Tax system models
There are broadly four tax systems relating to income and gains, with an almost infinite number of subtle but important variations amongst the 195 countries that are recognised by the United Nations across five continents.
Twenty countries (as of February 2019) have no direct taxation, in other words residents do not suffer tax in that country on locally derived income or gains, or on foreign income or gains. Well known amongst these are the UAE, Oman, Qatar and Monaco.
At the other end of the spectrum sits the USA. Here citizens are taxed on their worldwide income and gains irrespective of their residence. This is known as ‘taxation by citizenship’. It’s probably this situation that contributed to the need to implement FATCA, the Foreign Account Tax Compliance Act, which since 2016 has required foreign financial institutions and certain other non-financial foreign entities to report on the foreign assets held by their US citizen account holders to the Internal Revenue Service (IRS). Only one other country taxes their citizens worldwide in a similar way: Eritrea in East Africa.
The USA and Eritrea aside, countries that tax income and gains commonly use one of just two systems; these are known as ‘territorial’ (also known as source based) and ‘residence-based’ (also known as worldwide). In a territorial system, only local income and gains from a source inside that country are charged to tax there, for example Singapore and Hong Kong. In a residence-based system, residents of the country are taxed on their worldwide (local and overseas) income and gains, while non-residents are taxed only on income and gains in the country in which the income and gains arise. This latter category represents an increasing majority of countries worldwide, including almost all of Europe.
Lack of harmonisation in these two systems creates the potential for double taxation. This is where the same income or gains are taxed by different countries. Double tax treaties (also known as double tax agreements – DTAs) are entered into by many countries via unilateral agreements with selected other countries with the aim of alleviating the potential for double taxation. Occasionally they facilitate double non-taxation (where income or gains are not taxed at all). Actively looking to exploit this is often referred to as ‘Treaty shopping’.
Estate taxes and inheritance taxes are often subject to widely different rules, with individuals frequently unaware of their obligations. International law defines estate taxes as chargeable according to the estate of the deceased, often relating to their domicile or citizenship, whilst inheritance taxes relate to the value received by an individual beneficiary (and their personal circumstances), rather than that of the donor. In other words the former is a donor-based tax and the latter recipient-based. At this point, UK domiciles will note the system relating to them has the characteristics of an estate tax but is confusingly known as an inheritance tax!
It is also worth highlighting that residents and citizens of a country where there are no death duties might still have a liability if they own wealth situated in a country where the tax applies, such as the case for UK or US shares. For example, a Singapore parent leaving wealth to a Singaporean heir might expect death duties not to apply, as death taxes were abolished in Singapore in 2006. However, the deceased’s UK shares could be subject to a 40% liability above the nil rate band of £325k, and the same client’s US wealth (even if held on an overseas banking platform) could be subject to a US liability of between 18 and 40% above an exemption level of just $60k USD.
Interestingly very few DTAs exist for death duties. For example, the UK has just 10 and the USA just 16. Whilst unilateral relief might be available, results aren’t always as expected so this relief shouldn’t be relied upon.
In the example above regarding inheritance tax, purchasing UK or US securities through an insurance bond rather than a conventional banking or proprietary trading platform would help to ensure that the policyholder was detached from the underlying asset. This should apply equally to any investor from a country outside the narrow range of DTAs the UK and US have, and even some where there is a DTA but the UK or US has a higher rate than where the individual is domiciled.
For those who are residents of countries subject to taxation according to their residency (worldwide), which make up over two thirds of all countries, there is a clear distinction between owning wealth directly (or on a conventional trading platform) and through an insurance bond. For tax purposes, through direct ownership (or through a trading platform), in general the liability on income and gains occurs annually as they arise. This is often the case even if the tax is not remitted to where they live. However, when held through a bond, all income (dividend, coupon, rent and interest), as well as gains when holdings are realised within the bond, do not give rise to a liability at that point in time. This principle is known as gross roll up (explained on p.3 of our brochure ‘Offshore bonds for those moving to the UK and returning UK expatriates’) and can be invaluable in a number of ways:
- Firstly, tax deferred means that money that would have been deducted annually as tax on any profits works for the investor for longer before it becomes chargeable.
- Secondly, if a policyholder’s tax rate drops, or they move to a country where tax rates are lower, tax is source based or the country charges no tax, the savings can be significant.
- Thirdly, for an individual arriving into the UK from any other country, full credit is given for time spent overseas, known as time apportionment relief, and that could mean almost the full value of any profit can legitimately be removed from personal taxation.
As ever, the devil is in the detail, so the value of an adviser is in understanding how these subtleties and nuances, combined with the product options available, can become a meaningful tax planning solution in cross-border situations.
Visit our dedicated Expatriate Solutions webpages – which focus specifically on how your clients’ investments could be impacted by the country in which they live, either now or in the future.