Has 200-year-old tax loophole met its Waterloo?

Labour wants to abolish the non-dom tax status. What is it and who will be affected?The rules for "non-doms" - or non-domiciled residents - bestow special tax privileges on foreigners living in Britain. The main perk is that UK tax is only levied on offshore income and capital gains if they are brought into the UK.

Given that one in eight UK residents was born outside the UK, a huge number of Britons could claim non-dom status. But there are just 116,000 people who have told HM Revenue & Customs that they are non-doms.

A much smaller number - about 5,000 people a year - pay an annual charge in order to claim non-dom tax privileges. This charge was introduced in 2008 for non-doms who have lived in Britain for more than seven years. It starts at £30,000 but rises to up to £90,000 for non-doms who have lived in Britain for more than 17 years.

Among those claiming non-dom status are Stuart Gulliver, HSBC's chief executive; entrepreneur Richard Caring; and Lakshmi Mittal, the chief executive of ArcelorMittal.

The changes planned by Labour would push up taxes for those paying the annual charge but would probably not affect those living in the UK for just a few years. Labour said that temporary UK residents would only pay tax on what they earn here - and it would consult on the length of time for which the new rules for temporary residents would apply.

Where did this rule come from?Is it as ridiculous as Labour claims? It dates back to the origins of income tax at the time of the Napoleonic wars. It was a practical matter: produce on ships returning from the colonies could only be sold when ships came into port in England so it would have been unfeasible to have taxed them before that.

The rules are complex and arcane. Labour correctly points out that it is the domicile of your father, not your mother that counts. Domicile is a distinctively British legal concept - subtly different from nationality or residence - that is usually the country your father considered his permanent home when you were born - although it requires you to retain strong links to your home country and show some intention of returning there.

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But the principle of allowing temporary residents a tax exemption for their offshore income is reasonable. Many other countries, including Belgium, the Netherlands and some of the Scandinavian countries, offer incentives of this sort. The UK's seven year exemption is relatively generous by international standards.

How much will its abolition raise in revenue?Labour estimates that scrapping non-dom status will raise hundreds of millions of pounds. That estimate is based on the numbers paying the annual levy and an assumption that relatively few wealthy non-doms will leave the country.

In practice, it is hard for anyone to be sure whether changing the rules will have a positive or negative effect on the Exchequer. Some of the wealthiest non-doms - many of whom have houses across the world - are likely to respond to the tax changes by becoming non-resident, particularly because Labour plans to increase the top income tax rate to 50p - a high rate by international standards.

The rules on residence have recently been clarified to make it easier for people to spend time in Britain without inadvertently becoming tax resident here. In order to make it harder for non-doms to become non-resident, Labour might be inclined to tighten the residency rules.

If it is not guaranteed to raise money, why change the rules?Labour will badge the policy as evidence of its commitment to tax justice. No longer can the UK have one rule for the rich and one for everyone else. The idea is likely to receive a favourable reception from the public: the austerity that followed the financial crisis has pushed arguments about fairness to the top of the agenda. In the meantime, there has been some slackening of international competition. Some Swiss cantons have dropped their "forfait" arrangements, under which wealthy foreigners can pay a lump sum based on the annual rental value of their home, instead of taxes on wealth and income.

That said, politicians have been keen on reforming the non-doms but have had second thoughts in the past. Labour announced a review of the rules in 2002 but it was six years before it took action.

What happened last time Labour tried to make changes?There was a huge uproar. The City said the tax changes would damage London's role as a global financial centre. Museums and the arts fretted about the impact on philanthropy and there was debate about how far the restrictions would impact on employment and investment. The backlash may not be as strong this time round. But depending on how Labour defines a "temporary UK resident", the change in the rules will catch employees on temporary secondments. That is likely to be controversial - and not just in the financial services industry. More widely, critics will say the change will undermine the certainty of the tax system, reducing its appeal to investors.

What do the Conservatives say?The Conservatives started off the attack on the tax privileges of non-doms by proposing changes in 2007. Since in office, they have ratcheted up the £30,000 annual levy and created an incentive for non-doms to invest in UK businesses. But they have so far defended the principle underpinning the rules. In January, David Gauke, financial secretary to the Treasury, drew attention to the mobility of businesses, capital and labour. He said: "We recognise the significant contribution that non-UK domiciled individuals make in the UK, creating jobs and inward investment. That is why we stand firmly behind the remittance basis of taxation, which is a unique way of taxing people."

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