Non-dom reforms and offshore trusts
I am a trustee of an offshore trust settled by a UK resident, non-UK domiciled settlor (with no UK origins) for the benefit of himself and his family.
He previously opted to be taxed on the remittance basis. The trust holds only offshore investments. The settlor lent monies to the trustees and that loan remains outstanding. I am aware that as a long term UK resident, the settlor was due to be deemed domiciled in the UK from 6 April 2017 under new rules which were being introduced. Are these changes going ahead and if so, will they have any impact on the way the trust is taxed?
The changes you mention were originally included in the March 2017 Finance Bill but were removed due to lack of parliamentary time when a snap general election was called. The new government confirmed on 13 July that these measures will now be included in the next Finance Bill, which will be enacted in the autumn, largely in the same form as before with a few minor amendments and will take effect retrospectively from 6 April 2017 as originally planned. The relevant provisions are now contained in draft legislation also published on 13 July. Please note that the advice below assumes that the measures will go ahead substantively as announced, but until the legislation is actually enacted, there is always the possibility that the details, and even the timings, could still change.
The new rules
From 6 April 2017, your client has been deemed domiciled in the UK and so:
- his worldwide estate will be subject to IHT; and
- he will no longer be able to claim the remittance basis.
He will instead be taxed on his worldwide income and gains as they arise. Absent any special provisions, he would also be taxed on trust gains as they arise under TCGA 1992 s 86 and on trust income as it arises under ITTIOA 2005 s 624. However, the income and gains of certain ‘protected trusts’ can be rolled up free of UK tax for as long as he does not acquire an actual UK domicile of choice.
A ‘protected trust’ is an offshore trust created by a non-UK domiciled settlor. Protected trust status can be lost from the first tax year in which either:
- the settlor acquires an actual UK domicile (under the general law); or
- property/income is provided directly or indirectly for the purposes of the trust by the settlor, or the trustees of any other trust of which the settlor is beneficiary or settlor, once the settlor is deemed domiciled in the UK. (See further below regarding ‘tainting’.)
Capital gains tax
For CGT purposes, the benefit of protected status is that s 86 is, effectively, switched off so that gains arising post-April 2017 are not taxed on the settlor as they arise. Instead, they form part of the s 2(2) pool available for matching under TCGA 1992 s 87 when a capital payment is made to a beneficiary. Practically, the status quo for your client is preserved and so there is no change to the way CGT is levied on him. The benefit of various transitional rules introduced alongside the 2008 offshore trust reforms are preserved for beneficiaries who become deemed domiciled. Therefore, where a capital payment is made to a UK deemed domiciled beneficiary, who has not actually become UK domiciled under the general law, which is matched with gains realised prior to April 2008, no CGT will arise. Further, rebasing to prevent the taxation of gains not realised before 6 April 2008 may also be available, provided an election is made within prescribed time limits.
The treatment of income of protected trusts is more complicated. Essentially, the provisions which tax UK resident settlors on the foreign income of the trust (and of any underlying companies) as it arises are switched off for all non-domiciled settlors, including those who are deemed UK domiciled because they are long-term UK residents like your settlor (but not those who are deemed domiciled because they are UK resident and were born in the UK with a UK domicile of origin). Instead, foreign income which has been retained in the trust will be relevant income available for matching against benefits received by a beneficiary. A charge can therefore arise on a distribution or when the trustees otherwise confer a benefit on a beneficiary under the transfer of assets beneficiaries’ charge provisions (ITA 2007 s 732). If that doesn’t apply for some reason (for example, if the motive defence is available), there will be no income tax charge. As regards UK source income, this will continue to be taxed on the UK resident and deemed domiciled settlor as it arises.
There is an additional rule where benefits are received by a close family member of the settlor (broadly, a spouse, civil partner or equivalent or a minor child of any of those) who is either non-UK resident or a remittance basis user and the benefit is not remitted. The benefit will be taxed on the settlor instead and so a deemed domiciled settlor will be subject to income tax on this without the benefit of the remittance basis. The settlor could then recover the tax from the recipient beneficiary. Note that this only applies to the extent that the benefit is matched to income. It was originally intended that this rule would also apply to gains but, for now at least, this proposal is not going ahead.
What does this mean for the settlor?
From April, your client has no longer been taxable on foreign trust income as it arises. As your client has not previously been paying income tax on that income anyway, unless it was remitted to the UK, he may not immediately notice any difference but this is a significant change for him and the trustees. The UK remittance rules are very wide and so whenever trust income was previously used in the UK a remittance may have been triggered on him, so the trustees had to take great care to keep income segregated and make sure it was not accidentally remitted.
Going forward, the trustees will not need to be so concerned with inadvertently remitting income which arises (even where it arose pre-6 April) and the settlor will not continuously be building up a pool of funds which are potentially taxable on him. However, as all income (other than that spent to meet expenses, etc.) remains available for matching, when a beneficiary (including the settlor) does receive a benefit they may still face a large income tax bill. Remember that if there are both income and gains in the structure the income will generally be matched first. All pre-6 April 2017 income that is retained in the trust structure and has not actually been taxed on the settlor will remain in the tax pool available for matching.
If additions of property or income or value to trust assets are made to a protected trust after the settlor has become deemed UK domiciled, the protections for the whole trust will be permanently lost. Trust income and gains will from that point become taxable on the settlor as they arise. It is therefore important to ensure that the settlor does not now add anything to the trust. This is not as straightforward as it sounds, as the legislation is deliberately widely framed to catch a variety of situations.
Generally, additions of funds by persons other than the settlor will not taint the settlement, although it may mean the funder has created a new settlement with tax implications for them. However, a notable exception is that assets transferred from another
settlement of which the settlor is either the settlor or a beneficiary will taint the trust.
There are some specific exemptions, so that property or income added to the trust will be ignored in the following circumstances:
- property or income provided under a transaction, other than a loan, where the transaction is entered into on arm’s length terms;
- property or income provided, otherwise than under a loan, without any intention by the person providing it to confer a gratuitous benefit on any person;
- the principal of a loan which is made to the trustees of the settlement on arm’s length terms;
- the payment of interest to the trustees of the settlement under a loan made by them on arm’s length terms;
- repayment to the trustees of the settlement of the principal of a loan made by them;
property or income provided in pursuance of a liability incurred by any person before 6 April 2017; and
- where the settlement’s expenses relating to taxation and administration for a tax year exceed its income, property or income provided towards meeting that excess.
There is, nonetheless, still some potential for accidental tainting. Loans to and from trustees are a particularly tricky issue (see below), as is the payment of trust costs. The settlor will be able to provide funds to settle certain trust expenses to the extent the trustees cannot settle them from income, without tainting the settlement. However, not all expenses are covered. For instance, if the settlor provided funds to repair or maintain a trust asset, this is not an administrative expense and so could taint the settlement. In due course, HMRC will be producing guidance to assist with questions of interpretation. In the meantime, if the settlor wishes to add anything to the trust, even if it is just to help pay a bill, you should first seek advice.
We note that there is an outstanding loan made by the settlor to the trustees. The existence of the loan will itself taint the settlement unless it was made on arm’s length terms. Practically, this means that if interest is not charged at all, charged at least annually but at a rate below the official rate (currently 2.5%) or not actually paid at all but rolled up (capitalised), the amount of
the outstanding loan will be regarded as property directly provided by the settlor and will therefore potentially taint the settlement.
However, as the settlor is deemed UK domiciled, there are some transitional provisions and the trustees will have a year (until 6 April 2018) to rectify the situation, if the loan is not currently on arm’s length terms. There are two options; either:
- the whole loan including any outstanding interest can be repaid; or
- the loan must be put on arm’s length terms so that the official rate of interest is charged and this interest must actually be paid for this tax year (2017/18) and all subsequent years that it remains outstanding.
Note that if it is decided to pay interest to the settlor, this will be taxable income in his hands.
Other issues the trustees should be aware of
We have not mentioned inheritance tax (IHT) because there will be no changes to the treatment of the trust for this tax. It will continue to be an excluded property trust and therefore outside the scope of UK IHT trust charges, as long as it does not directly or indirectly own any UK residential property (or lend in respect of its acquisition, maintenance or enhancement), and as long as the other trust assets remain non-UK situs.
There are some new rules, which also took effect from 6 April 2017, concerning the valuation of nonmonetary benefits received from a trust by a beneficiary, such as rent-free use of trust property/chattels and interest free loans, which can be taxed when matched with income/gains in the trust structure.
These are intended to provide more certainty about how much rent/interest needs to be paid in order to avoid a taxable benefit arising; however, in some cases they will result in a benefit arising where it didn’t previously, unless more interest/rent is paid.
There are a few additional measures broadly concerning payments to non-UK residents that were due be introduced from April but which now will not be. They may however be included in a future Finance Bill, although not the one expected in the autumn, possibly with effect from April 2018. The key proposals include the following:
- trustees would no longer be able to ‘wash out’ stockpiled gains by making payments to non-UK residents. This is already the position in relation to income in the trust; and
- if a payment is made to a non-UK resident beneficiary or a remittance basis user and those funds or property derived therefrom become payable to any UK resident within three years of the initial payment, then that UK resident would automatically be subject to income tax and/or CGT as if they had received the payments directly from the trust, regardless of the intention of the parties.
This article first appeared in the Tax Journal.