The pitfalls of US/UK tax planning – the US Living Trust

While the perception of the pitfalls of US/UK tax planning has improved since this article was first written in 2011, there remains one series of pitfalls which is often overlooked.

The UK inheritance tax treatment of trusts may have a serious impact on UK domiciliaries who, either because they are resident in the USA or have US assets, enter into a common form of US tax planning known as the “Living Trust”. A Living Trust is a trust created during a person’s lifetime, usually to avoid having to apply for probate in the US or for US estate planning purposes. US nationals can also be caught unawares if they either hold UK assets, or have lived for many years in the UK.

UK domiciliaries

The difficulties for a UK domiciliary arise if he is either resident in the USA or is a US national because he will fall within both the UK inheritance tax and the US estate tax regimes (the UK taxes on the basis of domicile and the USA on the basis of nationality). Often people in this position (and even their US advisers) do not realise that the UK tax rules make it almost impossible to set up substantial lifetime trusts without incurring an immediate charge to UK inheritance tax. Living Trusts are heavily promoted in the US as a sensible planning option, one marketing slogan calling it “the fail-proof way to pass along your estate to your heirs”. This ignores the effect of such planning from the UK perspective, which can be costly for the UK domiciliary.

The broad effect of the UK rules is to impose an immediate 20% charge to UK inheritance tax on the creation of lifetime trusts (with few exceptions), plus periodic charges to UK inheritance tax every ten years and exit charges whenever assets leave the trust. The double tax treaty between the two countries will not prevent a charge to UK tax arising in these circumstances and there could be penalties imposed by the UK Revenue if the Living Trust is not disclosed to them.

It is quite possible that a UK domiciliary will believe he has lost his UK domicile, simply by virtue of becoming resident in the USA for an extended period. However a domicile of origin in one of the jurisdictions of the UK is not easily shed and the UK Revenue are likely to carry out a detailed investigation of such a claim. Not all Living Trusts will cause difficulty. Only those created (or amended) after 22 March 2006, the date when many changes to the UK tax treatment of trusts came into effect, are at risk. Much will depend on how the Living Trust document is worded and each case depends on its facts. The wording of any proposed Living Trust (or even an amendment to an existing Living Trust) needs a “health check” by a UK lawyer with expertise in UK inheritance tax and trusts, to avoid creating a “settlement” that will fall within the UK inheritance tax regime.

US nationals

Different considerations will apply to US nationals who do not appear to have any strong UK ties. The implications of the UK tax legislation are still relevant to them broadly if either or both of the following situations apply:

• if they hold assets situated in the UK; or
• if they become domiciled in one of the three jurisdictions that make up the UK, namely England and Wales, Scotland or Northern Ireland (for simplicity we are referring to “UK domicile” rather than domicile in one of these three jurisdictions, because the inheritance tax regime is the same in each).

It is important to be aware that the concept of “domicile” has a particular meaning in English law which is not the same as mere residence. Broadly, it is possible that a US national could acquire a UK domicile by virtue of:

• Having a father with a UK domicile;
• Being resident in the UK (even for a relatively short period) and forming an intention to permanently remain here; or
• Falling within the so-called “deemed domicile” statutory rules under section 267 Inheritance Tax Act 1984, by virtue of having been resident in the UK for at least 15 of the previous 20 UK tax years.

The following examples illustrate some of the implications for US nationals.

Example 1: US national with UK assets

Pete is a US national and a US resident who purchased a UK property ten years ago for his son to live in, when he came to study in London. The property is still in Pete’s sole name and is now worth approximately £1 million. Pete creates a Living Trust in 2019 over his worldwide property which is unfortunately worded in such a way as to be caught by the UK settlement rules. There is an immediate charge to UK inheritance tax on the value of the London property. This is at 0% on the first £325,000 (the so-called ‘nil rate band’), with the balance taxed at 20%, giving rise to a tax charge of £135,000. There are also charges (at a maximum of 6%) every ten years on the value of the London flat and, if the flat is sold, when any funds are paid out. If Pete dies within seven years of creating the Living Trust, there will be a further 20% charge on his death.

Example 2: US national who acquires UK domicile

Jake is a US national who has lived in the UK for 18 years, so fulfils the deemed domicile criteria. Most of his assets are in the USA, and, on a recent visit to the USA in 2019, Jake set up a Living Trust to cover his worldwide estate, including his UK assets. Though the Living Trust is transparent for US purposes, it is worded in such a way as to fall within the UK settlement rules. Because Jake is deemed domiciled in the UK, this gives rise to an immediate charge to inheritance tax, at 0% on the first £325,000 and at 20% on the balance of his worldwide estate (as the UK taxes on the basis of domicile).

Similar considerations would apply if Jake had been in the UK for a shorter period, but had formed an intention to remain here for the rest of his life and so became domiciled here for UK purposes. It is therefore advisable for any US national who may become UK domiciled to take advice on estate tax planning well in advance. In fact it can be helpful for US nationals who may become UK domiciled at a later date to have created a settlement over their non-UK assets, which will qualify as “excluded property”, and thus remain outside the UK inheritance tax regime even if they then become UK domiciled.

All this means that placing your estate into a Living Trust is not a step to be taken lightly by US nationals with UK aspects to their estates (or vice versa) without obtaining appropriate advice.

This is an updated version of an article which first appeared in the November 2011 edition of Private Client Adviser.