Foreign Tax Planning
By Carl Bayley BSc ACA
After twenty years in the tax advice business, there are few things which still surprise me. One thing which does still amaze me, however, is just how often people still seem to overlook the fact that the UK is not the only country in the world with taxes.
Anyone who lives, works, or invests abroad has a potential exposure to foreign tax. Not only is property investment no exception to this general rule, it is actually one of the fields with the greatest potential exposure to foreign taxation.
Most of us know just how many taxes the UK Government levies on property owners. Why then, should other countries be any different?
The worst thing of all, for a UK resident property investor, is that you will often be exposed to tax in both countries - the UK and the country in which you are investing.
Foreign taxes which are based on similar principles to UK Income Tax or Capital Gains Tax may generally be deducted from any UK liability for those taxes. If they exceed the UK tax bill, however, then no repayment is possible. This means that the investor effectively suffers an overall tax burden equivalent to the higher of the two tax rates applying.
If the foreign tax takes a form which the UK Treasury do not recognise as being equivalent to one of our own taxes, however, then no deduction is possible. This leaves the investor fully exposed to both countries' taxes. The effect of this could be to produce an extremely high rate of tax overall, or even an after tax loss.
Many investors are attracted by the possibility of high returns on foreign property investments, but it is essential to bear in mind the effective total tax exposure on these investments. When comparing the rates of return on potential investments, the investor should always consider the after tax return.
James, a UK resident investor, is considering two possible investments. The first is on the Caribbean island of San Monique and offers a return of 17.5%. The second is in the Isthmus Republic and offers a return of just 8%.
James is a higher rate taxpayer in the UK. He also finds out that San Monique imposes a property tax at a rate of 10% on the capital value of any property owned by a non-resident. This will reduce the rate of return on James' San Monique investment to just 7.5%. After also paying UK Income Tax at 40% , his overall rate of return, after tax, will be just 4.5%.
[The San Monique tax cannot be deducted from James' UK tax bill, but he can claim it as an expense, like he would for council tax. What this means, however, is that instead of getting full relief for his foreign tax, James gets relief at just 40% for it.]
The Isthmus Republic charges Income Tax at 25% and this will give James an after tax return in the Republic of just 6% if he buys property there. However, this tax is fully deductible against James' UK Income Tax bill. As a result, James' overall after tax return on this investment would be 4.8%.
James will therefore be better off if he invests in the Isthmus Republic.
What this example shows is that, when investing abroad, it is vital to take foreign taxes into account. It further shows that it is important to consider not only the rate of the foreign taxes, but also the nature of those taxes. The key factor for a UK resident investor is whether the foreign tax will merely be classed as a business expense for UK tax purposes or will be fully deductible from the UK tax bill as a recognised equivalent tax.
Having covered the principles, we will now take a look at some of those foreign taxes. I would remind readers that what follows is just a quick overview. Local professional advice will always be essential when investing abroad.
European Union: VAT & Holiday Accommodation
Any letting of property as holiday accommodation in any one of the 25 member states of the European Union is likely to be subject to VAT. Some EU countries, like the UK, have a registration threshold (ours is currently £61,000), so that registration for foreign VAT is only necessary if the total annual holiday rental from all of the investor's properties in that country exceeds this limit. Most countries' VAT registration thresholds are considerably lower than ours, however.
Foreign VAT will present an administrative burden and will also result in the effective loss of a major proportion of the gross rents receivable. In Denmark or Sweden, for example, holiday rental income is subject to VAT at 25%, meaning that VAT of £250 would have to be paid out for every £1,250 of gross rental income received.
Remember also that the beneficial rules available for furnished holiday accommodation in the UK are not available when the property is situated abroad. Arguably, this may be contrary to the principles of European law but do you want to be the test case?
Furnished lettings in France up to an annual value of E76,000 are eligible for a 72% flat rate deduction in respect of expenses under the 'Micro-Bic' regime. The remaining net deemed profit is taxed at 25%, thus producing an overall effective rate of 7% on gross rents received.
For unfurnished lettings, the deduction for deemed expenses is at 60% and the maximum annual rental eligible for the flat rate deduction is E15,000.
A UK resident investing in France will still need to calculate their rental profit on an actual basis (i.e. deducting actual expenses from the actual gross rent received) for UK Income Tax purposes, but the French Tax is deductible from the UK liability.
Holiday lettings will also be subject to VAT at 19.6%.
An investor with total French assets having a value in excess of E720,000 will be subject to an annual wealth tax of between 0.55% and 1.8%. Liabilities are usually deductible in establishing the total value of French assets, but local advice is needed to ensure that the liabilities are indeed deductible. This may necessitate using French borrowings to purchase French property. No deduction will be given in the UK in respect of any French wealth tax liability.
Disposal of a property after less than two years of ownership will be subject to income tax at rates of up to 47%. After two years, however, the gain is taxed at just 16%.
After five years of ownership, a French form of taper relief begins to apply, exempting 10% of the gain for each further year of ownership thereafter. Hence, after 15 years, the gain is exempt. For a furnished property within the 'Micro-Bic' regime, full exemption is given after just five years of ownership.
French Inheritance Tax is a serious problem. The rates applying can be up to 60% and the exemption for transfers to a spouse is a mere E76,000. The French equivalent of the nil rate band is just E1,500.
The best defence against French Inheritance Tax is to invest via a company or to use a form of joint ownership called 'En Tontine'. Local advice is essential!
Rental income in Spain is subject to a 25% tax on the gross rents with no deduction available for mortgage interest or other expenses. This will very often produce a Spanish tax liability well in excess of any UK liability on the same income. As explained above, no refund of the excess tax paid will be available.
A profitable Spanish investment property may easily even produce an after tax loss. Imagine a property with gross annual rents of E15,000 but annual mortgage interest of E10,000 and other costs of E2,000. In UK terms, we would see this as a profit before tax of E3,000. In Spain, however, the tax based on gross rents will remain E3,750, giving an overall after tax loss of E750!
Holiday lettings will also be subject to VAT at 16%.
All Spanish property owned by non-residents is also subject to an annual wealth tax of at least 0.2% (rising progressively to a maximum of 2.5% for those with Spanish assets worth over E10,000,000).
Non-residents also pay Spanish Capital Gains Tax at 35%. Purchasers have to withhold 5% of the purchase price and pay it over to the authorities on account of this tax.
Inheritance Tax is again a serious problem. The rate applying varies from 7.65% to 81.6%. There is no nil rate band and the exemption for transfers to spouses is just E16,000.
Investors should again consider the use of a company or joint ownership. Local advice remains essential!
Italy charges income tax on rental income at the same rates as other income. The first E100,000 of Italian income is taxed at 23%, with any excess being taxed at 33%. Expenses, such as mortgage interest are deductible in a similar way to the UK's system.
Properties not rented out (e.g. your own holiday home) are subject to a tax on notional rental. This is usually no more than 1% of the property's value per annum.
Holiday rentals would also be subject to VAT at 20%.
The gain on a property sold within five years of purchase is subject to income tax at the rates described above. After five years of ownership, however, any gain is exempt from all Italian taxes.
Local authorities in Italy levy a purchase tax on the acquisition of property and this is typically at rates of around 10%.
There is no Inheritance Tax in Italy, although those inheriting property will have to pay a 'transfer and registration tax'.
The Irish tax system has many similarities to the UK. A friend of mine working in Ireland once suggested to me that "they wait until Westminster passes a law, look it through and then just use the most sensible bits".
Most of the same deductions which we are familiar with in the UK are therefore allowable against rental income in Ireland, including interest and repairs. Capital allowances are also given for the costs of fittings within a rental property.
One thing which is not allowed in Ireland, however, is any costs incurred prior to letting the property.
Income tax rates on rental income may be as high as 42% with other charges applying of up to 5%.
Holiday lettings will be subject to VAT at 21%.
Portugal charges a flat rate of 25% on gross rents with no allowance for expenses, such as mortgage interest.
Holiday lettings will be subject to VAT at 21%.
Capital gains are taxed at 25%.
A 10% transfer tax applies to property inherited by close relatives or unmarried partners.
A 16% transfer tax also applies to some transfers of Portuguese properties by non-resident companies.
Rental income in Bulgaria is subject to a 15% withholding tax after deducting prescribed allowable expenses, including mortgage interest.
Bulgarian capital gains tax is also charged at 15%.
Inheritance tax has recently been abolished in Bulgaria.
Non-residents are not always permitted to buy property in Bulgaria, so it is sometimes necessary to use a Bulgarian company. As Bulgarian corporation tax is also 15%, this does not affect the tax on rental income, although it has other cost implications.
Many people regard Dubai as being tax-free. This is not strictly accurate and Dubai does have income tax. In fact, it is only certain zones within the small gulf state which are actually tax free, most notably the Jebel Ali Free Zone and the Dubai International Financial Centre. The tax-free status, principally aimed at businesses investing in the state, is not always permanent either. In the Jebel Ali zone it is given for an initial period of 15 years, with a further 15 year extension sometimes being available on application.
A standard 30% rate of withholding tax is applicable to US rental income received by non-residents.
However, by filing a US Tax Return you will be able to claim expenses including mortgage interest and a depreciation allowance.
The resultant net rental profit will then be taxable at progressive rates ranging from 15% to 35%. In some States, there will be State Income Tax to pay as well.
As far as Federal Income Tax is concerned, however, the likelihood is that the filing of your US Tax Return will lead to a repayment of much of that withholding tax.
When calculating your UK Income Tax on your US rental income, the depreciation allowance given by the IRS will not be allowed by our own Revenue & Customs!
For property owned for more than one year, US capital gains tax will be payable at either 8% or 15% for larger gains. The purchaser must withhold 10% of the purchase price and pay it over to the Internal Revenue Service on account of this tax. (The withholding requirement is dropped if the purchase is for less than $300,000 and the purchaser is to occupy it as their residence.)
Withholding tax is again repayable when it exceeds the actual liability.
The depreciation allowance given against rental income is 'clawed back' when the property is sold.
As a non-citizen, you will be restricted to a mere $60,000 exemption from US Inheritance Tax on your American property. The top rate of US Inheritance Tax in 2005 was 47%. You will also need to watch out for State Inheritance Taxes and also a Federal Gift Tax on lifetime transfers.
US Inheritance Tax is the major problem which a UK investor will face. Married taxpayers can alleviate the problem considerably by using a 'Special US Qualifying Domestic Trust' when leaving property to their spouse as this will provide access to the $1.5m spouse exemption available to US citizens. As usual, local advice is essential.
What About Double Tax Treaties?
The UK has a double tax treaty with each of the countries examined above.
When it comes to property, however, most double tax treaties allow the country in which the property is situated to tax a non-resident investor on income or capital gains from that property. Likewise, foreign Inheritance Tax continues to be payable on property in that country.
Sadly, therefore, the UK's double tax treaty network is of little help to property investors in most cases.
The title of this article is really the key to investing in property abroad. It is essential to get local advice and to understand what you are getting yourself into.
Many people concentrate so hard on avoiding UK taxes that they overlook the fact that foreign taxation can be just as important, or even more so. This will often be to their detriment as an investment which looks attractive before foreign tax is taken into account may provide a pretty poor return after tax, or even a loss!
So, if you're interested in property abroad, look before you leap!