti-abuse and limitation of benefits provisions). Prior to BEPS, it was argued that the appropriate remedy was to renegotiate existing treaties, adding protocols or negotiating entirely new treaties, rather than passing internal laws which seem to conflict with other national laws or the constitution itself.

Moreover, international law in the form of the Vienna Convention on the law of treaties suggests that the text of double tax treaties must be presumed to be the definitive intentions of the contracting parties, so that although unwritten intentions of the parties should be considered, the meaning of the text itself coupled with the customary interpretation already exercised by the contracting parties should be of paramount importance.

Despite this art.31(1) of the Vienna Convention requires a treaty to be interpreted in good faith in accordance with the ordinary meaning given to the terms of the treaty in their context and in the light of its object and purpose. It is here that the German tax administration may suggest that literal interpretations are at variance with the purposes of the treaty as a whole.

BEPS Action 6 
All of the above explains why the BEPS initiative on treaty abuse has been passed by so many of the OECD countries. However, instead of changing thousands of individual double tax treaties, participating countries were invited to sign a multilateral instrument (MLI) that would bring a host of wholesale amendments. The MLI aims to implement a broad number of BEPS recommendations, of which Action 6 is the most germane to the topic of this newsletter. The Action recommends the following to be introduced into the MLI:

• There should be a clear statement that tax treaties are not designed to encourage double non-taxation or to reduce appropriate taxation through evasion or avoidance, which covers the treaty shopping arrangements illustrated above;
• There may be a specific anti-abuse rule based on a limitation of benefits provision, which limits treaty benefits only to those persons (companies, individuals or other entities) who are entitled to such benefits as a result of their residence and their business activities;
• There may be a more general anti-abuse rule based on the principal purpose of the transactions or arrangements (the PPT rule), which would deny treaty benefits if these are not in accordance with the object and purpose of the treaty.

The multilateral instrument MLI was signed on 7 June 2017 by close to 70 jurisdictions. Despite its unifying nature, each country has a right to reservations to its provisions and we urge our clients to assess the individual impact that the new measure will have on their cross-border tax position. Here is a useful table with the most up-to-date summary of MLI’s implementation (click here).

Clearly the OECD has its sights on preventing treaty shopping, whether this be a ploy of multinational or smaller enterprises. But in doing so, the introduction of a general PPT rule rather than specific anti-abuse provisions has introduced an era of subjectivity and uncertainty as to how much professional advisers and their clients may rely on the existing provisions of double tax treaties. The Vienna Convention on the interpretation of treaties would no longer appear to be the over-riding authority, but has been superseded by an arbitrary rule which may have different interpretations in different jurisdictions. What is clear is that the use of double tax treaties to entirely eliminate a tax charge (so-called double non-taxation) will be open to legitimate challenge by tax administrations worldwide.

With kind regards

ROY SAUNDERS AND DMITRY ZAPOL

The post July 2017 (165) – IFS NEWSLETTER appeared first on IFS Consultants Ltd.

Dear Reader

The most fascinating part of my work over the past forty years has been to anticipate trends in international taxation. I have done this through studying the tax systems of various countries and reviewing case law and government statements. All of these confirm that business structures have to conform with the intention behind legislation, without the use of clever semantically driven constructions to create tax avoidance. The Ramsay Case in 1981 was perhaps the forerunner of a movement towards supporting the intention behind legislation and preventing the creation of artificial losses when in fact no loss was incurred. But it is only in the last ten years or so that we have witnessed such a sea change in the way business operates, and the structures which are past their sell by date as far as investors and entrepreneurs are concerned.

Following a new EU merger directive in 2009, and the adoption of Regulations to admit cross border mergers in the UK in 2007, corporate re-domiciliation came to the attention of practitioners who have seen changes in tax laws and double tax treaties negate the benefits of existing business structures. It would be commercially as well as tax inefficient to wind up operations in one country and start operations in another country, and therefore concepts such as the transfer of legal domicile, the transfer of the place of effective management, share for share exchanges, merger migrations under EU law or even the creation of a Societas Europea have to now be considered. Corporate migration is the theme of various discussion groups that I have held as chairman of the IBSA, and is particularly relevant now that Brexit is a certainty; this may indeed require UK companies to consider migration to a more favourable jurisdiction.

More recently, since the US introduced their FATCA provisions, we have seen the adoption of the Common Reporting Standard (CRS), legislation requiring the disclosure of beneficial ownership and persons with significant control (PSC rules), and a drive towards full transparency behind business structures through the requirement to maintain transfer pricing memoranda supporting inter-company pricing arrangements. Along with such heavy-handedness, however, comes a movement to demonstrate the unintended consequences of such global tax transparency. I am speaking with Philip Baker QC, Filippo Noseda of Withers, Richard Hay of Stikeman Elliott, along with many other established professionals, on such unintended consequences at an IBSA conference on 6 July in conjunction with Private Client Series at Merchant Taylors’ Hall, London on topics such as the infringement of human rights, the need to maintain data protection, the consequences of Brexit on the tax transparency agenda, and when it may be unnecessary to disclose ultimate beneficial ownership involving trusts and privacy. If readers of our IFS newsletters would like to attend this conference, the link to the conference is (CLICK HERE) but please contact the IBSA administrator, Lucie on lucie.hoyland@istructuring.com as she may be able to arrange special rates for attendance.

Another current trend that I would like to share with our readers relates to access to double tax treaties, and whether one can rely on the provisions of double tax treaties as hitherto. I was at a conference the other day when a speaker mentioned that ‘non-habitual residents’ of Portugal can benefit from double tax treaty provisions so that, for example, pension income from the UK would be exempt under the UK/Portuguese treaty and not taxable in Portugal under the non-habitual resident regime. I questioned whether the BEPS initiative aimed at preventing double non-taxation would be relevant in this case, and it is understood that certain countries have stated their intention to renegotiate their double tax treaties with Portugal to prevent non-habitual residents from benefiting from its provisions. Clearly the limitation of benefits provisions in various treaties, initiated by the US in its 1994 double tax treaty with the Netherlands, stipulates who may be entitled to benefit from relevant treaty provisions. However, even in the absence of a specific limitation, I believe that there is a movement by governments to negate double tax treaty benefits where the result is double non-taxation.

The Maltese regime of having a 35% corporate tax rate with 30% refunded to shareholders could even come under threat if significant treaty benefits were obtained at a cost of just an effective 5%. I intend to hold various discussion group meetings on this topic over the next few months in London and Amsterdam, and would be really interested to hear readers’ views on experiences they may have had where double tax treaty provisions are disregarded.

For those of you who have regularly heard of my fictitious case study centred around the Polycon Lens Company and its transition into the Eyemax Corporation, you or one of your junior associates may be interested in attending a Saturday morning workshop examining the international tax issues around the 12 stages of Polycon’s metamorphosis. As Chairman of the IBSA, it is my way of mentoring younger professionals on what international business structuring is all about, and the course is at no charge, courtesy of our sponsors, Squire Patton Boggs at whose premises near Liverpool Street, London the workshop will be held. The timing is 9.00 am to 1 pm followed by lunch, and the course will be presented by Dmitry and me. If you or a colleague would like to attend, again please contact IBSA’s administrator, Lucie, on her email lucie.hoyland@istructuring.com.

This month’s article is written by Dmitry as a teaser for a new e-book that he intends to write, answering the many questions we receive in the normal course of our advisory work, giving the readers an insight into technical issues prior to seeking formal advice from international tax practitioners.

With kind regards

Roy Saunders

UK Tax Primer for Entrepreneurial Clients

By Dmitry Zapol

Advising a client is a two-way process. The client knows how to get to their end destination and our duty is to help them do this with the least tax leakage and in the most commercially sound way. Although every client is unique, inevitably after years of providing advice, common patterns emerge as one realises that issues that trouble clients are largely the same. Here at IFS, we have always believed in “accessible knowledge”, doing our best to explain international tax and business planning to clients in the most practical way. Roy’s ITSAPT “Red” Book is the best example of a title that addresses the most commonly asked questions and which entrepreneurial clients can use to start organising their cross-border activities, even before coming to see us.

One day, after getting off the phone with yet another person looking to relocate to the UK, I realised that I should write a book of my own. Structured in a Q&A format, it would gather questions that trouble most international entrepreneurs getting involved with the UK — simple questions that require a surprising amount of research. Do I pay tax in the year I exchange contracts to sell my home or in the year I complete the sale? Can I pay a lower amount of tax if I sell my property rental company? Who will pay tax if my uncle gifts me £1 million? Will HMRC care that I tell my Cyprus corporate directors what to do from my UK home?

Rather than giving detailed responses, the book will give practical bite-sized knowledge that will arm its readers prior to seeking formal advice. However, of course some will attempt DIY tax planning, which we strongly discourage. The focus will be primarily on the tax side of things, although where appropriate references will be made to legal and compliance matters. The publication will come out as an e-book and perhaps as an app, which will allow me to update it regularly. In one of the following IFS newsletters, readers will find a proposed list of topics, on which they will be welcome to comment. The following passages illustrate the approach that the book is going to follow.

What is the difference between a UK LP and a UK LTD?

An LP is a limited partnership whereas a LTD is a limited company. The former is tax transparent with the tax liability falling on the partners, whereas the latter is tax opaque, subject to tax in the jurisdiction of its residence.

Provided that an LP has non-UK resident partners and does not conduct business in the UK, it will not be subject to UK taxation. For this reason, LPs are frequently used as fronts for offshore entities which want to trade in or with countries that blacklist low-tax jurisdictions. Commonly, the choice lies between English and Scottish LPs. The two have similar tax and reporting obligations, however, in Scotland LPs have their own distinct legal personalities that allow them to sign contracts in their own names without revealing their partners. So far, the UK’s Register of People with Significant Control (PSC Register) has excluded LPs that do not have any UK assets from publishing information about their individual owners. Recently, the UK Government called for a review of limited partnership (Reference 1 below) and whether the current regime will stay in place remains to be seen.

A company that is registered or managed and controlled in the UK has its own legal personality and is also liable to corporation tax on its worldwide income. A company is owned by shareholders that receive distributions from the company and pay tax according to their personal tax liability. UK companies must submit information about their UBOs to the PSC Register, which is available to the general public.

An LP can be incorporated into a company [See Question X], however, when incorporating a Scottish limited partnership, one must decide, whether they want to continue with a Scottish or an English limited company. Although company laws are very similar in both countries, an English solicitor would not normally advise on matters of Scottish law, which might cause practical difficulties.

How can I use a UK company in my international structure?

A company that is resident in the UK is liable to corporation tax on its income. The current tax rate is 19% and it is currently destined to go down to 17% in 2020. Where income suffers foreign withholding tax, it can be credited towards the company’s UK tax liability even in the absence of a double tax treaty.

By default, the UK taxes resident individuals and companies on their worldwide income, particularly with respect to their trading income. However, there are circumstances where territorial taxation takes precedence and foreign-source income is exempt from UK taxation. More particularly, dividends received from foreign subsidiaries may be exempt from UK tax [See Question X]. Secondly, a UK company may elect to avoid taxation of income earned by its foreign branch [See Question X].

A UK company may claim the substantial shareholding exemption [See Question X] and avoid taxation in respect of gains realised on disposal of foreign subsidiaries; however, it can be rather restrictive. In particular, the exemption only applies to disposals of subsidiaries that pursue trading activities within a trading group. As a result, disposals of purely investment subsidiaries are excluded.

These exemptions are subject to broad anti-avoidance rules. First, the controlled foreign companies (CFC) rules [See Question X] make a UK company liable to corporation tax on income earned by its foreign subsidiaries that are subject to a significantly lower rate of foreign taxation. Second, a UK holding company may be subject to corporation tax on capital gains earned by its foreign subsidiary under the attribution rules [See Question X]. Both the CFC and attribution of gains charges apply only where the UK company owns at least 25% of the foreign subsidiary’s shares and there are additional various exemptions that take most bona fide commercial arrangements outside their scope. Recently, a new tax on diverted profits was introduced; however, it should not be relevant for most small and medium-sized international businesses.

One key advantage of the UK is that there is no withholding tax on dividends, as a result of which non-UK resident shareholders suffer no further UK tax burden. Conversely, there is 20% withholding tax on interest payable on loans received from abroad. Although this may put foreign lenders at a serious disadvantage, the tax burden can be reduced under double taxation treaties, or the EU Interest and Royalties Directive, or through the use of special instruments such as deeply discounted securities or quoted Eurobonds. Also, interest on loans provided for less than a year is not subject to tax.

Most royalties are also subject to 20% withholding tax and recently we have seen an introduction of strict rules aiming at limiting the scope of potential avoidance. The rate can be reduced under double taxation treaties, or again under the EU Interest and Royalties Directive, or through using the UK company to hold a particular type of IP asset, to which withholding tax does not apply (for example, film copyrights).

What are the tax consequences of receiving a cash gift from abroad?

Gifts do not constitute income in the hands of a recipient, and a person who receives a gift of money is not liable to tax irrespective of who has made the gift. However, this presumes that the gift is genuine and is not a disguised distribution of the recipient’s income or chargeable gains.

However, the liability might fall on the person making the gift. First, if the donor is domiciled outside the UK and claiming the remittance basis of taxation [See Question X], the gift might constitute their taxable remittance. Second, if the donor is UK domiciled or deemed domiciled, or domiciled outside the UK but making the gift from a UK bank account, the gift might constitute a potentially exempt transfer [See Question X]. If they die within seven years of making it, their estate will suffer inheritance tax consequences. Third, if the donor is not resident in the UK at the time of making the gift but becomes resident later, he might suffer the income tax pre-owned asset charge [See Question X] should they benefit from gift themselves in any way. This can occur when, for example, a child uses the money received from their parents abroad to buy a home in the UK, into which the parents move later after becoming UK resident.

I would love to hear from IFS Newsletter readers on any questions they may have which I could incorporate into the e-book and app, and hope that I have whetted the reader’s appetite to continue watching this space!

Dmitry Zapol

1 (Reference)

The post June 2017 (164) – IFS NEWSLETTER appeared first on IFS Consultants Ltd.

It has been a good quarter for IFS. We have had some amazing clients, including a Scottish whisky distillery, a designer shoe-making business and an oil drilling company. We have also been working with entrepreneurs, delivering cutting edge technology, such as real time power tracking devices and artificial intelligence. Now, if your electric socket starts talking back you know who to blame. We have also had the usual mix of wealthy entrepreneurs, looking to make the UK or Cyprus or Spain (or even Italy and Portugal) their new home and requiring the usual pre-arrival tax planning — residence, trusts, personal trading and investment companies, estate taxes, property, etc.

Many of you must know about the International Business Structuring Association (IBSA), which we founded back in 2014. It has grown steadily, which would be impossible without its members’ contributions and especially amazing local committees — in the established branches such as the US, Europe and South-East Asia and the up and coming ones in Cyprus and the Middle East.

I have been the vice-president of the Association since the end of last year — thank you Roy for taking a leap of faith in me — and I have enjoyed my role tremendously. Not only have I had the chance to liaise with some of the world’s best professionals in the area of tax and business planning, but also in the last few months I have travelled to Cyprus, Switzerland and Dubai where I met the people behind IBSA’s domestic branches and have also furthered IFS’ business.

I look forward towards the rest of the year with guarded optimism — guarded because like most of my compatriots I suffer from a light form of cherophobia (fear of jinxing things, in case you didn’t know). I am speaking at a few high-profile events, including at the English Law Day forum in Kyiv, a tax and immigration conference in London, possibly at the Russian Legal Forum in Saint-Petersburg and at various IBSA events in Dubai and the rest of the world. I am also very proud to be delivering the ‘Polycon’ international tax planning course on 24 June 2017, which will be hosted by IBSA member Squire Patton Boggs at their London office. It is the new iteration of the programme that Roy and I have delivered at the Institute of Advanced Legal Studies (part of the University of London) for several years and which we took to Russia and Cyprus. You will receive separate invitations from me. And finally, I look forward to helping entrepreneurial clients solve their tax and business problems, essentially continuing with what IFS has been doing for the past 45 years.

Many readers have heard about sweeping changes to the UK’s tax regime, particularly in the areas of personal and residential property taxation. This month’s article talks about the key amendments that you should be aware of and it is based on the analysis prepared by IBSA member Simmons Gainsford LLP.

Enjoy the spring and speak to you in April.

With kind regards

DMITRY ZAPOL

Developments in UK Property Taxation

By Bas Kundu, Simmons Gainsford LLP

There have been some very significant changes to the taxation of real estate which have recently come into effect or are about to come into effect. This note sets out a summary of a number of these key changes, which need to be considered when undertaking UK property transactions.

1. Residential property issues

1.1 Higher stamp duty land tax (SDLT) rates
From 1 April 2016, an additional 3% SDLT charge applies where an individual, joint purchaser, or company purchases an additional residential property costing over £40,000. Spouses or civil partners are treated as joint purchasers even if the additional property is bought individually. The charge applies regardless of the location of the existing property and it frequently comes as a surprise to families moving to the UK from abroad. It is thought that with the expansion of the information exchange agreements network, introduction of the Common Reporting Standard and strengthening penalties for offshore non-compliance HMRC will have an array of tools to enforce the charge.

The additional charge won’t apply if an individual is replacing his main residence regardless of its location. If the purchase occurs prior to the sale, then the additional charge is payable, however a refund can then be claimed if the first property is sold within 36 months of the acquisition of the replacement.

The rules are complex, and there are various traps for the unwary. In particular, companies acquiring property are within the scope of the charge even if no other residential properties are owned, as are trusts unless a beneficiary has a life interest in the property and doesn’t own other residential property personally. There is no exemption from the 3% surcharge for institutional investors, although “multiple dwellings relief” is still available to reduce the applicable SDLT rate, and the purchase of six or more units in a single transaction can still benefit from the (lower) SDLT commercial property rates.

1.2 Inheritance tax on UK residential property
In the past, UK property held in a company incorporated outside the UK (possibly held in a non-UK resident trust) was not a UK asset for IHT purposes and therefore, for non-UK domiciled individuals (“non-doms”), not subject to IHT.

From 6 April 2017 Inheritance Tax (IHT) will be chargeable on all UK residential property, regardless of ownership structure. These new IHT rules affect all non-doms whether they are resident in the UK or not. Anyone who currently owns UK residential property through a company incorporated outside the UK or other opaque vehicle will be liable to IHT on the value of such UK property in the same way as UK domiciled individuals. The measure will apply to all UK residential property whether it is occupied or let and of whatever value.

Debts taken out to acquire such property will reduce the value subject to IHT. However, such debts will themselves be considered to be UK assets for IHT purposes rendering the lender liable for IHT on the value of the debt.

Because in most cases the new rules are making obsolete the use of companies and trusts to hold UK residential property, clients should consider de-enveloping strategies. Unfortunately, these come with their own tax pitfalls and prior advice should be sought.

1.3 ATED
The ‘Annual tax on enveloped dwellings’ or “ATED” was introduced in 2013. It is a form of tax designed to discourage individuals from acquiring and holding high value residential property in the UK through corporate vehicles, which is otherwise known as ‘enveloping’. Such companies were often used as a means of mitigating SDLT charges and / or IHT.

ATED is a single annual payment charged for each period of 12 months, beginning on the 1st April and ending on the 31 March the following year.

The threshold for this charge was initially set at £2m, based on the property value at 1 April 2012 (or date of acquisition if later). However, from 1 April 2016, the threshold has been reduced to £500,000. Properties will need to be revalued every five years and so for properties owned on 1 April 2012 the next valuation date is set for 1 April 2017. There are a number of reliefs available to eliminate the ATED charge, however please note that there will still be an ATED notification requirement. The reliefs include, in particular, where a property is held for the purposes of a property rental business or as trading stock. It should be noted that the ATED regime applies to all companies and not just non-UK corporates.

In the last years, we have seen many clients who had been unaware of their ATED liability and suffered penalties and interest, particularly where the property-owning company was managed by an independent services provider. It is in their best interest to check whether the company has complied with its ATED obligations.

1.4 Non-resident capital gains
Capital gains tax (CGT) applies to non-residents disposing of UK residential property, with some exceptions, on gains arising on disposals after 5 April 2015.

The CGT charge applies to gains realised by non-resident individuals who hold UK residential property directly or via a partnership, non-UK resident trusts and non-resident companies. The charge applies to rental properties as well as those ‘owner-occupied’, in other words, even if the property was let, its disposal will still lead to taxation if there are gains.

The charge will not apply to a ‘diversely-held’ company or a widely-marketed OEIC or unit trust. A ‘diversely-held’ company is one that is (broadly) not controlled by 5 or fewer shareholders and their associates.

Non-resident companies will be subject to CGT at 20%, on the gains affected, net of an adjustment for inflation. For individuals, the CGT charge is at 18% for basic rate taxpayers and at 28% for higher and additional rate taxpayers. The applicable rate will be determined by reference to the non-UK resident individual’s UK income levels for the relevant tax year. They may be entitled to the CGT annual exemption.

Disposals are to be reported within 30 days of completion of the disposal. Except where a UK self-assessment tax return is already required, the tax is also payable within 30 days of completion. This is an important deadline, particularly considering that a non-UK resident seller may not realise that they have to start liaise with HMRC.

Where ordinary self-assessment returns are being filed, the tax will be payable according to the usual timing for self-assessment. Therefore, individuals and trustees already paying tax under the self-assessment system, the tax will be due by 31 January next following the tax year in which disposal occurs (which would generally be on exchange of contracts).

1.5 Property repairs and renewals
From 6 April 2016 the wear and tear allowance for furnished properties and the statutory renewals basis for furnished or unfurnished properties no longer apply, being replaced by the Replacement of Domestic Items rules.

“Domestic items” include furniture, household appliances and kitchenware which are not revenue in nature and so, without these rules, a landlord would obtain no relief on this expenditure. Fixtures (fixed plant and machinery) and central heating systems are not domestic items, but may obtain relief if they are being repaired.

The level of deduction available is the cost of a like-for-like replacement. Any cost for an improvement, or any sales proceeds must be taken off the allowable cost.

1.6 Individual landlords – finance cost restrictions
From 6 April 2017, landlords will not be able to deduct all their finance costs (most importantly mortgage interest and fees) from their property income. Instead they will receive a credit equal to 20% of their finance costs. This may affect buyers of high-value properties where the mortgage interest would have significantly reduced the taxable amount under the old rules.

This restriction is being phased in over 4 years, with 75% of finance costs allowed as a deduction in 2017/18, reducing to 0% by 2020/21. Further restrictions will apply if total property income or total non-savings taxable income is lower than the finance costs incurred.

The new rules don’t apply to companies so it may be more attractive for landlords to own properties within a company structure with the additional benefit of lower corporation tax rates, but additional rate SDLT will need to be borne in mind for new purchases with either form of property holding.

2. Property Companies and Groups – corporation tax

2.1 Finance cost restrictions
From 1 April 2017, larger UK-based property groups will suffer restrictions on the tax relief they can claim in respect of their loan finance. Under the new rules the corporation tax deduction UK companies can claim for finance costs will be capped at the higher of £2m and 30 per cent of their adjusted UK EBITDA (in some cases the cap will be higher, where a group’s third party finance costs are higher as a proportion to the worldwide group’s EBITDA). There will be an exemption from the new rules for some commercial landlords. In response to extensive lobbying from the real estate industry, the Government indicated its intention to extend the exemption for “public benefit infrastructure” activities to some commercial letting. The details of this exemption is yet to be announced.

2.2 Losses

New rules on tax losses also come into effect on 1 April 2017. The rules will restrict the amount of losses which can be utilised. In effect, companies with annual profits in excess of £5m will only be able to use losses from earlier periods to shelter 50 per cent of the excess.

3. UK property developers
The cap on the use of carried forward losses will particularly impact on developers who typically incur losses in the early years of a project and realise a significant profit on practical completion. In response to concerns that the new rules could lead to developers being taxed on more than their economic profit, the Government have provided the ability for developers to carry back unused losses over the final three years of trading. However, this will not always assist particularly where a development trade continues for more than three years after practical completion, due to the time it takes to sell all the completed units.

New rules have also been introduced which extend the scope of UK tax on the profits of developing UK land. Previously it was possible to use offshore structures to shelter development profits from UK tax. Under the new rules, which took effect for disposals of land on and after 5 July 2016, the scope of corporation tax has been extended so that in broad terms all profits of UK development will be taxed regardless of where the developer is based and how they have structured the development. The UK’s double tax treaties with Jersey, Guernsey and the Isle of Man have also been amended to ensure that developers cannot use vehicles based in these jurisdictions to escape UK tax.

HMRC in their guidance have stressed that the new rules will not be applied to genuine investment transactions.

4. Other international issues

4.1 Extension of corporation tax: – non-resident landlords
The Government is consulting on extending the scope of corporation tax to non-UK resident companies which receive taxable income from the UK, such as rental income from UK land. This change will affect the large number of investors who hold their UK real estate assets offshore.

The stated desire here is to “deliver equal tax treatment” of UK resident and non-resident vehicles. On the plus side, it will reduce the headline rate of tax for offshore landlords’ rental income in line with the UK corporation tax rate (which will reduce to 19 per cent for the financial year 2017 and to 17 per cent for the financial year 2020), and may enable greater flexibility to use losses within a group.

However, it will also mean the application of the new interest barrier and loss restriction rules noted above to offshore landlords, resulting in a potential restriction to their deductible finance costs and ability to utilise tax losses.

There has been no suggestion, yet, that this extension of corporation tax will apply to capital gains of offshore property companies.

No date has been given for the implementation of this measure, and with the Government’s consultation only beginning at Budget 2017 it seems unlikely that this change will take effect before April 2018.

4.2 Offshore property developers’ taskforce
HMRC have established a taskforce targeting developments that used offshore structures where little or no UK corporation tax was paid on residential development profits (the Candy brothers’ Hyde Park development apparently being one such instance that is currently very publicly in the news).

Any challenge to an offshore structure is likely to be on the basis that the developer company had a “permanent establishment” in the UK, to which profits can be attributed and taxed accordingly. HMRC’s chances of success will depend to a large extent on how the tax structuring has been implemented in practice, and they will investigate how the development was carried out on the ground and the role of onshore development managers. In addition, HMRC have said that they will also scrutinise other tax aspects of the structuring including any VAT and SDLT planning.

With kind regards

Roy Saunders

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