The U.K. tax authority, HM Revenue & Customs (HMRC), believe there is a significant group of U.K. investors misreporting their income and gains from investments in offshore funds, and, as a consequence, their overall U.K. tax liability. OOctober 31, 2019, HMRC announced that they would write to many U.K. resident holders of offshore funds.
The fact that U.K. residents are failing to fully report resulting income and gains of investments in offshore funds is not wholly a surprise, as the taxation of such investments can be complex.
Most investments held in such asset classes will usually be via pension funds or, for example, investment portfolios with private banks or asset managers. In such cases, the taxpayer may well be wholly unaware that they are possibly tax non-compliant on such matters. It is often the case that the income and gains are notified to the investor in a tax report, provided by the bank or asset manager, and investors will often simply hand these reports to their tax advisers and accountants, assuming such advisers are experts on both offshore tax matters, or in deciphering what can sometimes be extremely complicated tax reports, indeed often bordering on a completely different language.
What are Offshore Funds?
Offshore funds are generally open-ended investments located overseas, often in low taxation territories.
The current rules for offshore funds were introduced in 2009 by Finance Act 2008. The U.K. legislation defines an offshore fund as a mutual fund constituted by a company, often an open-ended investment company (OEIC) or trust (often a unit trust) resident outside the U.K. A mutual fund is a fund where participants do not have day-to-day control of the fund property and when they do realize all or part of their investment, it will almost entirely relate to the net asset value (NAV) of the fund.
Offshore funds can include offshore companies, but can also include offshore unit trusts.
Offshore funds can generally involve transparent and opaque entities, and under the U.K. legislation are placed into two categories: reporting and non-reporting.
Taxation of Investors in Offshore Funds
If offshore funds are transparent, the treatment of income will follow the underlying income as it arises, regardless of whether it is distributed to the U.K. investors or not. It is a requirement of the reporting fund regime that the fund manager provides regular reports to U.K. investors of income, dividends, etc.
Where the funds are non-transparent (opaque) the income will generally be treated as a distribution in the case of a company, and share of trust income after expenses for, say, an offshore unit trust.
Disposals of interests in offshore reporting funds will be taxed applying the capital gains rules. An important aspect of the reporting funds regime is that where funds do not make full distributions, any excess reporting income (ERI) needs to be included within the investor’s tax return.
Non-reporting funds are generally different in that they will often roll up income rather than make distributions. As an anti-avoidance measure, the disposal of interests in offshore non-reporting funds will be therefore be taxed using income tax rules.
Non Domicile Remittance Basis Tax Regime
The U.K. is well known for its special tax regime for U.K. resident non-domiciled individuals (“non-doms”). The U.K. non-dom regime essentially limits non-doms to the taxation of U.K. income and gains, and overseas income and gains to the extent they are remitted to the U.K.
Where they have lived in the U.K. for seven out of the previous nine years and they hold offshore income or gains exceeding 2,000 pounds ($2,590) per annum, non-doms need to pay the remittance basis charge (RBC) of 30,000 pounds per annum (or 60,000 pounds where they have resided in the U.K. for 12 out of 14 years). It is important to bear in mind that if a non-dom who is required to pay the RBC does not do so, they will be treated as taxable on a worldwide basis, and so taxable on all offshore income and gains whether remitted to the U.K. or not.
However, significant changes were introduced from April 6, 2017, to the extent that those non-doms who have been living in the U.K. for 15 out of the previous 20 years will be deemed U.K. domiciled for tax purposes.
To soften the blow for those non-doms becoming deemed domicile, HMRC introduced opportunities for non-doms to set up offshore protective income trusts. Such trusts essentially protect non-doms who hold interests in an offshore trust from being taxed on underlying income and gains unless they take out specific amounts, or the trust becomes tainted by adding new property after becoming deemed domicile.
It is extremely important that trustees and non-doms with such trusts appreciate that, due to limited time available to the Parliamentary Draftsperson when the legislation was introduced, offshore income gains (OIGs) are not protected, and so any such income within a protected income trust will flow through to the non-dom with a beneficiary interest.
Additional Risks of Under-reporting
The risks for under- or misreporting of income or gains in reporting or non-reporting funds is significant: either because ERI income in non-reporting funds is missed altogether or miscalculated or, in the case of non-reporting funds, because the gains have been treated as capital gains and the annual exemption applied. In addition, capital gains are taxed at 20% whereas an OIG is taxed at marginal income tax rates up to 45%.
Another area of potential risk of misreporting for non-reporting funds is the fact that losses should be capped at nil and other capital gains related matters such as indexation are not available.
International Exchange of Information
Over the last 10 or so years we have seen various jurisdictions committing to exchange of information, either on request or automatically. From 2005, countries within the EU have exchanged details of interest concerning where beneficial owners are located within EU member states. Through the Directive on Administrative Co-operation (DAC), automatic exchange of information within the EU is significant.
In 2010, the U.S. introduced the Foreign Account Tax Compliance Act (FATCA). In 2013, the U.K. and the Crown Dependencies (Isle of Man, Jersey and Guernsey) signed agreements to exchange personal bank account details automatically and, since 2017, we have seen a steady flow of OECD member countries sign up to automatic exchange of financial account information by way of the Standard for Automatic Exchange of Financial Account Information (Common Reporting Standard (CRS)). The CRS also requires the automatic reporting of offshore companies controlled by individuals resident in relevant third party countries, where those companies hold passive income, often overseas investment portfolios, holding combinations of various investments, including interest, bonds and equities.
Finally, in recent years we have seen a steady flow of legislation for international governments to start to hold registers of beneficial ownership of companies or of offshore trusts.
Offshore Tax Sanctions
As part of a drive to counter offshore tax evasion and avoidance, HMRC has introduced various options to both identify holders of overseas assets and, where they are non-compliant, to charge penalties.
The U.K. introduced the offshore penalty regime from 2011, which can result in increased penalties linked to offshore territories with measures to limit exchange of information. Whereas the maximum civil penalty in the U.K. for tax evasion is 100% of the tax lost, in the case of assets held overseas, the resulting penalty for non-compliance can increase to 200%. Also, from 2015, HMRC introduced measures to increase the offshore penalties where an individual has moved funds to avoid exchange of information. In 2016, HMRC also introduced additional penalties allowing them to charge penalties of up to 10% of the value of an asset linked to deliberate non-compliance. They also introduced legislation to charge penalties on advisers associated with deliberate non-compliance.
HMRC also has a policy to undertake criminal investigations in serious cases of tax evasion. It is important always to appreciate that deliberate misreporting of tax positions amounts to criminal behavior.
In 2017, HMRC introduced the failure to correct (FTC) legislation, which required those individuals and trustees with historical tax non-compliance to correct the position or face penalties of up to 200%. Many U.K. taxpayers will therefore have corrected their offshore non-compliance, making HMRC’s recent initiative all the more worrying. Those receiving these newly announced letters have potentially missed the requirement to correct deadline, and so face significant penalties at the point of correcting any underlying non-compliance, albeit their position will be better than those on the end of an HMRC inquiry or investigation.
Additionally, in 2017 the U.K. government introduced a criminal offense for legal bodies, companies and partnerships, etc. to be found criminally liable where they fail to hold policies to prevent the facilitation of U.K. or foreign tax evasion. This offense could in principle include a financial institution failing to assist U.K. resident investors in meeting their U.K. tax obligations.
In light of the broadening and international crackdown on offshore non-compliance, it is no surprise that HMRC is writing to U.K. investors in offshore funds and investments. It is well accepted that the taxation rules around overseas assets and income can be complex, particularly because of the interaction with the U.K. non-domicile rules. Add to that the impact of automatic exchange of information and wider tax transparency, and this potentially provides HMRC with the core information enabling them to identify non-compliant taxpayers, or those who should be accurately declaring their foreign tax positions.
In the years ahead, we would expect HMRC to undertake similar exercises on areas such as offshore pensions or in relation to life insurance products located overseas, as well as offshore employee benefit trusts—which have also been a long-established target of HMRC. This is far from the end of the road in terms of HMRC’s, and other jurisdictional tax authorities’, campaigns to tighten up on tax compliance and, as both companies and wealthy individuals become more globally mobile, we would expect the tax world to likewise increase in both international scope and complexity.
Gary Ashford is a Tax Partner (Non Lawyer) at Harbottle and Lewis LLP. He is a Fellow of the Chartered Institute of Taxation, Associate of the Association of Tax Technicians and a full member of STEP.
The author may be contacted at: gary. firstname.lastname@example.org
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners