Residency: a taxing issue

Residency status and the domicile of an individual can dramatically impact their tax position. The fallout of COVID-19 has meant many people have been unexpectedly caught on the wrong side of borders – and for some, this could prove expensive. 

In our first Q&A in this series, Baker Tilly International’s private high net worth specialists Alison Wood from Australia, Nigel May from the UK and Ian Halligan from the US analysed how COVID-19 has changed cross-border planning and the challenge facing many of how and where they choose to continue to play out the pandemic.

In this episode, we focus on the growing issue of tax residency – expelling the facts from the myths – as movement between territories continues to be fraught with restrictions.

Similar, but very different

One of the most common mistakes people make from an international tax planning perspective is assuming that the rules of residency are similar from one territory to another. As many are now discovering, that is simply not the case.

According to Nigel May, partner in the UK, the UK’s rules are kept deliberately complicated to avoid evasion.

“In the UK we have the concept of definitive UK residence, definitive non-UK residence and for people who fall between the two, we have what are known as linking factors. These linking factors include whether you have a home available to you, where your family is based, etc. For those people that fall between definitive and non-definitive residency, the number of days you can spend in the UK is dependent on these linking factors.

“You then have to consider whether you are dealing with someone who is leaving the UK or coming into the UK. There are only limited situations where someone who’s coming to or leaving the UK during the tax year can have what’s called ‘split year treatment’.”

In the United States, as well as considering the Federal position on residency, the individual State’s position comes into play – and there’s not always symmetry between the two.

As Ian Halligan, partner from the US explains, the US is one of the few countries left in the world where tax is still applied on a residency basis.

“You can live in another country for a whole year, but if you are a citizen of the United States, you are considered a US tax resident. Green Card holders get similar treatment.

“We do have a substantial presence test that can give you residency – but once the US has got their tax hooks into you, it’s difficult to extract yourself.

“We also have an exit tax that can come into play when citizens and certain Green Card holders relinquish their US residency status. So, rules are potentially complex and dependent on a number of factors in play – and during the pandemic we have seen people accidentally trip up over these things.”

In Australia, the test for people trying to leave and break residency is subjective. Based around where you reside, rules become complicated: you can have individuals leaving to different jurisdictions but with almost identical fact patterns who have differing residency status, as Alison Wood, partner in Australia explains.

“For individuals entering Australia, rules became easier with the introduction in 2006 of a temporary residence status (a halfway residence status). But while things are easier, they are not without complications. Temporary residence status depends on the visa you are on, and whether that is a permanent or temporary residence visa, or whether you are coming through the back door via New Zealand.

“We don’t have death duties or gift taxes currently. There are some backdoor capital taxes when it comes to people passing away, but we do have a deemed disposal of assets that aren’t Australian for Australian residents who wish to break tax residency. You also have to look at the various treaties because some give a choice as to whether you deem dispose or not – and that double negative adds to the complexity and highlights the subtle differences with the English language.”

Lack of symmetry

These subtle differences in language is a common theme and one that people fall fowl of without the right advice.

The UK relies on the dual concept of residency on the one hand, and domicile on the other.

For people who did not originally derive from the UK, non-domicile status carries with it certain advantages and will be important for non-UK people coming to the UK, particularly from a death duty and an inheritance tax point of view, explains Nigel.

“Someone who is not domiciled in the UK is only liable to UK inheritance tax on UK situated assets. Right now, there are deemed domicile rules under which, if you outstay your welcome in the UK, you effectively join the UK tax club. However, there are also rules under which UK expats who have left the UK for many years and have established non-UK domicile elsewhere may encounter problems from a capital tax viewpoint if they find themselves UK resident.

“For income tax, the non-domicile rules allow remittance basis to apply. So, for foreign-source income you are able to pay tax only on income that you bring into the UK, either directly or constructively.

“For high net wealth or ultra-high net wealth individuals, how you deal with domicile status is of the utmost importance.”

The differentials between the approach for domicile versus residency is one of the key misunderstandings Ian sees and the knock-on impact that has on income versus inheritance tax. 

“The concept exists that international tax all works together: everyone is applying the same rules. But we know that is not the case, and this is where the planning opportunities exist and, conversely, where the real danger lies from a tax perspective.”

It is these subtle nuances that can lead to unwelcome tax outcomes, explains Alison – thoughts echoed by Nigel who believes in many instances we end up with a set of tax rules really not fitting what the set of circumstances are from a cross border tax perspective.

“Where jurisdictions like the UK and the US have a capital gains tax rate, in Australia our foreign income tax offsets are effectively halved because they are applied to what we term as the gross gain before the general discount. This can be very expensive and a difficult conversation to have with clients: they’ve paid 25% tax in the UK and are under the impression that no additional tax is due as they’re subject to tax here on a worldwide basis. The reality is that they lose almost half of that 25% tax credit because it’s applied to the gross gain  not the net gain.”

Plan. Plan. Plan.

How governments around the word deal with the massive deficits they are faced with coming out of COVID-19 having pumped vast amounts of money into struggling economies, remains to be seen. Tax hikes, and pretty hefty ones at that, are certainly expected in many jurisdictions.

What is clear is the importance of planning at the earliest opportunity – and that means several months before you want to do something. Getting everything from a residency standpoint in order, often taking into account the viewpoints of multiple jurisdictions, takes time, and advice.