12 February 2007
The private client world is changing. The UK tax system, despite being grounded in a heavy mass of black letter law, can be extremely difficult to pin down. Underneath apparently arid and technical rules lie subtle developments. The challenges to clients of all levels of wealth are constantly shifting and their advisers have to adapt accordingly. Tax is not necessarily boring, it is certainly not certain, and it is not always fair.
There is no shortage of examples, such as the oblique but aggressive attack on trusts perpetrated by the Chancellor in the last budget. Unannounced, it was imposed summarily, without so much as the courtesy of consultation. Only now, following recent HM Revenue & Customs (HMRC) research, does there appear to be recognition that trusts are not inherently objectionable. Misconceived legislation has necessitated urgent and creative responses across the profession.
A particularly controversial example from late 2006 is the HMRC special commissioners' dismissal of Robert Gaines-Cooper's preliminary appeal against the HMRC authorities, which has provoked considerable consternation.
The background to the case is roughly as follows. The UK bases its jurisdiction to tax on two key factors - residence and domicile. Residence is where you live and domicile is where your permanent home is located. The importance of identifying an individual's residence and domicile status cannot be overstated, as this determines exposure to the key UK taxes - income tax, capital gains tax and inheritance tax. In a nutshell, being able to argue non-resident or non-domiciled status is a nuclear weapon in a potential taxpayer's arsenal. Unsurprisingly, HMRC increasingly scrutinises such claims with care.
The special commissioners rejected Gaines-Cooper's assertion that he was neither resident nor domiciled in the UK. This was notwithstanding the care taken by Gaines-Cooper to ensure that his visits to the UK averaged less than 91 days per year, which is the figure given in HMRC's guidance booklet IR20. IR20 contains detailed and clearly articulated guidance on when an individual will be regarded as resident in the UK. IR20 is not legally binding and expressly excludes its own application where an attempt is made to rely on it for tax avoidance, but it is generally regarded as a reliable and approachable guide to the analysis of UK residence.
Critically, when counting days for the 91-day test, IR20 provides that days of arrival and departure are ignored. For individuals with a peripatetic lifestyle - epitomised by Gaines-Cooper - this provision is extremely useful. If you come to the UK on a Monday morning and leave on a Friday, applying this rule means you have spent only three days in the UK. Gaines-Cooper, like many others, calculated his day count on this basis.
Night and day
The special commissioners considered that this gave a distorted picture of Gaines-Cooper's 'unusual' lifestyle. Central to this was the comparison between the number of days spent in the UK and in the Seychelles, where Gaines-Cooper claimed to be resident. They therefore declined to apply IR20, noting: "We must apply the law rather than the provisions of IR20."And, after pages of analysis on decades of Gaines-Cooper's life, they concluded that he had not relinquished UK residence. As part of their rationale for reaching this conclusion, they counted not days spent in the UK, but nights spent there. Unsurprisingly, this brought the average day count above the 91-day threshold. Just like Cinderella, by staying out past midnight Gaines-Cooper's riches took a turn for the worse.
The residence finding has attracted the most attention, but aspects of the rationale behind the domicile finding are also extremely concerning.
While his connections to the UK (and those of his wife) later in life had clearly increased, there were times when Gaines-Cooper maintained very few links with where he regarded as his former home. Yet the special commissioners refused to be swayed by this and, citing a Soren Kierkegaard quote from a prior case, they were of the view that, while life must be lived forwards, it can only be understood backwards.
The lack of weight given to Gaines-Cooper's own evidence is also concerning. The increasing burden of proof that is required from taxpayers who believe that they have successfully lost their UK domicile of origin further highlights the growing disparity between the core of certainty in UK tax planning and the penumbra of doubt. Any individual with a UK domicile of origin considering moving their lifestyle away from the UK and the long arms of HMRC would be well advised to treat IR20 with some scepticism - for example by leaving the UK completely for the first full tax year and severing almost all remaining ties to the UK, including their homes and social connections.
Despite HMRC's vocal protestations that the decision does not represent a change in its practice, the ruling is open to serious criticism. This is not the place to debate the flaws in depth - it is understood that an appeal is intended.
So what is the point of this? Where does it leave us? And what lessons are to be learnt? There will clearly be immediate consequences for certain classes of internationally mobile and globally wealthy clients: playing with tax fire can lead to unpleasant burns - sometimes in unexpected places - and individual tax planning strategies may need to be reviewed accordingly.
In particular, it would be prudent for individuals previously hoping to rely on IR20 to begin a comparative night count. The impact is big. Love it or loathe it, it must not be underestimated and long-term tactics may need to be revisited and revised. But the case is symptomatic of wider developments.
It is a trite half-truism, frequently trotted out by commercial and private client lawyers alike, that 'the tax tail should not wag the dog'. In some cases this is patently obvious - you would not advise an elderly client to give away assets that they urgently need, simply in order to save a little inheritance tax. But the reality of international wealth is such that sometimes people will be quite prepared to alter their behaviour precisely in order to mitigate exposure to tax. Change the way you tax people and you change the way they behave.
There is plenty more in the pipeline, from a rumoured tax amnesty to changes in money laundering law courtesy of the third European Commission Directive, that threaten private banking and the UK trust industry. And quite aside from these anticipated developments, the Treasury has demonstrated its ability to spring nasty surprises on a fertile growth industry without warning. Gaines-Cooper was caught out by a 'Cinderella ruling', and the pantomime looks set to continue.
Clare Maurice is head of private client at Allen & Overy. She was assisted with this article by associates Ed Powles and Catherine Grum