How the UK system currently works
Individuals are taxed in the UK according to where they live. You are considered “resident” in the UK and must pay UK tax on all of your income and gains for that year if you spend 183 or more days living there in a single tax year (or more than 90 days if you own a residence here).
According to others, the issue with this is that it becomes extremely simple to cease paying UK tax. Just leave the UK. Numerous wealthy people leave the UK for tax havens, frequently shortly before realizing significant capital gains. You can be sure that if the UK were going to enact a big wealth tax, we would see more of it.
Whether you consider this to be “tax avoidance” and/or immoral is a matter of personal opinion, and various people will have different opinions. However, leaving the UK is unquestionably a genuine, legal, and 100% successful technique to avoid UK tax as long as they truly spend 270 days abroad each year and do not return within five.
The US alternative
“Citizenship-based taxation” is a practice unique to the US.
This means that regardless of where they live, US citizens (and those who possess green cards) are entirely subject to US tax on their international income and earnings. So, moving to Panama won’t help you avoid paying US taxes. By giving up your citizenship, you can avoid paying US taxes, but doing so carries a substantial departure fee that essentially negates the entire immediate benefit of doing so.
It’s interesting that nearly no other nation practices this.
But, on the face of it, if you want to stop billionaires from leaving the UK and escaping UK tax, this is the approach to adopt.
(You may, alternatively, regard such an approach as immoral, and think that no country has the right to tax people who want to leave – but I’m going to park such political questions and look at the practicalities)
Where citizenship-based taxation goes wrong
The issue is that you would have to pay taxes twice. A British national who resides in France must pay both French and UK taxes since they are both residents of France.
On the surface, this shouldn’t be an issue since the UK has double tax treaties with France and the majority of other nations, which in theory prevent you from paying taxes on the same income twice. And you can be sure that if you earn £100, neither the US nor the UK will apply their full rates of tax to that income. However, the issues transcend beyond straightforward double taxation.
Here’s how it goes:
- The US has the “foreign earned income exclusion” for the first $107,000 of income for citizens living abroad. But it doesn’t protect the self-employed, who still have to pay US self-employment tax on their income. If you’re a plumber or an IT contractor, you have to file two complete tax returns in two countries. Those tax returns have different rules for e.g. what is deductible and what isn’t. Nightmare.
- To make life more fun, those tax returns will often cover a different period – for example the UK tax year runs from April 6th, but the US tax return runs from January 1st. Even if you’re employed, and all your income is exempt in the US under the foreign earned income exclusion, you still have to file.
- Filing tax returns in two countries is complicated, because of the interactions between the two sets of returns. I know someone who had a $5k capital gain – filing US taxes for that year cost them $3k.
- Capital gains are a problem, because the US taxes you on your US dollar gains. For example: say you buy a house in the UK for £300k and sell it a few years later for the same price. No UK capital gain. But if Sterling appreciated over that period, so that the dollar purchase price was $380k but the dollar sale price was $450k, then you have a $70k US capital gain, but no cash proceeds to fund it. And the UK will do the same to your US assets.
- If you make a capital gain then the different filing and payment timetables mean that you’ll sometimes have to pay the full US tax, then the full UK tax, then claim a refund of the US tax.
- It’s a nightmare for the spouse. If a couple have a joint account, and one is a US citizen and the other is not, then the joint account becomes subject to U.S. tax. Married couples can normally not worry about the tax treatments of their family finances – but where one of the couple is a US citizen then even simple arrangements like joint accounts become very complicated.
- Many people in the UK have an ISA, where you can put cash or shares into an account and the return is exempt from tax. But it’s not exempt from U.S. tax. So a U.S. citizen living in the UK cannot use an ISA (or, to be more accurate, if they use an ISA they get no benefit from it). Some US advisers think it’s worse than that, and an ISA has a particularly awful US tax treatment: that’s a whole other class of problems that arises when one country’s tax system has to characterise the tax effect of another country’s legal and tax system.
- You always get the worst of both worlds. For example, the US and UK take the opposite approach to the taxation of your house. The UK gives you no tax relief on your mortgage payments, but exempts you from capital gain on the value of the house. The US gives you tax relief on mortgage payments, but then taxes the capital gain. Both are somewhat balanced results. A U.S. citizen living in the UK gets the worst of both worlds. They get no tax relief on the mortgage for their UK tax, but have to pay US capital gains when they sell. That’s an unbalanced result.
- It becomes impossible to buy investment funds. The UK has rules that in practice mean no UK residents can buy an investment fund unless it is either established in the UK, or foreign but an “approved offshore reporting fund”. The US has rules that in practise mean it is very disadvantageous for a US citizen to invest into a non-US fund (the PFIC rules). The poor U.S. citizen living in the UK is subject to both sets of rules, and therefore cannot realistically invest in any funds.
- There’s an obvious incentive for US citizen’s abroad to simply not declare or pay their US taxes. That’s a criminal offence, but historically it was very hard for the IRS to spot. A whole international reporting regime – FATCA – was introduced to stop this. But that imposes a significant admin burden on non-US financial institutions with US citizen clients and, as a result, some banks don’t allow US citizens to open accounts.
- I could go on. The impact on minors. “Accidental Americans”. Retirement account taxation. Inheritance/estate tax interaction. Complexity when couples divorce. Social security/national insurance interaction. You don’t need to be wealthy, or to have complex personal finances, to have a horrible time navigating the US and UK tax systems at the same time.
These are unjust results for regular individuals, especially for those who cannot afford extensive tax guidance. Billionaires can handle it, but doctors and IT professionals struggle with it.
Therefore, you might see the UK adopting citizenship-based taxation as a “win” for taxing the very affluent. However, it would be detrimental to many common people who prefer to reside overseas.
That’s why the US is the only developed country that taxes on the basis of citizenship. Why does it do that? Some combination of: changing the US tax system is very hard, US expats don’t have valuable votes and so the campaign to change the law gets nowhere, and the US is big enough and bad enough to get away with things that other countries can’t.
Surely there’s a way to do the good stuff and not the bad stuff?
One suggestion is to continue taxing people based on their citizenship, but only for those who relocate to tax havens.
The issue with this is that many nations work just like tax havens for British citizens who relocate there. Rich British expats’ income is not or just minimally taxed in Singapore, Israel, Portugal, and even Italy. Therefore, our list of “tax havens” would either need to be quite extensive or have many gaps in it.
Additionally, as only a small number of nations today levy a wealth tax, practically every other nation would be a “tax haven” from the UK’s wealth tax.
So what’s the answer?
I think there are two.
One is to have no problem with people leaving the UK if they choose, and escaping UK tax. You can justify this on the principled grounds that everyone has a right to vote with their feet, or the pragmatic grounds that people may be less likely to come here, and entrepreneurs less likely to stay, if we hit them with a large tax bill when they leave.5
The other is to say that in some cases, where a person has accrued lots of untaxed capital gain during their time in the UK, the UK should have a right to tax it if they leave. I think that’s worth more thought, and will be writing more about it soon.
But citizenship-based taxation is unfair and unjust.