Clean Capital planning

As a UK resident but non-UK domiciled individual you can live off your “clean capital” while in the UK without incurring a tax liability.  However, clean capital must be appropriately segregated or “ringfenced” so that it cannot be mixed with foreign income and gains arising after you become tax resident in the UK.

Therefore, UK resident but non-UK domiciled individuals can elect to shelter unremitted foreign source income and gains from UK taxation. This is achieved by electing to be taxed on the remittance basis.

Ensuring tax-efficient access to “clean capital” is one of the most important tax matters for a non-UK domiciled individual. The expression “clean capital” signifies that this is money which can be remitted to the UK without tax consequences. Most commonly this will be foreign income and gains that arose before you became UK resident, but it can also include outright gifts and monies received by way of inheritance.

Subject to careful planning, some UK resident but non-UK domiciled individuals can structure their affairs to live off their clean capital for their entire stay in the UK.  However, after 15 years of being tax resident in the UK you will be deemed to be UK domiciled so the remittance basis will not be available to you.

Pre-arrival planning should focus on quantifying the amount of clean capital you will require to sustain your lifestyle while tax resident in the UK. Secondly, you should structure your affairs appropriately so this clean capital is segregated (or “ring fenced”) so that it cannot be mixed with foreign income and gains arising after you become UK tax resident. Therefore, knowing when you become tax resident, whether on 6 April in the year of arrival or on the date of arrival under the split-year rules, is imperative.

Mixing clean capital with post-arrival foreign income or gains will create a “mixed fund”. Remittances from such funds are subject to some onerous ordering rules. Broadly, these deem the remittance to be sourced from the most unfavourable component of the fund. In practice, any income in the mixed fund is treated as remitted first (at rates of up to 45%), followed by gains (at rates of up to 28%), and finally clean capital. Further complications can arise if there are transfers between a mixed fund and another account. In this case, a proportion of the income, gains and capital are transferred across. A check must be repeated annually by reference to the income, gains and capital paid into the mixed fund each year.

Segregating clean capital can be difficult in practice and caution must be taken when structuring your affairs to avoid applying the mixed fund rules. Many people are not prepared to allow inflation to erode their capital and require the capital to be invested to derive regular income or long-term gains. As a result, segregating clean capital from current income and gains can be especially challenging.

Some points to consider are: -

Don’t mistakenly convert clean capital into foreign income. For example a common misconception is that the clean capital of an offshore company, such as its retained profits derived before you became UK resident, will retain its character when paid out to you after your arrival in the UK. This is not the case.  Distributing clean capital as a dividend after you, the shareholder becomes UK resident will convert the clean capital into “relevant foreign income” for the year in which the dividend is paid. This will make the dividends taxable if and when they are remitted to the UK, notwithstanding their previous underlying characterisation as clean capital.  If an offshore company’s retained profits are expected to be required to meet your living expenses while in the UK, you should declare and pay dividends before you become UK tax resident. This will allow the funds to be segregated as clean capital moving forwards.

Don’t automatically trust banks to understand the clean capital tax rules. It is common for high net worth, non-UK domiciled individuals to establish ostensibly “segregated” accounts before arriving in the UK. However, sometimes interest is paid into the clean capital account and swept out only on a monthly basis (or less often). If this is the case, the capital account becomes a mixed fund and the “sweeping out” of income needs to be treated as an offshore transfer when applying the mixed fund rules.

Also, don’t notionally segregate. For clean capital to be properly segregated from income and gains it must actually be segregated into separate accounts.

As a further point, don’t use foreign income and gains as collateral. A previously common tax planning technique was for an individual to use their foreign income and gains as security for a loan before bringing the borrowings into the UK to fund living expenses. HMRC’s previous position was that, assuming the loan was on commercial terms and regularly serviced, the borrowed monies would not themselves constitute a remittance of the foreign income and gains when the borrowings were brought into the UK. 

However, HMRC reversed their view on this issue in 2014 and now consider that borrowings brought into the UK that are secured against foreign income and gains will constitute a remittance of the underlying foreign income and gains that are being used as security.  It should be noted that there is nothing to prevent the taxpayer from borrowing against a clean capital account and remitting the borrowings to the UK.

Account Segregation

It is important to operate appropriately segregated accounts because these will help to avoid the complications associated with the mixed fund rules. The aim of account segregation should be to identify distinctly separate accounts where clean capital is deposited, where gains are deposited and where income is deposited. As a suggestion, the following three accounts could be maintained.

A “clean capital account”. A common segregated account structure will start with an account, which will hold cash balances representing foreign income and gains arising before the account holder becomes UK resident. The only funds which would be added to this account after that point would be UK-sourced income (taxed as it arose), inheritances or gifts.

A “foreign interest account”. Interest arising on the clean capital account after arrival in the UK should be paid directly into this.

A “capital gains account”. This can receive the proceeds from the disposal of any foreign investments or assets that have produced a capital gain after arrival.

If possible, remittances should not be made to the UK from the foreign, capital gains or foreign income accounts because such payments would be taxable.  However, funds can be remitted to the UK tax-free from the clean capital account.

Pre-arrival income and gains

You should where possible and subject to local tax laws realise income and gains before arrival as a tax resident in the UK. By definition, clean capital refers to income or gains realised before you become UK tax resident under the statutory residence test.

This is especially important from a capital gains tax perspective given that you do not receive a “step up” to market value on your chargeable assets when you acquire UK tax residency, when you dispose of an asset you are taxed on the entire gain.

Another potential planning opportunity is to bring forward the declaration of dividends from associated companies before you become UK resident.

Offshore investment bonds/Portfolio bonds

These can be an effective way to preserve access to clean capital, as well as offering other potential benefits for non-UK domiciled individuals. If a bond is purchased with clean capital, a withdrawal of up to 5% of the premium paid can be taken each year without triggering a UK tax liability. The 5% allowance is cumulative and can be carried forward to future years. Once 100% of the initial premium is withdrawn, any further withdrawals will generally trigger a UK tax charge.  However, if the bond was taken out before you became UK tax resident the amount taxed will be time apportioned so only the growth arising while you were UK tax resident is taxed.

Offshore bonds are an especially attractive investment wrapper if you expect to stay in the UK only for the short to medium term. Then you can purchase the offshore bond on arriving in the UK and the growth will roll up tax-free while you are UK resident. You may be able to cash in the entire bond once your UK tax residence status ceases without incurring any UK tax liabilities.

If you do have a mixed fund there is now a limited opportunity to reorder your affairs.  HMRC will allow any tax payer who has claimed the remittance basis to re structure their banking arrangements to segregate accounts which are currently mixed.  This window of opportunity is only open until April 2019 and will require a detailed analysis of all bank statements relating to the mixed accounts. So the correct amounts can be allocated to the appropriate new accounts and clean capital identified.

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