The significance of domicile
The professional negligence case of Mehjoo v Harben Barker has focused the attention of the accountancy profession on the issue of domicile. In that case, a non-UK domiciled individual, (“non-dom”), Hossein Mehjoo, won a claim in the High Court against his accountants who had failed to consider his domicile status in providing tax advice. We are currently awaiting the outcome of the accountants’ appeal. Whatever the decision, it has highlighted the need for practitioners to note domicile status in their client records and tailor their advice accordingly.
The incidence of UK inheritance tax (IHT) depends on a person’s domicile. An individual who is UK domiciled or deemed domiciled will be subject to IHT on all his worldwide assets, while an individual who is not UK domiciled will benefit from the “excluded property” provisions.
The concept of excluded property
There are a number of categories of excluded property, of which the most important is property situated outside the UK, owned by a non-UK domiciled individual. (IHTA 1984, s6). Excluded property is not subject to inheritance tax.
Specifically, this means that:
- excluded property does not fall into an individual’s chargeable estate for IHT on death
- excluded property is not included when calculating any transfer of value made by an individual
- excluded property is not ‘relevant property’, and therefore not subject to the periodic ten year or exit charges on trusts
- liabilities relating to excluded property are not deductible for IHT purposes
An individual’s potential UK inheritance tax liability, and that of any trust he has created, will therefore depend on:
- his domicile status, and
- the location of his property
Situs of assets
Property is located in the place determined by the rules of common law. These are known as the lex situs rules. The following table gives the situs of some common assets:
|land||is located in the country where it is physically sited|
|chattels||are located in the country where they are physically sited|
|bank accounts||are located at the branch of the bank at which the account his held|
|registered shares||are located in the country where the register is kept|
|life assurance policies||are located in the country in which the proceeds are payable|
A non-dom may have a mixture of chargeable and excluded property, as illustrated by the following example:
Priyesh came to London from Malaysia to take up a well paid post with an American bank. His wife and children remain in Malaysia in their family home. Priyesh has purchased a small flat to live in for the duration of his two year assignment in London. After completing his assignment in London, he will divide his time between Kuala Lumpur and New York. He will let the London flat, retaining the rental income in a UK bank account, which he will use to finance his son’s education at an English university. Priyesh owns a substantial portfolio of US investments managed by his stockbroker in New York.
Priyesh is clearly domiciled in Malaysia, although resident in London. His non UK assets are therefore excluded property. If he were to die, his London flat and UK bank account would be within the charge to inheritance tax. This would be the case if his death occurred whilst he was living in London or subsequently. His home in Malaysia and the US investments are excluded property and not subject to IHT.
Property in trust which is situated abroad is excluded property if the settlor was not UK domiciled at the time that he made the settlement. It is irrelevant whether the settlor later becomes domiciled for IHT purposes, or if the beneficiaries of the trust are UK domiciled, or indeed whether the trustees are resident in the UK. (IHTA 1984, s 48(3))
This provision offers a very useful tax planning tool to non-doms. It enables them to place their non UK property in an excluded property trust and it will remain outside the remit of inheritance tax.
Expenses and liabilities may reduce the value of property to be charged to inheritance tax. Where a non- dom owns both chargeable and excluded property, the inheritance tax on his chargeable property will be affected by how the expenses and liabilities are deducted from the estate as a whole. Clearly, if they are deducted from excluded property, tax will not be reduced because the property is not taxable. Non-doms and their advisers should take account of the following rules which determine how liabilities are to be allocated:
Rule 1: Where a liability is to be paid outside the UK to a person who is not resident in the UK, it reduces the value of property outside the UK, (subject to Rule 2). (IHTA 1984 s 162 (5))
Vikram, who is domiciled in India, owns an accountancy outsourcing business in Delhi. He spends three to six months a year in the UK developing the services offered to UK accountants. He makes an informal arrangement to borrow £350,000 from his father, resident in India, to enable him to purchase a flat in Reading. If Vikram were to die, the Reading flat would be subject to IHT and the liability to his father would not reduce its value. The liability would be notionally deducted from his Indian assets which are excluded property.[On the other hand, if his father had taken a legal charge on the Reading flat, the liability would reduce the value of the estate chargeable to IHT. See Rule 2]
Rule 2: Where a liability is secured on a specific property, it reduces the value of that property, (subject to Rule 3). (IHTA 1984 s 162 (4))
Jean-Claude is domiciled in France and lives with his partner Timothy in Manchester. Jean-Claude, together with other members of his family, owns a chateau in the Dordogne. An English bank was pleased to lend him £150,000, secured on the chateau, to assist with the purchase of their city centre flat in Manchester. Jean Claude inherited some valuable paintings from his grandfather, which he keeps in Manchester.
On Jean-Claude’s death, he would be subject to IHT on the assets situated in the UK, – his share in the Manchester flat and the paintings. The loan taken out to purchase the flat is not secured on the UK property and will not reduce its value.
Rule 3: Where a liability is attributable to financing the acquisition or maintenance of excluded property, it is to be matched with that property. (IHTA 1984 s 162A)
Mikhail is domiciled in Russia and lives with his fourth wife in Esher. He borrows £2 million secured against his property in Esher to purchase homes for a former wife and children who remain resident in Moscow. Since living in Surrey, he has developed a passion for cricket. He assisted the local team by purchasing their grounds and building a new pavilion and clubhouse. He borrows £850,000 secured on the cricket club property in order to invest in a holiday village in France.
On Mikhail’s death, he would be subject to IHT on the full value of the residential property in Esher and the cricket club assets. The value will not be reduced by the liabilities secured on them because the loans have been taken out to finance excluded property.
Rule 4: Expenses incurred in administering or realising property situated abroad on death may be deducted from the value of the foreign property in the individual’s chargeable estate. Therefore, where the foreign property is excluded property, they are not deductible. (IHTA 1984 s 173)
The non-domiciled spouse or civil partner
The full IHT exemption for transfers between spouses and civil partners, whether made in lifetime or death, does not apply to transfers by a UK domiciled spouse or civil partner to a non-domiciled one. In this situation, the exemption is capped at an amount equivalent to the nil rate band, currently £325,000. Thus, a UK domiciled spouse is able to transfer up to twice the value of the nil rate band to his non-UK domiciled partner before incurring a tax liability.
There is a distinction though between the two allowances. The non-domiciled spouse exemption is a lifetime limit whereas the nil rate band is refreshed every seven years. For lifetime gifts that exceed the spouse exemption, the balance is initially a potentially exempt transfer (PET) which only becomes chargeable if the donor dies within seven years. The following example illustrates how this works in practice.
Michael is domiciled in England and married to Lei, who is domiciled in China. In April 2013 Michael gives Lei investments worth £700,000. Of the total, £325,000 is spouse exempt and the balance of £375,000 is a PET. Michael dies two years later in 2015. The whole of his estate, valued at £800,000 passes to his wife. The nil rate band of £325,000 is allocated to the failed PET leaving the balance of £50,000 and the £800,000 estate chargeable to inheritance tax.
If, alternatively, Michael dies eight years later (and assuming that the nil rate band is still frozen), £375,000 of the initial gift falls out of account because it was a PET but the spouse exempt portion is still on the clock. No further spouse exemption is due. The chargeable estate is £800,000- less the NRB of £325,000 = leaving £475,000 in charge to tax.
Election for UK domicile
Finance Act 2013 introduced the option to elect to be treated as UK domiciled. The obvious advantage to making such an election is that the exemption for transfers from the UK domiciled spouse or civil partner becomes unlimited. The non-UK domiciled partner will be entitled to inherit the whole of their partner’s estate tax free. The disadvantage is that the election causes the non-UK domiciled partner to be fully taxable on their worldwide assets, instead of just their UK assets.
Whether to make the election or not will depend very much on individual circumstances – not just the value and location of each partner’s assets but the long term plans of the couple and the tax regime of the jurisdiction in which the non-UK domiciled partner is domiciled. Double taxation relief will be available in the usual way.
Fortunately, the decision as to whether to make the election can be deferred until after the death of the UK domiciled spouse. The election can also be backdated for seven years, so it is not necessary to predict the future to make an efficient arrangement.
Author – Tolley – all of the material in this post has come from Tolley®Guidance. Tolley®Guidance is a practical, tax technical service with guidance notes, examples and templates to make your job easier. For more information on TolleyGuidance and to request a free trial, please visit www.tolley.co.uk/guidance.