Severing Tax Ties Is Harder Than You Think

For many North Americans, Europeans, and other expatriates, moving to the Cayman Islands, often to a lucrative job, unencumbered by income taxes, can seem too good to be true.

The Cayman Islands does indeed lack taxes on profits, capital gains, income or any withholding taxes for residents and foreign investors.

There are also no estate or inheritance taxes due on real estate or other assets held in Cayman.

But leaving the taxman behind is not necessarily as easy as packing a suitcase and boarding a plane to the Caribbean.

First off, Cayman does of course have indirect taxes in the form of duties on many imported goods of 22 percent or more.

More importantly, expatriates do not automatically cut all ties to their country of origin.

U.S. Citizens

For instance, U.S. citizens who live and work outside of the United States continue to be taxed on their worldwide income.

However, they can qualify for a foreign earned income exclusion of about US$101,000, which means they do in fact only pay tax on income that exceeds this threshold, which is adjusted annually for inflation.

Even if U.S. taxpayers earn less, they must still report their income to the Internal Revenue Service.

It is a common misconception that because no income tax is due, Americans who live abroad do not have to file a tax return, says Tim Min, head of tax at BDO Cayman.

Some taxpayers believe that netting the gross income and the foreign income exclusion results in no taxable income, so they do not have to file, but the requirement to file depends on gross income hurdles.

Any American who earns over US$10,000, regardless of where the income was generated, must file IRS form 1040 by April 15, although most expats qualify for an automatic two-month filing extension.

U.S. taxpayers living abroad must also declare their overseas assets on Specified Foreign Financial Assets form 8938 if the assets are worth more than $200,000 (for singles) on the last day of the tax year or more than $300,000 at any time during the tax year.

If U.S. taxpayers have a total of at least $10,000 in one or more foreign bank accounts at any time during the year they must also file FinCEN form 114, otherwise known as a Foreign Account Bank Report or FBAR with the U.S. Treasury Department. Private pension plans are considered financial accounts for the purposes of FBAR, so long-term expatriates in Cayman are likely to the exceed the minimum amount.

Not filing these annual reports can quickly land U.S. expatriates in hot water and even subject to heavy fines. However, for those who did not know they had to file income tax returns, there is a program called the IRS Streamlined Procedure that taxpayers can use to make current filings without paying penalties, provided they meet certain requirements. For those taxpayers who have not filed tax returns but do owe tax, there is a voluntary disclosure program with reduced penalties available.

Filing wrong or incomplete tax information can not only attract significant penalties and fines, it is also very likely to be detected. Under the U.S. Foreign Account Tax Compliance Act, financial institutions in the Cayman Islands report the account holdings and other assets of U.S. taxpayers to the Cayman government, which then passes on this information directly to the IRS.

For other foreign nationals, there is also no longer any confidentiality as far as tax information is concerned. Their bank account information is reported to their respective home governments and tax authorities under the Common Reporting Standard.

In contrast to Americans, most of these foreign residents in Cayman are not taxed on their worldwide income by their home countries, provided they are no longer tax resident there.

This means that income taxes are only due where they are paid, which in the Cayman Islands effectively amounts to zero income tax regardless of the size of the salary.

Tax Residence

Determining tax residence is not always a straightforward task.

For instance, there is an assumption among many U.K. citizens that by moving abroad from the U.K. they no longer have to concern themselves with U.K. tax.

“That is not the case,” says Oliver Piper, a partner at Farrer & Co. in London. “People who move abroad need to think carefully about their U.K. tax residence and domicile position.”

Some believe that if they spend no more than 90 days in the U.K., there will be no tax issues.

In effect, the ability for British expats to spend time in the U.K. without tax consequences depends on a sliding scale of ties to their home country. The more ties to the U.K. a British citizen has, the fewer days they are entitled to spend there without being considered tax resident.

“For those who were tax resident in the U.K in one or more of the three previous tax years, it is technically possible to be still tax resident if you spend as little as 16 days in the U.K., if there are sufficient ties to the U.K.,” Piper says.

The connecting factors include family ties, such as the spouse or children remaining in the U.K.; retaining a place to live there, irrespective of ownership; working at least 40 days in the U.K.; having been present in the U.K. for more than 90 days in either of the two previous tax years; or spending more midnights in the U.K. than in any other country.

The only way to automatically ensure not being tax resident in the U.K. is by spending no more than 15 days in the country, increasing to 45 days once an individual has ceased to be U.K. tax resident for any of the three previous tax years.

British nationals who are still U.K. tax resident and domiciled are liable to pay U.K. income tax and capital gains tax on their worldwide income and gains. Although there is a double taxation treaty in place to ensure that U.K. citizens are not taxed twice on the same income, it is conceivable that a British citizen who lives in Cayman and receives a Cayman salary still has to pay U.K. income tax on it.

“People need to be sure that they ceased to be U.K. tax resident,” advises Piper, “because otherwise they might be liable to pay tax on their worldwide income.”

Tax Domicile

Another factor for British nationals, tax domicile can affect estate and tax planning. In most cases one’s tax domicile is determined at birth by the tax domicile of the father, if the parents are married.

It is possible for British nationals who move abroad to create a domicile of choice in another country if they intend to remain indefinitely in their new domicile. Just living in a place without any clear idea of when one is going to leave is not sufficient. The intention must be to live in the new domicile forever.

“Proving intent is a very difficult thing,” Piper says.

“I imagine that a lot of British people who move to Cayman to live there will retain their U.K. domicile, because they won’t come to the Cayman Islands with the intention of spending the rest of their lives there.”

Even if British citizens no longer live in the U.K. and are no longer tax resident in the U.K., being tax-domiciled in the U.K. means that on their death they are still liable to U.K. inheritance tax of 40 percent on their worldwide assets (subject to certain reliefs, such as when assets pass to a surviving spouse, in which case there is no inheritance tax charge). If the permanent domicile is abroad, inheritance tax is only paid on U.K. assets, such as properties and bank accounts in the U.K.

Inheritance tax charges can also kick in during the lifetime of the U.K. taxpayer, Piper notes.

“Under inheritance tax legislation, anyone who has a U.K. domicile who creates a trust is liable to pay an immediate charge of 20 percent on the value of the assets settled. So even if you now live outside the U.K., think twice before creating that new Cayman Islands trust!”

In any case, for inheritance tax purposes, U.K. citizens are deemed U.K.-domiciled for the first three years after leaving the U.K., even if their intention is to have a new domicile.