After domicile and residence issues are resolved, the next step is to look at clients' property
When advising clients on structured tax and estate planning solutions the first step to take is to determine the jurisdictions with which the clients are connected by virtue of such factors as domicile, residence, citizenship, habitual residence etc, which were discussed in the first eight articles of the series. The next step is to categorise their property.
Categorising property comes down to answering the five questions of what, why, where, who and when with respect to any property transaction or asset. The answers to these questions determine how the property 'gets connected' with individuals and jurisdictions and whether the property is involved in trading or investment which, in turn, determines its tax treatment.
For instance, if a non-resident individual owns property in the UK, it is not subject to UK capital gains tax (CGT) on sale, unless the property is used in connection with a trade. So, a hotel building used in the hotel trade in the UK carried on by a non-resident individual would be subject to CGT on any gain realised on sale. However, if the hotel building were held in an offshore company and leased to the hotel trade, the gain on sale would not be subject to CGT, because the offshore company is not 'carrying on a trade in the UK through a permanent establishment' but holding the hotel property as an investment to obtain a rental income stream from the hotel trade.
In the first case the answers to the five questions would be:
• What: a hotel building.
• Why: to use in a hotel trade.
• Where: in the UK.
• Who: a non-resident individual trading in the UK through a permanent establishment.
• When: for the duration of the hotel trade.
In the second case the answers would be:
• What: a hotel building.
• Why: to hold as an investment to lease to the hotel trade.
• Where: the leasing is carried on in Jersey in respect of an hotel in the UK.
• Who: a Jersey company.
• When: for the period of investment, which may cover successive hotel trades.
The same non-resident individual could own both the UK trade and the offshore investment company but, by interposing the company and taking the hotel out of the trade, the tax treatment of the hotel property is fundamentally changed. These distinctions may appear to be artificial and, indeed, trivial but they are crucial when it comes to tax and estate planning.
The above example shows how property can be connected with a trade. Property can also be treated as trading stock as opposed to being treated as an investment. In a classic case, the actor and comedian Norman Wisdom sold sterling and acquired silver bullion, since he believed that sterling was about to be devalued. It was devalued and he realised a large gain. When the Revenue assessed him for trading in silver he maintained that he was simply using the silver to hedge his sterling funds. Unfortunately for the diminutive comedian, he did not have any sterling funds in the first place and had borrowed from a bank to acquire the silver! The answer to the question why, was not 'hedging his sterling assets' but 'to undertake an adventure in the nature of trade' and so he was subject to income tax. (There was no CGT at the time and so if the transaction had been hedging it would have been tax free.)
UK case law has built up a set of criteria to determine whether a transaction is trading, known as the 'badges of trade', which include the circumstances of acquisition and sale, the intention on acquisition, alteration of the property during the holding period, how the acquisition is funded, frequency of transactions, the period of ownership and whether there is a connected trade.
Individuals worried that their internet stock trading activities may be caught as trading can relax. The Inland Revenue manual states 'share transactions by individuals normally fall within the charge to CGT. Any claims to treat Stock Exchange speculations as trading should be resisted.' The Judge's comments in the case supporting this rule, made in 1965, are worth quoting:
The word 'speculation' is not, I think, as a matter of language, an accurate antithesis either to the word 'trade' or to the word 'investment': either a trade or an investment may be speculative. On the other hand, it is certainly true, at any rate in the case of an individual, that he may carry out a whole range of financial activities which do not amount to a trade but which could equally not be described as an investment, even upon a short-term basis. These activities include betting and gambling in the narrow sense. They also include, it seems, all sorts of stock exchange transactions. For want of a better phrase, I will describe this class of activities as gambling transactions.
However, corporate funds are always in danger of an attack by the Revenue for trading, especially if they invest in derivatives for non-hedging purposes.
Another example of the application of the categorisation of property would be where a non-resident borrower obtains a loan from a non-resident lender where the loan is secured on a UK property. It might be thought that the interest payable on the loan is entirely offshore and therefore could not fall within the scope of the UK's income tax withholding rules. However, following the Greek Bank case, the Revenue consider the following factors must be taken into account in determining the location of the source of the interest:
• The residence of the debtor i.e. the place in which the debt will be enforced.
• The source from which interest is paid.
• Where the interest is paid.
• The nature and location of the security of the debt.
If all of these are located in the UK then it is likely that the interest will have a UK source and therefore be subject to UK withholding tax. Since the debt will be enforced in the UK, the interest will be paid out of the UK rental stream, the interest may be paid by the UK letting agent and the loan is secured on a UK property, the Revenue may take the view that withholding tax is due since the loan is located in the UK!
The categorisation of property is therefore essential in determining its exposure to taxation and family and inheritance rules and next month's article will look at the categorisation of bank accounts.
The 'guidance' in this article does not constitute professional advice and is intended only as an informal introduction. The views expressed are entirely the author's own and should not be relied or acted upon in any way. Professional advice should always be sought before undertaking tax or estate planning.
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