Calculation of UK tax on Mixed Funds

I have quite a few questions, but I'll try and keep it simple in the hope of getting some answers.

My husband and I are hoping to retire to the UK.  We are both dual citizens and have been living in the UK for the past 5 years - husband seconded here from the US with his company. Taxes have been paid on the Remittance Basis.  Unfortunately, we had no clue about all the rules and how we would be impacted down the line, and so all of our taxable investments in the US (which we are dependant upon for our retirement) are now Mixed Funds.

1) I am trying to find how to calculate what the tax will be on a remittance from these funds.  I can't seem to find a specific formula anywhere on the HMRC website.  Can anyone point me in the right direction?

2) Although I understand that our taxable investments qualify as Mixed Funds, will that also be the case for funds in his 401K and in his NQDC?

3) All of our taxable investments are Mutual Funds with Vanguard.  I've read here that ETFs are preferable because they are HMRC reporting funds. (I hope I'm getting the terminology right!) Should we therefore convert to ETFs or is that only of benefit to those who are remitting "clean capital" rather than "mixed funds"?

My first question is about your residence status. As UK citizens living in the UK with the intention to retire in the UK you'll be taxed on an arising basis?

The US/UK tax treaty recognizes the 401k wrapper and it protects your funds from UK taxation until income is taken and then HMRC will tax it as a foreign pension payment. The NQDC is trickier as the US taxation is not necessarily deferred until a retirement date, it's often deferred until you stop working for the company. So the question is whether HMRC will recognize it as a pension.

Vanguard provides clear documentation about dividends, interest and capital gains. If your funds are HMRC non-reporting, then HMRC will tax any gains as income and obviously the IRS will tax you on the gains as you are US citizens. If you move the funds to an equivalent ETF it will not be registered by Vanguard as a sale at all, just a re-naming. The ETF will probably be HMRC reporting and you will be able to pay the tax on the dividends and capital gains at the right rate and in the right proportions to the UK and US.

Yes, assuming we can afford to settle here in retirement, we will choose to pay taxes on the arising basis. Currently husband is under a tax equalization agreement with his company, and it is I think in the company's interest to file taxes on the Remittance Basis.

Your reply is really helpful -thank you.  Let me just confirm that I have understood you rightly.  Even though our Vanguard mutual funds are mixed funds since dividends have been reinvested during the past 5 years, you are saying that if they are converted to ETFs, and assuming those ETFs are HMRC-reporting, then we will be taxed in the UK at the dividend rate for dividends, and at the capital gains rate for CGs. So, in actual fact, there is no penalty for their being mixed funds? Is that correct?

There are numerous strands to Angeline’s questions. Here are some additional comments on some aspects.

The mixed fund rules are best understood by way of a simple example. Capital before UK residence commenced can be termed clean capital. Suppose this was $1,000 and was used to purchase an investment, which paid dividends of $100 and was sold for $1,500, which was placed in a bank account. The bank account has $1,600. If a remittance is made from that account the first $100 is matched with the dividend income, the next $500 with the capital gain, and the final $1,000 with the clean capital. The detailed rules are complex and the calculations can be difficult, but this example gives the general idea.

Under UK tax rules, if a gain is made on a non UK collective investment scheme that it is not a reporting fund, the gain (which is known as an Offshore Income Gain or OIG) is, as Nun has said taxed to UK income tax rather than UK capital gains tax, generally resulting in a higher tax charge.

Under the mixed fund rules, OIGs come after dividends but before capital gains.

If the remittance basis is claimed but dividends are later remitted to the UK, the dividend rates do not apply. The dividends are taxed at the full normal rates of tax. It should be remembered that there are disadvantages to the remittance basis-loss of personal allowances and the capital gains tax annual exemption, and usually less effective offset of UK tax later paid on subsequent remittances against US tax.

Thank you Dunedin. I think I am beginning to understand the process then.  Let's say we want to remit the total dollar amount we own in the Vanguard Total Stock Market fund and the date we took up residence in the UK was April 1st 2011.  First we would check our March 31st 2011 statement from Vanguard  and note the number of shares we owned at that point.  That number of shares is our "Clean Capital", and we will owe no tax in the UK on that dollar amount.  So far so good, but after that it becomes more complicated. We then need to calculate:

1) All income invested in the fund since April 1st 2011
2) All dividends reinvested since April 1st 2011
3) Capital Gains since April 1st 2011

All income invested in the fund had already been taxed in the U.S. so the income tax owed on this portion in the UK will be offset by the US tax already paid. But you say it will be a "usually less effective offset".  Could you be more specific?
2) and 3) will all be fully taxed as income in the UK because we have claimed the RB during these years. Again we have paid US taxes on the DIVs and CGs, so we should be able to offset those taxes paid against the UK tax owed, correct?

I am confused by your statement: "Under the mixed fund rules, OIGs come after dividends but before capital gains".  I must be missing something.  From your post my understanding is that the Offshore Income Gain is just another name for the capital gain on a non-reporting fund.

Apart from the confusion about OIGs and capital gains, am I on the right track?

Sadly not. The UK will not give you credit for US tax because the UK will then have the primary taxing right. Under Article 24 of the US/UK treaty you would re-source the income in the US and claim a credit in the US for the UK tax.

Do remember that there will be a special re-basing rule for 2017/18 (only) which might assist in your circumstances.

Since you were tax equalised, why did your existing accountant fail to tell you to create segregated accounts when you moved to the UK? Are they at fault here, as that has always been the standard advice?

One good thing is that all the income and gains information you need should be readily available from Vanguard. Also Total Stock Market hasn't given Capital Gains Distributions in years......so you just have to worry about dividends.

As Guya says, it's important to do some housekeeping before moving to the UK if you have US investments. Moving funds to Vanguard ETFs is important if you will be remitting money or being taxed on an arising basis. For many people using the arising basis and keeping the UK's capital gains and dividend tax free allowances is useful.

Do remember that there will be a special re-basing rule for 2017/18 (only) which might assist in your circumstances.

That is interesting.  From what I can find it seems to apply exclusively to very long-term non-doms who will be forced to become domiciled in 2017/18 and who have paid the Remittance Charge in at least one year.  Therefore it wouldn't apply to us, but I will investigate further because obviously the option to re-base and untangle mixed funds would change our situation entirely if we could use it.

Since you were tax equalised, why did your existing accountant fail to tell you to create segregated accounts when you moved to the UK? Are they at fault here, as that has always been the standard advice?

Husband had a meeting with the tax accountant at the start of his secondment here in which lots of things were covered.  He doesn't remember any mention of the need to separate accounts, but he could have been suffering from information overload, and may have thought that it didn't matter to us since at the time we had no intention of remitting money to the UK, assuming we would be here for 2-3 years and then returning to the US for evermore.

One good thing is that all the income and gains information you need should be readily available from Vanguard. Also Total Stock Market hasn't given Capital Gains Distributions in years......so you just have to worry about dividends.

And yet on my cost basis page at Vanguard I have considerable Long-Term Capital Gains.  So would this be the Overseas Income Gain that is different from Capital Gain, and which I was failing to understand earlier on in Dunedin's reply?  So in other words, CGs only applies to the actual fund's CG distributions, whereas increase in value over time is the OIG?

You are correct, you would only be to use the special re-basing rules if you paid the remittance charge. However, you will still be able to use the special cleansing rules in 2017-18.  This is your best hope. Most advisers are recommending selling now so as to move into cash and benefit from cleansing next year as it will only apply to cash and deposits.

The following additional comments add to the points made in earlier posts.

Domicile status
If Angeline intends to retire permanently to the UK, then it is likely that she will acquire a domicile of choice in the UK. If so, the remittance basis will cease to be available, and non UK source earnings will be taxed on an arising basis.

Better choice?
The overall tax position for a UK resident US citizen is-
•   The UK has primary taxing rights.
•   The US then taxes income and gains, and gives credit for UK tax.

It is frequently the position that the better choice, where the remittance basis is available but there is an intention for long term UK residence, is to be taxed on the arising basis. The means that the UK will grant the personal allowance, the annual capital gains tax exemption, the dividend rate on non UK distributions, and there will not be a build-up of contingent UK tax liabilities on unremitted income and gains. The US will grant effective relief for UK tax.

Past unremitted profits
If a switch is made to the arising basis, then the issue of prior unremitted income, offshore income gains and capital gains remains, and needs to be managed as best as can be done in the circumstances.

Reporting funds
There is a list of non UK funds which have reporting status. It is updated monthly.
https://www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds

Mixed funds
If a mixed fund has a mixture of dividends, offshore income gains, capital gains and clean capital, then remittances from that fund are matched in that order. OIGs are a separate category.

Clean capital
If an investment was owned at the date of commencement of residence, the amount of clean capital is the cost of that investment, in sterling, using the exchange rate at the time of the purchase of the investment.

And yet on my cost basis page at Vanguard I have considerable Long-Term Capital Gains.  So would this be the Overseas Income Gain that is different from Capital Gain, and which I was failing to understand earlier on in Dunedin's reply?  So in other words, CGs only applies to the actual fund's CG distributions, whereas increase in value over time is the OIG?

You need to distinguish between "capital gains" and "capital gains distributions" that a fund might pay each year. Vanguard Total Stock Market hasn't distributed any capital gains for a long time so you will only have to deal with CGT when you sell shares.

That is all incredibly helpful information for me to digest and work on.  I can't thank each of you enough for sharing your knowledge.  No doubt I will have other questions in due course, but that has been of enormous help. Thank you, thank you!

Clean capital
If an investment was owned at the date of commencement of residence, the amount of clean capital is the cost of that investment, in sterling, using the exchange rate at the time of the purchase of the investment.

It would seem logical to me that the clean capital should be the value of the investment in sterling using the exchange rate of the day prior to taking up residence in the UK.  Yet Dunedin's wording here seems so precise, that I am afraid it means exactly what it says.  Could you please confirm that I do need to go back and account for every purchase within each fund and convert to sterling using the exchange rate of the date of each purchase?  This represents a lot of accounting, and a substantial difference in value for me as well, but I want to make sure I do things correctly.

You will struggle harder than you are already thinking because your current accountant may have failed to make a 16ZA election for you; OIG losses cannot be offset against gains but you'll still have to create a s104 share pool to do the calculations.

The cleansing rules next year may help; but you'd need to be in cash so you may want to act by 31 December 2016.