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02 Mar 2023

Ask an expert: Offshore trusts & trustee borrowing

Q: We are trustees of an offshore trust, which holds UK real estate through an underlying wholly owned non-UK resident company. We need to make distributions to beneficiaries, some of whom are UK resident. We are not holding sufficient cash reserves in the trust, and we wondered if, instead of receiving a dividend from the company, it would be better to borrow funds from the company in order to fund these distributions.

A: It is generally not recommended for trustees of offshore trusts to borrow at the trust level, particularly where there are UK resident beneficiaries. This is because of complex ‘trustee borrowing’ rules in TCGA 1992 Schs 4B and 4C. (All statutory references below are to TCGA 1992.) Where a trust makes a ‘transfer of value’ that is ‘linked with outstanding trustee borrowing’, the trustees are treated as making a deemed disposal of all or a proportion of the remaining trust assets (but not of assets held by underlying companies) (Sch 4B para 10). Transfers of value can be loans or distributions to beneficiaries. In order to be ‘linked’ with the borrowing, all that is required is that, at the time the transfer of value is made, there are outstanding loans owed by the trust (TCGA 1992 Sch 4B para 5). This is therefore a snapshot of the borrowing position when a transfer of value is made. If the borrowing is repaid before the transfer of value is made, the rules are not engaged.

To the extent the borrowing has been for ‘normal trust purposes’, the rules are not invoked (Sch 4B para 6). This includes borrowing used:

  • to make payments on arm’s length terms in respect of ‘ordinary trust assets’ (broadly, shares or securities, tangible moveable or immoveable property that are generally held immediately after the
    transfer of value);
  • to discharge an existing loan obligation of the trustees, where this loan itself was used for normal trust purposes; and
  • to meet bona fide current expenses incurred by the trustees in administering the settlement or any of the settled property (but excluding expenditure incurred in administering any underlying company owned by the trust).

Borrowing to fund distributions to beneficiaries will not therefore constitute normal trust purposes.

If the trustee borrows from the underlying company and subsequently uses the loaned funds to make distributions to beneficiaries, thereby invoking the trustee borrowing rules, the trustee will be deemed
to dispose of its assets at market value and reacquire them (Sch 4B para 10). There are complicated formulae for calculating the proportion of assets that the trustee is deemed to dispose of (Sch 4B para 11).

The resulting gains generated from the deemed disposal form a separate pool of gains known as the ‘Sch 4C pool’. This is a floating pool of gains available for matching against distributions to UK resident beneficiaries under s 87. The pool is available for matching against distributions to such beneficiaries not just of the trust in question, but also of any other trust which has directly or indirectly received funds from the trust (a ‘relevant settlement’, Sch 4B para 8A). The Sch 4C pool is carried forward for matching against future capital payments to UK resident beneficiaries of relevant settlements until it is extinguished. Once a Sch 4C pool has been extinguished, a new Sch 4C pool will be created if the trustee makes a further transfer of value at a time when there is outstanding borrowing owed by the trust and which is not for normal trust purposes.

However, the result of the deemed disposal rules is not just the creation of a floating pool of Sch 4C gains. In addition, there is scope for the trustee to become immediately chargeable to non-resident capital gains tax (NRCGT) depending on the assets it holds when the deemed disposal under Sch 4B occurs. This is due to recent changes which introduced CGT charges on non-residents in respect of direct and indirect ownership of UK real estate. As a result, trustees with outstanding borrowing when they make a transfer of value may end up with an inadvertent and immediate liability to NRCGT to the extent that the trust fund comprises:

  • directly held UK real estate;
  • a 25% or greater participation in a ‘property-rich company’ (see below); or
  • an interest in a collective investment vehicle which satisfies the property richness test.

The NRCGT charge in relation to property-rich companies has only applied from 6 April 2019, while it has applied in relation to disposals of direct holdings of UK real estate from 6 April 2015 (residential property) or 6 April 2019 (commercial real estate). Previously, an NRCGT charge would not have arisen directly on the trustee as a result of Sch 4B. This inadvertent charge under Sch 4B is therefore a somewhat unusual point that has only been applicable since the NRCGT rules were introduced. In our scenario, the trust does not hold UK real estate directly, but through a wholly owned company. A company will be property rich if at least 75% of the value of its assets is attributable to UK land. An ownership threshold of 25% of the company must also be satisfied. Consequently, assuming the company’s main asset is UK real estate, the 75% threshold will be met as will the 25% de minimis ownership requirement. There will be a rebasing of the base cost of the company shares to 5 April 2019 (Sch 4AA), so only any uplift in value from this date could result in an NRCGT liability for the trustee under the trustee borrowing rules.

Any NRCGT gain or loss arising from a deemed disposal under the trustee borrowing rules must be declared by the trustee by filing a return and paying the tax due within 60 days (30 days up to 26 October 2021). This is done via a ‘CGT on UK property account’ and registration with HMRC’s trust registration service also needs to be considered. NRCGT losses can only be used to reduce NRCGT gains, which would arise from the direct or indirect (i.e. through property-rich companies) ownership of UK property and land. Unused losses can be carried forward to set against future NRCGT gains arising in later years. However, if instead of using the April 2019 rebasing figure, an election is made to use the original acquisition cost instead (the ‘retrospective basis’ of calculation), the loss is not allowable at all (Sch 4AA para 4).

In light of the above rules, the trustee should look at the increase in the value of the company from April 2019 in order to assess the extent to which an NRCGT liability could arise under the trustee borrowing rules. However, given the reporting and accounting consequences of triggering the trustee borrowing rules, it will probably be simpler for the trustee to fund distributions to the beneficiaries by way of a dividend declared from the company to the trustee. With careful planning involving segregating the dividend on receipt and paying it out the same tax year, the dividend received should not add to the relevant income pool at trust level. Income distributions to UK resident beneficiaries will be liable to income tax at their marginal tax rates.

This article was written for The Tax Journal and published in March 2023.