April, 2008: Route Newsletter

Welcome to the first Route Newsletter of 2008 – and the last in the current format.  Our marketing people have been working on a whole fresh new image for all of our operations, and the next newsletter will usher in the fruits of their labours.

But for now we remain with the ‘old’ format, and in this newsletter we are taking the opportunity to take stock of two areas of tax legislation which have been subject to considerable upheaval over the last few months (not to mention about-faces and wholesale changes), and which are likely to affect Route Member clients in particular: Capital Gains Tax, and the new rules on Residence and Domicile.  Much has been written on these two topics in the last few months, and what we hope to do in this newsletter is sort fact from fiction, and to unravel the practical implications of the new regimes.  We will then round off by looking at a new service open to Route Member Clients, as well as attempting to take stock of the current situation facing the mortgage market.

Capital Gains Tax: Has It All Gone A Bit Flat?

One of the things that characterised Gordon Brown’s time in office as Chancellor was his habit of sweeping away simple one- or two-tier tax systems and replacing them with complex multi-faceted systems, within which individual rates could be tweaked and adjusted as desired to achieve whatever end result was deemed necessary or politic at the time.  Such was the case in Brown’s first Budget, both with Capital Gains Tax and with the introduction of tiered Stamp Duty – although perhaps a better example still would be the introduction in the same Budget of the concept of tiered rates for dear old ‘road tax’ (Vehicle Excise Duty), where today a mind-boggling 29 options now replace the simple, ‘Would Sir be wanting that for six months or twelve?’ system of old.

To his credit, the changes made by Brown to Capital Gains Tax – and certainly the rationale behind them – made a lot of sense.  By dividing the source of the gain into either ‘Business Assets’ or ‘Non-Business Assets’ it was possible to reward genuine entrepreneurial effort over simple, passive investment.  And by stepping down the effective rate over time, long-term investment was encouraged over short-term speculation.

With the system as established as it was, and working as well as it was, what changed?

Well, one of the problems is that real, serious, wealth tends to come about through entrepreneurial endeavour rather than through passive investment (although Warren Buffett may beg to differ).  As a consequence, those who were in the fortunate position of making a serious pile of money often found themselves in the even more fortunate position of only paying 10% tax on it when they did.  So we ended up with the rather perverse position that in order to get away with paying a miniscule amount of tax, you either had to be grindingly poor, or stupendously rich: an awkward paradox for the Government to try to reconcile, especially when it was one of its own making.

However, reconcile it they had to, and the solution arrived at was to throw away the old system and bring in, in its place, a single flat rate of Capital Gains Tax.

A flat rate has one over-arching point in its favour versus any other system: it is simple (both to understand and to administer).  In this sense it is the polar opposite of the multi-tiered system it succeeds, and as a consequence, we should rightly expect that the positives of the old system should become the negatives of the new – and vice versa.  An overview of the negatives of a flat rate system shows this to be so:

- Flat rate systems do not confer any advantage (nor hence offer any incentive) for long term ownership of assets

- Flat rate systems do not distinguish between one class of asset and another (for example, business versus non-business assets)

- And versus the (pre-1998) indexation system that the taper-relief system itself succeeded, flat rate systems make no allowance for the natural increase in an asset’s value through inflation, and instead tax all profit from ‘Pound One’

Against this, an advantage of a flat rate system is that such systems do not influence the buying or selling decision: under a tiered system capital can stagnate ahead of the next break-point in the schedule as the investor hangs on in order to move into a lower tax band.

Regardless or the rights and wrongs and pros and cons of a flat rate system, a flat rate system is what we now have, and so we will have to learn to live with it.

The next obvious question once a decision has been taken to implement a flat system is what rate to choose?  The rate selected, 18%, has no obvious precedent, so the likelihood is that the government simply looked at the aggregate amount of tax currently being collected under the multi-tiered system and compared this number to the aggregate gains being declared, and then simply divided one by the other to arrive at the average rate being paid.  Assuming that the answer was 18% (or, in all probability, slightly less than 18%) then the introduction of an 18% flat rate would achieve simplicity and ensure that the public purse was no worse off: amongst individual taxpayers there would be winners and losers, but the Treasury’s cash flow would remain unaffected (life insurance companies work on a similar principle when assuming ‘risk’ on annuity policies).

The only fly in the ointment is that by treating everyone the same, you end up inevitably disadvantaging people who were better off under the old system.  In particular this applies in this case to entrepreneurs, and so howls of derision were heard from the many who felt that the new system flew in the face of the government’s supposed commitment to encouraging an enterprise culture.

In the face of these protests, and perhaps unsurprisingly, something of a mini-climbdown was achieved, when the Treasury announced that a concessionary 10% flat rate* would continue to apply for the first £1m of profits that an individual realises during their lifetime which are of an entrepreneurial nature (*technically the rate remains 18% - it’s just that the value of any such assets is discounted by 4/9ths before the tax is applied).

Assets that qualify for Entrepreneurs’ Relief are not simply one and the same as the assets which used to qualify as ‘Business Assets’ (for example, businesses involved in furnished holiday letting are eligible under the Entrepreneurs’ Relief concession, but not any other type of property letting business).  The list is now tighter and more focussed, and comprises the following:

- A sole trader enterprise (either the business itself, or the selling-off of assets in the event of cessation)

- A partnership (either the business itself, or the selling-off of assets in the event of cessation)

- Shareholdings in a “personal” trading company or group of companies - defined as a company or group of companies in which the individual is either an officer or an employee AND where that individual holds at least 5% of the ordinary/voting shares

Assets falling outside these categories, and profits over and above the first £1m arising on assets from within these categories in an individual’s (post 6 April 2008) lifetime, are all taxed at the new 18% flat rate.

Perhaps the biggest losers under this shift to the new system are those who hold shares in their employer which previously would have qualified for full Business Asset Taper Relief (10%), but who now, because the stock they hold represents less than 5% of their employer’s share capital, find themselves liable to tax at 18%.

In bringing this section to a close, it is worth noting that, whatever else the pros and cons of the new system, one ‘tactical’ issue that arises is that, henceforth, assets which produce growth are to be preferred, from a tax perspective, to assets which produce income.  The reason for this is twofold: 18% tax on gains is preferable to 40% tax on income (or even the 20% tax rate on savings income for the basic rate taxpayer); and each individual has a further ‘personal allowance’ (the Annual Exemption) to be applied against their capital gains each year (for 2008/2009 this is £9,600, and allows this amount of profit to be realised without any liability to tax).

Residence and Domicile: Should I Stay Or Should I Go?

The other recent initiative that has given rise to considerable consternation is the new regime regarding non-domiciles.

Although the issue of non-domicile taxation (and offshore taxation in general) had always figured high on Gordon Brown’s agenda, the complexities of the issue had meant that the review of non-domicile taxation remained very much ‘work in progress’ - until the Tories, in the guise of George Osborne, came up with a solution of their own.   That their solution was so well received in the media, and with an election supposedly imminent, ensured that a remarkably similar draft initiative was wheeled out by Alistair Darling in his hastily put-together Pre-Budget Report of October 10th.

Of course the plans for an election – if they ever existed – were shelved shortly thereafter, but having made the case for taxation of non-domiciles, Darling was hardly in a position to drop this too, and so much time was spent between the Pre-Budget and the Budget proper trying to iron out the bugs.

With much media speculation as to what would and wouldn’t make its way through as a feature of the definitive rules it is perhaps not surprising that a great deal of confusion has arisen about the impact of the new rules, and so we thought we would take this opportunity to try to clarify.

Firstly, it is advisable to consider who classes as a non-domicile:

‘Domicile’ is a peculiarly British concept, distinct from nationality, citizenship, or residence.  Broadly speaking domicile can be thought of as your ‘roots’ – your natural home, and the place to which you would ultimately expect to return if given the choice.  If that place is the UK, then you are a UK domicile; if it is anywhere other than the UK, then you are a non-domicile.  Note that tax law does not draw degrees of distinction: you are either a UK domicile or a ‘non-dom’ (there is no consideration of whether you’re ‘French domiciled’ or ‘Spanish domiciled’, for example).

Although it is possible to be resident in many countries at a time (or better still, not resident in any country at all!), and to hold multiple passports, it is not possible to have dual domicile under UK law.  Domicile is generally (subject to the definition above) taken from your father at birth, although it is possible to acquire a domicile of choice over time.  Note that a pattern of behaviour which establishes permanence in a new country can lead to you acquiring a domicile of choice, and that it’s significantly easier to acquire UK domicile status than it is to lose it – principally because domicile is a tax concept and having UK domicile status simply expands the number of things upon which the Revenue can demand tax.

[Mention should also be made at this point that there has long been a ‘special category’ of ‘Deemed Domicile’.  This category applies to anyone who is long-term resident in the UK (defined as resident for at least 17 out of the preceding 20 tax years) – however it only applies in respect of Inheritance Tax, not Income Tax or Capital Gains Tax.]

Usually of course it’s pretty clear whether you’re UK domiciled or non-domiciled, but in a significant number of cases, particularly perhaps where there’s a question as to whether you’ve knowingly or unknowingly acquired a domicile of choice, it can be a very ‘grey’.  In such cases where clarification is necessary, it is possible to seek a ruling from the Revenue itself by submitting a DOM1 form, but, remembering that UK domicile once acquired is very difficult to shed, professional advice should always be sought when completing a DOM1 form.

Assuming that the individual is able to determine their domicile status, what are the practical implications?  Well, in simple terms:

A UK domicile declares and pays UK tax on all their worldwide income and wealth

A non-domicile declares and pays UK tax only on their UK income and wealth plus any offshore income and gains that they bring into the UK

For obvious reasons, holding money and accumulating wealth offshore has always had great appeal for the ‘non-dom’, whereas for the UK domicile it’s something of a non-starter.

The new rules attempt to impose the worldwide net already suffered by UK domiciles on long-term resident ‘non-doms’, and it works in the following ways:

If you have been resident in the UK for less than seven out of the last ten years then there is no change to the position as before (and as described above)

If you have been resident for at least seven out of the last ten years then you must declare and pay tax on your worldwide income and gains in the same way as a UK domicile, unless:

(i) You make a flat payment of £30,000 per tax year to the Revenue, in which case you can continue to be taxed as before*; or

(ii) Your total income and gains sum to less than £2,000 for the year, in which case, whilst there will be more paperwork to complete on your tax return, you can continue to be taxed as a non-domicile as before and not pay the £30,000 charge.

[* Whilst the position on your offshore income and wealth may not change, opting for the £30,000 charge means that you also lose entitlement to the Personal Allowance on your declared income and the annual Capital Gains Tax exemption on your declared gains – a further change to the previous regime]

Also note that each tax year is considered separately and so it is possible to opt in and opt out of the £30,000 charge each tax year as desired, and that husbands and wives are considered separately for tax purposes and therefore not tied by each other’s election – although the further consequence of this is that a ‘non-dom’ couple could potentially face an annual charge of £60,000 (fortunately, children under the age of 18 who might otherwise qualify under the criteria given are exempt from the charge).  The £30,000 does also carry forward as a credit to be used against any offshore income and gains that do get brought into the UK in the future.

At one stage income and gains earned by offshore trusts was also to be included within the remit of the new legislation, but this has been changed so that it is only the trust’s income from its assets (and gains on any UK-sited assets) that is caught – gains made by offshore trusts on offshore assets remain outside the scope of the legislation unless such gains are subsequently brought into the UK.

So, in simple terms: if you are a ‘non-dom’ who has been in the country for less than seven years, nothing changes; if you are a ‘non-dom’ who has been in the country for more than seven years, but with little or no offshore assets, nothing changes; if you are a ‘non-dom’ who has been in the country for more than seven years, with offshore assets producing sufficient income and gains to give rise to a UK tax liability of anything up to £30,000, you must now start declaring and paying that tax; and if you are a ‘non-dom’ who has been in the country for more than seven years, with offshore assets producing sufficient income and gains to give rise to a potential UK tax liability of in excess of £30,000, you have the option of either declaring and paying that tax, or simply paying a flat £30,000 to cap the liability and maintain privacy over your offshore interests as before.

Despite the thrust of the new regime, there are certain financial planning options open to the ‘non-dom’ who finds none of the above options particularly appealing, and you should speak to your Relationship Manager if this applies to you and is something you wish to explore further.

Property Search Consultancy

Route Group is pleased to announce that it has been able to secure the services of property search specialists, Garrington, for its Member Clients.

Catering specially for the high-value end of the market, Garrington can work with Route Member Clients to establish a brief, locate a suitable property or properties, and, upon the client making their choice, professionally negotiate the price on the client’s behalf.

The service is designed to deliver efficiency both in terms of time spent locating a suitable property, and the cost of acquiring that property; it works equally for private residences, second homes, and foreign property.  Because of the nature of the high-value end of the market and Garrington’s network of contacts, unique properties are often sourced as private sales from equally time-pressed vendors who do not wish necessarily to expose themselves to the traditional Estate Agent based sales process.

For further details of this specialist service, please speak to your Relationship Manager in the first instance.

The UK Mortgage Market

Talk of the property search service inevitably raises the issue of the current state of the UK mortgage lending market.

Pick up any paper or watch any news article at the moment and you can be certain that the spotlight will be on the ‘credit crunch’ and the effect that this is having (and is likely to have) on UK mortgage lenders.

In simple terms, a combination of greatly restricted liquidity in the money markets, fear over the future direction of house prices, and bottle-necks in mortgage lenders’ own processing capacities, has meant that in a very short space of time we have moved from a position of oversupply to undersupply in the mortgage market.

For the borrower, oversupply means a wide choice of lenders and products, with each lender vying to be the most competitive or attractive, and greatly ‘softened’ criteria applied when it comes to assessing both the borrower’s status, and the property’s suitability as security for the loan.

Undersupply, on the other hand, means fewer lenders and, with the reduction in competitive pressure that follows, a greatly reduced product range as well as far stricter criteria applied when it comes to considering the applicant’s status and the property they would like to buy.  Impaired credit products are the first to go, along with 125% Loan-to-Value mortgages, then 100% mortgages, etc. There then starts a general trend back towards the traditional ‘Maximum 3 x salary, 95% (or lower) Loan-to-Value, clean credit cases only’, with many mortgage products getting ‘pulled’ with little or no notice as lenders tighten criteria in this way.

In addition, lenders begin to retrench towards lending based on the deposits that they hold rather than seeking to leverage via the money markets, which in turn means that they borrow less and less from each other: the practical effect of this is that the rate at which they offer each other money (LIBOR) gets more expensive, and we see a ‘de-coupling’ of mortgage rates and Bank of England base rate.  In other words, even if the base rate falls, it is not certain that mortgage rates will follow suit.

Despite all this, UK lenders are still in business and still looking to lend.  For people looking to buy or re-mortgage, as well as those coming towards the end of a cheap fixed- or tracker-rate deal, clearly an accurate appraisal of options is a necessity.  Because of this, we recommend any such Route Member Clients take advantage of the review service offered by Route Mortgages; this service is free to Route Member Clients with charges only becoming payable in respect of admin fees if a new mortgage product is implemented.

For further details of the mortgage review service, please contact your Relationship Manager in the first instance.