Practical clean capital planning

The UK tax code marries Byzantine complexity with generosity towards foreign domiciled individuals, which makes the UK an attractive destination for wealthy foreigners. For them the key tax relief is the remittance basis of taxation (RBT), which allows UK resident non-UK domiciled individuals to avoid UK tax on foreign income and gains for as long as these are not remitted (brought) to the UK. Conversely, anything that does not constitute foreign income and gains is described as clean or pure capital and is not taxed in the UK regardless of whether it is remitted or not.

Pre-arrival tax planning for a non-UK domiciled individual seeking to relocate to the UK begins with finding out whether he has clean capital and whether in its absence clean capital can be created. Despite its key role in individual tax planning, clean capital is not defined in the UK’s tax acts. HMRC also does not directly explain the meaning of clean capital, although for income tax purposes it talks about maintaining income and capital sources from a tax year separately “keeping capital clean” to avoid the effect of mixed fund rules.

Interestingly, for capital gains tax purposes HMRC staff are advised that:

An individual who becomes resident in the UK for the first time but remains domiciled abroad may have realised gains on assets located outside the UK before he or she became resident in the UK. Those gains may be brought to the UK after that individual has become resident, but they will not be chargeable as remittances when that happens. This is because the remittance basis cannot have applied in the year the gains accrued and so TCGA92/S12 cannot apply to them.

In practice clean capital is deemed to include all income and gains that the individual received immediately before he became UK tax resident. However, there are certain planning aspects relating to what constitutes clean capital and the timing of its creation, which deserve a more detailed exploration.

Creation of clean capital

Clean capital only includes cash funds which belong directly to the individual looking to become UK resident. In principle under UK law the individual can obtain the beneficial title to the funds and keep the legal title with another person — usually a body corporate or a trust — however, due to a limited availability of the split ownership concept outside the UK this is not a very popular arrangement.

Therefore, income which belongs to a company or a trust does not turn into clean capital unless and until it is distributed to the ultimate beneficiary as dividends or otherwise. Loan interest only becomes clean capital when it is paid to the lender, although clean capital given as a loan always remains clean. Trade income, including property rental income, becomes clean capital when it is paid to the person running the trade. Note that UK tax acts refer to foreign-source income not as paid to the individual but as arising to him, the significance of which is explained below.

It is a common misconception that when a person becomes UK resident the base cost of his non-UK capital assets — usually securities and real estate — is stepped up to its current market value. This is true say in Canada or Malta, however, in the UK capital gains tax will be charged on the entire historical capital gain accumulated since the assets were acquired. By consequence, where funds are locked up in assets “pregnant” with gains, in order to become clean capital they should be crystallised through the disposal of the assets. At the same time, if the asset is likely to be disposed of at a loss, the disposal will not create any clean capital and it should occur later when the owner becomes UK resident. By making an election in his first self-assessment return, the remittance basis taxpayer can offset the loss arising on such disposal against his UK or non-UK chargeable gains, thus minimising his capital gains tax charge and thus the amount of clean capital that has to be used in the UK (TCGA 1992, s 16ZA).

The future UK resident should not forget that receiving income or crystallising capital gains can trigger a tax charge in the place of his residence or in the source from which income or gains are received. Where the tax liability is likely to be significant, it might be worth taking up intermediary tax residence in order to take advantage of more benign domestic tax rules or a favourable double taxation treaty. However, care must be taken when leaving countries with the so-called “extended tax liability as a non-resident” that include Ireland, Germany or the US. These typically retain taxing rights for certain kinds of income and gains for up to 10 years following the individual’s departure, which sometimes cannot be reduced (for example, see ordinary residence in Ireland and its effect on post-departure capital gains).

Timing of creation of clean capital

UK income tax is charged on the income that arose during a tax year, that for individuals begins on 6th April and ends on the following 5th April. Similarly capital gains arise in the tax year in which the person disposes of an asset. Generally income or gains arising refer to the right to receive income or gains as opposed to the actual receipt of the payment. In order to form clean capital, income and gains should be timed to arise in the tax year in which the recipient is non-UK resident, or during the non-UK part of the tax year if split year treatment is available.

For example, interest is deemed to arise in the tax year in which it is received or made available to the recipient. Interest has been made available if it is credited to an account on which the account holder is free to draw, even if he cannot withdraw and spend the money, for example, where the account had been charged as security for a business guarantee. Dividends due from a non-UK resident company (even if the company is UK registered) follow the same treatment as interest.

For capital gains tax purposes, where the individual sells a property under an unconditional contract, the date of disposal for capital gains tax purposes is the date on which he exchanges contracts with the buyer, and not the actual completion or when the payment is received. Where the contract is conditional, the date of the disposal is the date on which the last of the conditions is met. The same logic applies to disposals of securities and other assets that generate chargeable gains on disposals.

Planning for UK residence

Individual tax residence in the UK depends on the number of days that a person spends in its territory combined with different factors that demonstrate his connections with the UK or conversely their absence. The statutory residence test is explained in HMRC’s brochure RDR3. As a general rule a person is resident for the entire tax year that for individuals begins on 6th April and ends on the following 5th April, irrespective of when they actually arrive in the UK. However, there are circumstances under which a person relocating to the UK can split the tax year and remain non-UK resident for the part immediately preceding his arrival.

Individuals often make preparatory visits to the UK and arrange for their accommodation prior to the long-term relocation. Unless they keep track of the number of midnights spent on UK soil, it is easy to become resident before all the pre-arrival tax arrangements are made and particularly before clean capital is created. Also the split year treatment may become unavailable. There are several practical recommendations, which if followed help minimising these risks.

The number of midnights spent in the UK in a tax year should not exceed 182, although the risk would be brought to the minimum if this number is less than 91.

While visiting in the UK it is preferable to stay in hotels or short-term rented accommodation, and the maximum length of rental of the same place in the tax year should not exceed 90 days.

If it is necessary to buy accommodation in the UK, the transaction should not be completed until the start of the tax year in which the individual is planning to become resident. However, there is no risk in completing the property transaction early on the condition that the accommodation does not become habitable until the start of the tax year of permanent relocation.

If it is necessary to enter into a long-term lease of accommodation in the UK, it should not begin until the start of the tax year in which the individual is planning to become resident.

It is preferable not to begin full-time work in the UK until the start of the tax year in which the individual is planning to become resident.

Keeping clean capital

Once clean capital is created, it should be kept in a bank account separate from foreign income and gains that arise after the person becomes UK resident. This includes interest that clean capital might generate if kept at a bank account or lent to another person. The bank account can be opened with a bank located in or outside the UK although in the former case clean capital will be liable to UK inheritance tax on its owner’s death. Therefore it is safer to keep the majority of clean capital in a bank account located outside the UK and only bring to the UK the minimum to cover the necessary spending. Because UK-source income and gains will suffer UK tax, this in a way constitutes an individual’s clean capital and can therefore be mixed with the true clean capital in the same bank account without adverse tax consequences.

Clean capital can remain in its original currency and it does not have to be converted to pounds sterling before the start of the tax year in which its owner becomes UK resident, or before it is brought to the UK. This follows the abolition of the rules that deemed foreign currency accounts to be chargeable assets for capital gains tax purposes in April 2012.

As mentioned earlier, clean capital can be lent and used to earn interest income that will not be liable to UK tax unless remitted to the UK or mixed with clean capital. Clean capital can also be used as collateral for a bona fide commercial loan received from a bank and used to invest in non-UK assets that generate capital gains on disposals. Conversely, it is not recommended to make direct investments of clean capital in such assets for fear of tainting it with capital gains that cannot be avoided by purely accounts’ separation — capital gains are inseparable from the capital creating such gains.

Finally, clean capital does not have to be declared to HMRC unless it is mixed with foreign income or gains. In fact, UK tax codes do not allow for such possibility, although it is recommended to keep documents substantiating the creation of clean capital.