The UK has a favourable tax regime for individuals who are non-UK domiciled, and this extends to inheritance tax (IHT). With careful planning, which may involve the use of offshore trusts, most non-UK domiciled individuals can protect their non-UK assets from UK inheritance tax, even after they have become deemed domiciled in the UK.
Scope of Inheritance Tax
A charge to UK inheritance tax can arise on the following events:
- On death, in relation to the deceased's chargeable estate, and on certain gifts made by the deceased within the previous seven years;
- When a 'chargeable lifetime transfer' is made, which would usually occur when chargeable assets are settled into trust during an individual's lifetime.
The extent to which an individual's assets are within the scope of inheritance tax depends on the individual's domicile status at the time of the event. Domicile is a concept of general law and is much more adhesive than residence. It is generally construed as the place which an individual regards as their permanent home and with which they have the closest ties.
From 6th April 2017, an individual is deemed to be domiciled in the UK (even though they may continue to have a non-UK domicile under general law) if they have been UK resident for at least 15 out of the past 20 tax years.
Where an individual is UK domiciled or deemed domiciled at the date of the taxable event, his global assets are within the charge to inheritance tax, subject to any specific reliefs or exemptions.
Individuals who are neither domiciled nor deemed domiciled in the UK are only liable to inheritance tax in respect of their UK assets. Their non-UK assets are 'excluded property' and outside the scope of IHT.
From 6 April 2017, the shares of an overseas company holding UK residential property are regarded as UK assets for IHT purposes. At present, there is no charge to IHT on shares in overseas companies owning UK commercial property.
The domicile or residence status of the beneficiary is not relevant for UK inheritance tax purposes. However, some jurisdictions levy tax on gifts or inheritances received by a resident of that country, so particular care needs to be taken where cross-border gifts or inheritances are made as there is potential for double taxation. In many cases, however, double tax relief should be available through a treaty or under domestic law.
Rate of Tax
Every individual has a Nil Rate Band (currently £325,000) to offset against his chargeable assets. From 6 April 2017, an additional Residential Nil Rate Band may be available if the deceased's main residence (or equivalent value if it has been sold) is included in their chargeable estate, and is left to one or more direct descendants. The Residential Nil Rate Band increases each year up to a maximum of £175,000 in 2020/21 but gradually tapers away where the chargeable estate is worth more than £2 million.
Spouses and civil partners
References to spouses include civil partners. Assets passing to a spouse or civil partner are generally exempt from UK IHT without limit. However, there is one exception to this rule, and that is where assets pass from a UK domiciled spouse to a non-UK domiciled spouse. In this instance, the spouse exemption is limited to £325,000.
If some or all of an individual's nil rate band is unused on his or her death, the proportion of the deceased's unused nil rate band (including any unused residential nil rate band) can be transferred to the surviving spouse.
For example, if none of the nil rate band is used (because, for example, the deceased's assets pass to the surviving spouse who is exempt, the surviving spouse will have double the nil rate band on their death (i.e. £650,000, based on current rates), plus potentially double the residential nil rate band, if available.
Election for non-domiciled spouse to be treated as UK domiciled
A non-domiciled spouse or civil partner can, at any time, make an election to be treated as UK domiciled for the purposes of inheritance tax. This may be a favourable option for a mixed domicile couple where the UK domiciled spouse passes away first. In this case, if an election is made by the non-domiciled surviving spouse to be treated as UK domiciled for IHT purposes, any assets received by that spouse will be exempt from inheritance tax. If the election were not made by the surviving spouse, only assets up to a value of £325,000 would be exempt. Therefore, by making the election, inheritance tax can be deferred to the second death.
The potential drawback to making the election is that the worldwide assets of the surviving spouse would then be brought within the charge to inheritance tax, as for any other UK domiciled individual.
Nevertheless, the election automatically lapses once the electing spouse has been non-UK resident for four successive tax years, at which point they regain their non-UK domicile status for IHT purposes. In this instance, their non-UK assets (including those inherited from the UK domiciled spouse) will fall outside the scope of UK inheritance tax altogether, allowing potentially significant IHT savings to be achieved.
This type of planning can be particularly useful where a mixed domicile couple is resident overseas, or where the electing spouse returns to their home country (or elsewhere) following the death of their UK domiciled spouse.
Professional advice should be taken if an election is being considered as, once an election is made, it cannot be revoked.
Deductibility of Debts
Under general inheritance tax rules, there are three circumstances in which a debt is not deductible:
1. Debt used to acquire excluded property
Where the debt proceeds are used (directly or indirectly) to acquire, maintain or enhance excluded property (i.e. property that is outside the scope of inheritance tax), the debt is disallowed for IHT purposes.
For example, a debt would be disallowed in circumstances where:
- a non-UK domiciled individual borrows money, secured against UK assets, and uses the borrowed funds to purchase assets situated overseas; or
- trustees of a trust settled by a non-domiciled individual borrow against UK assets and use the funds to invest in assets overseas.
The debt will be allowable, however, where the excluded property has been sold and the proceeds have become chargeable assets in the deceased's estate, or where the assets themselves are no longer excluded property.
2. Debt used to acquire property that qualifies for another relief (e.g. Business Property Relief).
This rule only applies to liabilities incurred on or after 6 April 2013.
The broad effect of this provision is that the loan is first set against the relievable assets, thus reducing their value. Where the value of the loan exceeds the value of the relievable assets, the excess may then be deducted against the remaining chargeable estate.
3. Debts that are not repaid on death
A debt can only be deductible from the value of an estate if it is repaid after death out of the estate, unless there is a commercial reason for not repaying the liability, and it is not left unpaid as part of an arrangement to obtain a tax advantage. This rule applies regardless of when the debt was incurred.
Non-UK assets settled into an offshore trust by a non-domiciled individual before they become deemed domiciled are 'excluded property' and are outside the charge to UK inheritance tax (provided there is no underlying UK residential property).
The assets of the trust will continue to enjoy excluded property status even after the settlor has become deemed domiciled in the UK as a result of having been UK resident for 15 out of the last 20 tax years.
Trusts settled by non-UK domiciled individuals can also benefit from significant income tax and capital gains tax advantages. Professional advice should always be taken when considering setting up an offshore trust as the UK tax rules are particularly complex.
UK residential property interests
It was common planning for non-domiciled individuals to hold UK real estate through an offshore company (which may, in turn, have been held by offshore trustees) in order to avoid a charge to IHT on the real estate. The overseas shares were non-UK assets, and therefore excluded property, in the hands of the non-domiciled individual or trustees (if held through a trust structure). There was no look-through to the underlying UK real estate.
However, changes to the legislation, which became effective from 6 April 2017, now bring all UK residential property within the scope of UK IHT, as well as certain loans used to purchase UK residential property. A property under construction or being adapted for residential use is treated as residential property for these purposes.
The legislation is widely drawn, and brings the following assets within the scope of IHT:
- Interests in non-UK close companies (e.g. shares and loans) and overseas partnerships which derive (directly or indirectly) their value from UK residential property. The value for IHT purposes is based on the shareholding or partnership interest and therefore minority interests may be significantly discounted. Interests of less than 5% (when aggregated with interests of connected persons) of the total value of the close company or partnership are disregarded. A connected person is a spouse, ascendant, descendant, sibling, niece or nephew, uncle or aunt, and companies owned, or trusts settled, by any of the above.
- A loan used to acquire, maintain or enhance a UK residential property (a 'relevant loan') in the same way as a direct interest in a UK residential property. This includes loans made by a trust, partnership or an individual.
- Any asset given as security, collateral or guarantee by a borrower, or a third party, in connection with a relevant loan, up to the value of the loan.
- The proceeds of a loan used to acquire any asset where that asset is sold and the proceeds reinvested in a UK residential property interest (either directly or indirectly).
It is the lender of the funds who is subject to inheritance tax where the loan proceeds have been used to finance the purchase or enhancement of a UK residential property (directly or indirectly). These rules also apply where the lender is a close company, but would not normally catch bank loans, unless the bank is a close company.
Lenders will therefore need to be aware of what the loans are being used for. If they are being used to invest in UK residential property, this may give rise to an IHT liability in hands of the lender. Difficulties may arise for lenders who are resident and domiciled outside the UK and who have no understanding of the UK tax implications of the loan, and who have no knowledge of the intended use of the funds.
Similarly, care will need to be taken by non-UK resident trustees who make loans (or provide guarantees) to a beneficiary. They will need to enquire what the loan is for, and also have an understanding of the IHT implications if the beneficiary intends to use the loan to purchase UK residential property.
Two Year Tail
In circumstances where the shares of a non-UK company or an interest in an overseas partnership that holds UK residential property are sold, the sale proceeds remain within the scope of inheritance tax for the following two years.
In addition, where a loan is taken out to invest in UK residential property, or assets are used as security for such a loan, and the loan is repaid or the security/guarantee released, the consideration received (or any asset purchased with that consideration) will continue to be subject to IHT for a two year period following the loan repayment or release of security.
On the other hand, where the residential property itself is disposed of, the loan will cease to be a relevant loan (and will therefore cease to be within the scope of IHT) from the date of disposal.
Double Tax Treaties
Where the terms of a tax treaty provide for exemption from UK IHT in relation to a UK residential property interest, the UK legislation will override the terms of the tax treaty unless a liability to inheritance tax or an equivalent tax (however small an amount) arises in the other jurisdiction.
Non-UK domiciled individuals benefit from significant planning opportunities to minimise or avoid liability to UK inheritance tax. In particular, non-UK assets can be sheltered from inheritance tax by settling those assets into an offshore trust before acquiring deemed domicile status in the UK. The protection from inheritance tax can continue even after the settlor has become deemed domiciled, allowing the assets to be passed down to future generations free of UK inheritance tax.
Nevertheless, there are also potential pitfalls due to the extensive anti-avoidance provisions that have been enacted over recent years, particularly in relation to debts and indirect interests in UK residential property.
Professional advice should be taken to maximise the opportunities for inheritance tax planning and to avoid the pitfalls.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.