For many years there have been UK anti-avoidance provisions which seek to tax UK resident settlors on income realised within an offshore trust (and in some cases an underlying company) where the settlor or their spouse/civil partner can benefit.
Further provisions seek to tax UK resident settlors on capital gains realised within an offshore trust (and in some cases an underlying company) as they arise where a wider class of persons can benefit, including the settlor, their spouse/civil partner and minor children.
Non-UK domiciled settlors
Non-UK domiciled settlors are able to shelter foreign income realised within an offshore trust from UK tax by making a claim for the remittance basis and ensuring the income remains offshore. UK source income is however always taxable on the settlor as it arises.
Capital gains realised within offshore trusts are not automatically attributed to a non-UK domiciled settlor, even if the remittance basis is not claimed. Instead, the settlor is subject to UK Capital Gains Tax (CGT) on the gains to the extent that these match to capital payments, in the same way as for beneficiaries. All matched gains are treated as foreign gains, which can be sheltered using the remittance basis subject to eligibility.
UK tax changes from 6 April 2017
From 6 April 2017, non-UK domiciled individuals who have been resident in the UK for at least 15 of the previous 20 tax years are deemed domiciled in the UK for all tax purposes (along with UK residents who were born in the UK with a UK domicile of origin, known as Formerly Domiciled Residents, (FDRs)). As a result, deemed domiciled settlors are now exposed to UK tax on the income and capital gains realised within an offshore trust as they arise.
However, the Government has recognised that many non-UK domiciled individuals living in the UK hold their wealth in offshore trusts. In an effort to soften the blow of the new rules and encourage such long term residents to remain in the UK, protection from an immediate tax charge on foreign income and capital gains realised within their offshore trust has been made available in certain circumstances.
Trust protection conditions
Foreign income and capital gains arising within an offshore trust are protected from UK tax provided that:
The settlor retains a foreign domicile under general law;
The settlor is not a FDR;
The trust was established while the settlor was not domiciled (or deemed domiciled) in the UK;
The trust is non-UK resident; and
No property or income is provided by the settlor, or the trustees of another settlement of which the settlor is the settlor or a beneficiary (‘associated trust’), whilst the settlor is deemed domiciled.
Implications of trust protection
If the trust is protected, the settlor will pay UK tax by reference to benefits received. UK source income will however continue to be taxable on the settlor as it arises.
For income tax purposes, a benefit received by a close family member of the UK resident settlor (spouse, civil partner, cohabitee or minor child) may also be taxable on the settlor. Similar rules will be introduced from 6 April 2018 for CGT purposes.
These rules apply to all trusts established by non-UK domiciled individuals and not just those where the settlor is deemed domiciled. As deemed domiciled settlors are no longer able to access the remittance basis, UK tax is payable on the income and/or capital gains which match to benefits regardless of whether or not this is remitted to the UK. However in cases where the settlor is not yet deemed domiciled, the benefit may be protected from UK tax if the remittance basis is claimed and the benefit is not remitted.
Trust protection will be lost if an addition is made directly or indirectly to the trust (or an underlying entity) by the settlor or an associated trust whilst the settlor is deemed domiciled in the UK. This is known as ‘tainting’.
Protection will also be lost if the settlor acquires a UK domicile under general law. It is therefore crucial that settlors who become deemed domiciled are aware of the implications for trust protection of giving up their foreign domicile. HMRC have in recent years targeted the issue of domicile in many of their enquiries and therefore it is important a robust argument to support a non-UK domicile status can be presented. Contemporaneous evidence of links outside the UK and future intentions is key.
The tainting rules are wide reaching and include any scenario where there is an addition of value.
If the settlor pays for improvements to a property owned by the trust, this enhancement expenditure could taint the settlement.
The failure by the settlor to reclaim tax from the trustees could taint a trust. However, provided the settlor claims reimbursement within a reasonable timeframe, tainting should not occur.
If tainting occurs, trust protection will be lost and the settlor will be subject to UK tax on all income and capital gains realised within the trust as they arise. If the trust has multiple settlors, the protection is only lost in relation to property derived from the settlor responsible for the tainting.
There are some useful exceptions from tainting. These include scenarios where property or income is added without intention to confer a gratuitous benefit and additions (including loans) made on arm’s length terms. For dry trusts, cash added to pay UK or overseas taxes and administration costs at trust level will not cause tainting but this does not extend to underlying companies. Property or income provided in pursuance of a liability incurred by any person before 6 April 2017 is also excluded from tainting, as illustrated in the following example:
In December 2016 the trustees decide to purchase a property. As the trustees do not have sufficient funds, the settlor, Holly, agrees to settle a further £280,000. The trustees enter into a conditional contract to purchase the property in March 2017 but the conditions are not fulfilled until May 2017, when Holly provides the funds. As Holly had already committed to provide the funds before 6 April 2017, the trust is not tainted by her actions.
It is clear that loans are a risk area and where borrowings are in place, these require urgent review.
There is a twelve month grace period for loans made to a trust by the settlor where:
The loan was made before the settlor became deemed domiciled;
The settlor became deemed domiciled on 6 April 2017; and
The loan was not entered into on arm’s length terms.
In these circumstances tainting will not occur if either the loan (including all interest) is repaid before 6 April 2018, or the terms of the loan are altered on to arm’s length terms and all interest up to 5 April 2018 is settled by the following day.
Inheritance Tax (IHT)
Regardless of whether the trust has protected status, trusts established when the settlor was not domiciled or deemed domiciled in the UK will remain excluded property for IHT purposes, unless they are FDRs. As a result, non-UK situs assets held within the trust will remain outside the scope of UK IHT. For IHT purposes, it is therefore still worthwhile creating excluded property trusts before an individual becomes deemed domiciled. In such cases, we would always recommend a full domicile review is carried out to ensure that the planning is effective.
Although the trust protection provisions are generous, the concept of tainting is complex and widely drawn and therefore protection can very easily be lost. There is no de minimis and so even a small addition could have catastrophic and permanent consequences for the settlor.
The following action points should be considered:
Extreme care should be taken by the trustees and the settlor to ensure no value is added (unless covered by an exclusion). If there is any doubt surrounding the impact of a transaction, we recommend this is confirmed with us beforehand.
All loans to and from a trust should be reviewed before the settlor becomes deemed domiciled and, where these are not on arm’s length terms, they should be repaid or the terms altered beforehand.
Where the settlor became deemed domiciled on 6 April 2017, loans from the settlor to the trust should be reviewed as a matter of urgency as there may be scope to repay the loan or alter the terms before 6 April 2018 to avoid tainting.
Carefully review the terms of any new loans and ensure the terms of all loans are adhered to.
If you would like advice on any aspect of the points discussed in this article, please do not hesitate to get in touch with Alice Pearson or your usual contact at Mercer & Hole.