Brendan Harper, technical services manager at Friends Provident International, looks at the practice of 'bed and breakfasting', and how it can be an ideal way to achieve tax-free capital growth
Prior to 1998, it was common practice for expatriates to sell and repurchase shareholdings before they returned to the UK, but this strategy was stopped by a change in the law. Now, however, it appears that this strategy will work again.
'Bed and breakfasting', as it was known, was a popular strategy for mitigating capital gains tax (CGT) on holdings in shares and mutual funds in the UK. UK residents have an annual CGT exemption that currently stands at £9,200, which means they can realise capital gains up to that level without incurring CGT. So it used to be common practice to sell your shareholdings when the inherent gains were close to this level, and then buy them back again the next day. Over time, this would result in substantial tax-free capital growth.
Using the same principles, a returning expatriate could sell shares one day and buy them back the next in advance of becoming UK resident again. For example, say he had a portfolio of shares worth £200,000 that he bought for £50,000 10 years ago. If he goes back to the UK and sells the shares, there would be a capital gain of £150,000. However, if he bed and breakfasts the shares before he returns, then the cost basis will be reset at £200,000, so that all the gains made while he was offshore are tax free.
Unfortunately, in Gordon Brown's first Budget in 1998, rules were introduced that effectively killed off bed and breakfasting. This was done by introducing a provision that ignored a share transaction for capital gains tax purposes where the sale and purchase involved shares in the same company or fund and happened within a 30-day period. In most cases, 30 days would be considered too risky a time period to be out of the market, and therefore not worth doing.
In 2005, however, HMRC lost a case which involved a strategy that used this anti-avoidance provision to avoid tax. The case, Hicks v Davies, involved a UK resident trust that held shares with substantial gains that would become chargeable if sold by the trustees.
The goal of the client's advisers was to move the trust offshore and to then sell the shares free of UK CGT. However, there are rules in place that would create a deemed disposal for CGT if UK resident trustees resign in favour of non-resident trustees and, even if this were successful, there are other rules which charge CGT on gains made by non-resident trustees of trusts where the settlor is UK resident and domiciled.
To get around these obstacles, the CGT planning stategy utilised two provisions:
(i) the double tax treaty between the UK & Mauritius, which at the time gave total taxing rights over capital gains to Mauritius residents, including trustees (this has since been changed), and;
(ii) the anti-bed and breakfasting provisions.
The steps undertaken were as follows:
• Step 1 – The trustees sold the shares;
• Step 2 – The UK resident trustees resigned in favour of Mauritius resident trustees;
• Step 3 – The shares were bought back again – within 30 days of the sale.
As the 30-day rule applied, the share transaction was ignored for CGT purposes, and as the trust held nothing but cash from the sale of the shares when it emigrated, there was nothing to tax. The result was that the shares were now in a Mauritius trust, and could be sold free of tax as there is no CGT in Mauritius. Finally, because of the double tax treaty, the settlor was not taxed on the gains made by the trustees.
Naturally, the UK taxman was keen to close this loophole for fear of opening the floodgates, and this happened in the Finance Act 2006. Since 22 March 2006, shares acquired while the taxpayer is non-UK resident or ordinarily resident are not subject to the 30-day rule.
So, in closing off the loophole employed by the taxpayers in Hicks v Davies, HMRC has effectively reintroduced the ability to bed and breakfast for expatriates planning to return to the UK. This is excellent news for those individuals.
I should point out that the anti-bed and breakfasting rules outlined above never affected offshore bond wrappers, as those contracts are within the income tax regime and thus not subject to CGT in the first place. This means that you have always been able to bed and breakfast a bond before returning to the UK. Of course, even if you do not bed and breakfast a bond wrapper, the gains you make while non-UK resident will still be tax free due to time apportionment relief n
Head of UK intermediary distribution
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