A tax avoider’s dream

Mike Truman explains the importance of domicile in the UK tax system

Who would have thought that a relatively obscure common-law legal doctrine for establishing which national system of tax should apply to an individual would become the focus of a heated dispute on tax avoidance? Yet that is what has happened to the law of domicile as it applies to UK taxation.

The main purpose of the law of domicile is to determine which system of laws should take precedence in deciding such issues as whether or not you are validly married, or the inheritance laws which should apply to you. This in turn is held to depend on where 'home' is - where are you to be considered as permanently based, even though you may temporarily be away from that base at the moment?

However, for UK tax purposes, domicile determines what income and gains fall into charge, and what is considered to be outside the territorial scope. If you are UK resident, ordinarily resident, and domiciled, then your worldwide income and gains are liable to UK tax. If, however, you are not UK domiciled, then even if you are resident and ordinarily resident in the UK, you will not be liable to tax on overseas income and gains unless they are remitted here.

There is some merit to that approach when dealing with people coming to the UK on a short secondment. It would seem unreasonable to tax a US executive seconded to the London office for three years on his or her worldwide income, for example; they really have little ongoing connection with the UK. In such a case it is surely more appropriate just to tax what they earn here, or any other income and gains brought into the country.

The problem is that domicile is a notoriously 'sticky' status. A full explanation of the rules is beyond the scope of this article, but it is generally true that someone who was born and brought up overseas and only came to the UK as an adult can normally maintain non-domiciled status for very many years if they intend eventually to leave. The fact that for inheritance tax purposes only (where domicile also plays a part) there is a statutory rule deeming someone to be UK domiciled if they have been resident for 17 out of the last 20 years only goes to emphasise how easy it is to maintain non-domiciled status under the common-law rules which apply to other taxes.

Advisers have also developed effective ways of getting round the rules taxing remittances of income and gains. For example, any remittance from an overseas bank account which has had interest added to it is treated as a remittance of that interest income first. Most advisers therefore explain to their clients how to operate the 'two account trick', whereby the interest is not added to the capital in the main account, it is instead credited to a separate income account. Remittances can then be made without any tax liability from the main capital account because these are not remittances of income.

The issue of whether these advantages should be maintained has hit the headlines recently because it is thought that the non-domiciled partners in private equity firms have also been taking advantage of them, ensuring that income and gains on some of their investments arise overseas and are not therefore taxable. However, these are also the sort of taxpayers who defenders of the current regime will point to as examples of why it should be maintained. They argue that wealth creators such as these are highly mobile, and that if the system is changed to their detriment they will leave for a more friendly regime in an overseas tax haven.

Richard Murphy, from Tax Research, has made a special study of the effect that the non-domicile rules have on the UK tax system. He estimates that perhaps as many as seven million people resident in the UK may be entitled to claim that they are not domiciled here, even though only 112,000 actually do so. For the rest, the issue is not relevant since they have no unremitted income or gains overseas. The result, Murphy says, 'is that we have a special tax law in the UK for a tiny but wealthy elite of foreigners who choose to live here'. Estimates of the amount of tax saved by claiming non-domiciled status vary from £1bn to £3bn.

Murphy is also dismissive of the argument that the UK benefits from the wealth of these non-domiciled residents which is brought into the country. He points out, first, that there has been no research to show that this effect occurs, and second that it makes no logical sense to assume that it does: 'If non domiciled people do bring their wealth into the country, then some of it must be income and it should as a result be taxed here. But non-domiciled millionaires live in the UK precisely because they don't want to pay tax here. So either they don't bring their money in, in which case there's no benefit to the UK from having them, or they do bring the money in and pretend it's not theirs, which is called tax evasion. Either way we lose.'

Change

So, is it likely that anything will change in the near future? In theory, we are currently in the process of reviewing the domicile and residence rules for tax purposes. However, this review started with an announcement in the 2002 Budget speech, promising a consultation paper in the Pre-Budget Report (PBR) that autumn. In fact, the PBR merely announced that consultations were ongoing, and the paper was finally published the following spring as part of the 2003 Budget.

This paper made no firm proposals; it merely set out the background against which the discussion should take place, and highlighted some anomalies. One could, however, read between the lines of the anomalies and conclude that the Government was thinking about the possibility of extending the deemed domicile rule for inheritance tax mentioned above into other taxes, reducing the number of years of residence which were needed to deem a taxpayer domiciled to around 10 and, as a quid pro quo, offering further tax breaks to those seconded here for shorter periods.

However, since then, there has been an almost embarrassing repetition in every Budget and PBR that consultations are ongoing. The 2003 PBR said: 'The Government recognises that this is a complex and far-reaching issue, and is determined to proceed on the basis of evidence and in keeping with its key principles. The Government is continuing to examine responses to the background paper and welcomes further contributions. Once this process is complete, it will move forward with a formal consultation paper on possible approaches to reform.'

By the time of the 2007 Budget this had been shortened to the rather shamefaced 'the review of the residence and domicile rules as they affect the taxation of individuals is ongoing'.

Whether changes will ever happen must be open to question, although the issue is certainly back on the agenda. Until then, the non-domiciled will continue to take advantage of the special regime made available to them by the UK - and tax advisers will continue to argue about whether that is a sensible incentive to attract mobile wealth to the country, or a loophole which needs to be closed.

Mike Truman is editor of Taxation magazine.