What is the UK tax treatment of Dubai (DIFC) Foundations?
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This article considers the characteristics and typical UK tax treatment of Foundations registered with the Dubai International Financial Centre (DIFC) Registrar of Companies. References to Foundations means DIFC Foundations.
Definitively classifying a Foundation is difficult because it is not a vehicle recognised under English law. In broad terms, a Foundation may be treated as a trust, a bare trust or a company for UK tax purposes
Foundations under DIFC law
DIFC law has been drafted to create a hybrid between a trust and a company. For UK taxation, it is difficult to classify a Foundation as one or the other. As it is a new entity, there have been no cases to examine how to classify DIFC Foundations.
According to DIFC Law No. 3 of 2018 (the ‘DIFC Law’), a Foundation ‘is a body corporate with a legal personality separate from that of its Founder(s) and any other person’. According to article 10(3), ‘the property of a Foundation is not held by it upon trust for any other person’. However, notwithstanding the reference in Article 10(3) of the DIFC Law, it seems clear that the property transferred to a Foundation is held for the benefit of specified persons subject to a contingency (namely the decisions of the Council members). A Foundation’s ability or right to deal with its own assets may then be constrained by the legal obligations contained in any charter or by-laws of the Foundation. Such rights seem to be analogous to the rights and obligations of a common law trustee with the described objects of a Foundation being similar to a discretionary trust arrangement (it also bears some resemblance to the manner in which partnership assets are held for the benefit of partners in a partnership).
Classification of Foundations under UK tax law
There is no equivalent to a DIFC Foundation under English law, so there are no authoritative rules on how they are to be treated for UK tax purposes. To determine the tax treatment of a Foundation, it is necessary in each case to consider (a) the drafting of the Foundation’s constitutional documents and, (b) the local law that governs the Foundation. DIFC Foundations are corporate in nature: they exist with separate legal personality and are managed by a board or council akin to a board of directors of a company. Given this, arguably the most significant aspect of the analysis is whether a Foundation holds its assets for itself beneficially, like a company, or whether it holds them subject to obligations to other individuals or entities which are sufficiently similar to fiduciary obligations, like a trust (or perhaps a partnership). In broad terms, the approach is to analyse the legal rights and obligations of a Foundation (as a matter of its governing law) and determine whether those rights and obligations are similar or equivalent to the rights or obligations that exist under English law for a trust, a bare trust (that is, like a nominee arrangement or like partnership assets) or a company.
The meaning of trust
The definition of ‘settlement’ (which encompasses trusts) for IHT purposes includes (IHTA 1984 s 43(2)): ‘any disposition … of property … whereby the property is for the time being—
(a) held in trust for persons in succession or for any person subject to a contingency, or
(b) held by trustees on trust to accumulate the whole or part of any income of the property or with power to make payments out of that income at the discretion of the trustees or some other person, with or without power to accumulate surplus income …
or would be so held or charged or burdened if the disposition or dispositions were regulated by the law of any part of the UK.’
For CGT purposes, ‘settled property’ is defined as ‘any property held in trust other than property to which section 60 [nominees and bare trustees] applies’.
Critically, where the tax legislation defines ‘settlement’ and ‘settled property’, the definitions refer to ‘trust’ and ‘trustee’, yet the legislation provides no further definitions for these terms. The Convention of 1 July 1985 on the Law Applicable to Trusts and on their Recognition provides that a trust has the following characteristics:
- the assets constitute a separate fund and are not a part of the trustee’s own estate;
- title to the trust assets stands in the name of the trustee or in the name of another person on behalf of the trustee; and
- the trustee has the power to and the duty, in respect of which he is accountable, to manage, employ or dispose of the assets in accordance with the terms of the trust and the special duties imposed on him by law.
The meaning of bare trust/nominee
According to Lewin on Trusts (20th edition), ‘a bare trustee holds property in trust for a single beneficiary absolutely and indefeasibly, and is a mere passive repository for the beneficial owner, having no duties other than a duty to transfer the property to the beneficial owner or as he directs.’ A bare trust would not fall within the definition of settlement or settled property as the trust property is not held for the beneficiary subject to a contingency and the trustee does not have discretion over income accruing from that asset. Similarly, under the Partnership Act 1891, partnership property is held for the benefit of the partners in accordance with the terms of the partnership agreement, if any. It is recognised that the partners have proportionate entitlement to a share in the partnership assets, and usually one or more partners holds one or more assets on trust for the other partners.
The meaning of company
A ‘company’ for UK tax purposes includes any body corporate or unincorporated association but does not include a partnership. There is no modern definition of ‘body corporate’ under English law and HMRC’s guidance on the term notes that a body corporate is one which has perpetual succession and a legal personality, distinct from that of its members.
Application to DIFC Foundations
In determining which of these three categories a DIFC Foundation falls within, it is necessary to ask two questions. The first is whether the Foundation hold assets for itself beneficially. If the Foundation holds assets for itself, it will likely be treated as a company for UK tax purposes. If the Foundation holds assets for others, it will likely be treated as a trust or a bare trust for UK tax purposes. If the Foundation holds assets for others beneficially, the next question is whether the individuals for whom the Foundation holds assets are absolutely entitled to the assets of the Foundation and can call for them at any time. If the answer is no, the Foundation is likely to be treated as a substantive trust for UK tax purposes. If the answer is yes, the Foundation is likely to be treated as a bare trust for UK tax purposes (i.e. as transparent, in the same way as a partnership). A clear indicator of this is whether the council members have discretion over the income and capital of the Foundation.
HMRC’s view
HMRC have published guidance on how certain foreign entities will be classified for UK tax purposes, but the guidance does not specifically refer to DIFC Foundations. An indication of HMRC’s approach to Foundations can be found in the UK’s Liechtenstein Disclosure Facility (LDF). The second joint declaration by the UK and Liechtenstein in connection with the LDF contains agreed guidance on the treatment of certain Liechtenstein entities, stating that: ‘Trusts … or Foundations … are to be characterised, recognised and treated as trusts for UK [trusts] purposes’. However, this is of relatively limited use when considering DIFC Foundations because the DIFC Law is not identical to Liechtenstein law governing Foundations. Further, even in the context of Liechtenstein structures, it remains necessary to analyse each structure on its own facts.
DIFC Foundation treated as a trust
Whether the assets are within the scope of IHT depend on the settlor’s domicile and the location and type of asset. Where a Foundation is established by an individual who was not domiciled in the UK and does not own UK property (including property deriving value from UK residential property), there may currently be no IHT entry charges or ongoing IHT charges; although one should consider the proposed non-dom changes, discussed below.
IHT
On creation/adding property:
- No IHT entry charges are likely to apply if the settlor is non-domiciled and transfers non-UK assets.
- For a UK domiciled settlor, or where a settlor transfers UK property, IHT may be payable at a rate of 20%, and if the donor of the gift dies within seven years the rate of tax increases up to 40%.
- The IHT regime is concerned with transfers of gratuitous value so there would be no immediate charge to IHT if value was not transferred by the founder gratuitously (i.e. if the founder sold their interest in relevant assets to the Foundation for full market value, with the consideration being left as a debt outstanding at completion, although there can be complexity with this sort of planning, depending on the facts of the case).
Ongoing:
- Settlements that hold assets within the scope of IHT are subject to the relevant property regime which, broadly, applies periodic charges of up to 6% on every 10-year anniversary of the trust, and exit charges in the event that value representing relevant property leaves the trust. The exit charge is determined by reference to the number of quarters that have elapsed since the trust’s last ten-year anniversary charge.
- There are also rules applying to gifts with a reservation of benefit (GROB). The GROB rules ensure that assets that an individual has given away but continues to enjoy or benefit from remain within their IHT estate for so long as they continue to benefit from them.
CGT
On creation/adding property:
- A transfer for value would be a disposal, and a gratuitous transfer would be a deemed disposal at market value, though holdover relief may be available if the Foundation is UK resident. The CGT position on any transfer would need to be checked in advance of any disposal.
Ongoing:
- Whether the Foundation is subject to CGT itself depends on its tax residence. If the Foundation is treated as a trust for UK tax purposes, its residence will depend on the residence of its council members. If it is UK resident, it will be subject to CGT on its worldwide gains. If it is not UK resident, it will only be subject to CGT on certain assets, for example gains relating to UK real estate. Anti-avoidance provisions can attribute those gains to the settlor (if UK resident and domiciled) or to UK resident beneficiaries on receipt of a benefit in certain circumstances.
Income tax
On creation/adding property:
- There are unlikely to be any income tax charges on transferring assets into the Foundation, but this will depend on the circumstances.
Ongoing:
- Whether the Foundation is subject to income tax depends on its tax residence. If the Foundation is treated as a trust for UK tax purposes, its residence will depend on the residence of its council members. If it is UK resident, it will be subject to UK tax on its worldwide income. If it is not UK resident, it may be subject to UK tax on its UK-source income. However, an important point to note is that there are anti-avoidance provisions, which may apply depending on precise facts, to attribute income to a UK resident settlor as it arises or to a UK resident beneficiary when they receive a benefit.
DIFC Foundation treated as a bare trust
If categorised as a bare trust, the Foundation would be transparent for UK tax purposes, which means the tax consequences are as follows:
IHT
On creation/adding property:
- For UK domiciled settlors or for UK property, a transfer of assets into the Foundation without receiving consideration will most likely be a potentially exempt transfer (PET) for IHT purposes, assuming the settlor is not the sole beneficiary. GROB rules apply if the settlor retains a benefit.
- For non-UK domiciled individuals transferring non-UK property, there will be no IHT charge.
Ongoing:
- The relevant property regime will not apply, regardless of the domicile of the settlor and the location of the assets.
CGT
On creation/adding property:
- Assuming the assets are not being held on bare trust for the transferor, a transfer for value would be a disposal, and a gratuitous transfer would be a deemed disposal at market value, so the CGT position on any transfer would need to be checked in advance of any disposal.
Ongoing:
- The beneficiary of the Foundation is treated as owning the assets, so will be subject to CGT on gains in the Foundation if they are UK resident or if the gains arise from certain property such as UK real estate.
Income tax
On creation/adding property:
- There are unlikely to be any income tax charges on transferring assets into the Foundation, but this will depend on the circumstances.
Ongoing:
- The beneficiary of the Foundation is treated as owning the assets. If the beneficiary is UK resident, they will be subject to UK income tax on the income of the Foundation. If the beneficiary is not UK resident, they may be subject to UK income tax on income that is of UK source.
Foundation treated as a company
IHT
On creation/adding property:
- No IHT entry charges are likely to apply if the settlor is non-domiciled and the assets are non-UK assets.
- For a UK domiciled settlor, or where a settlor transfers UK-situs assets, IHT may be payable at a rate of 20%. If the donor of the gift dies within seven years, the rate of tax increases up to 40%. However, the same analysis outlined above in relation to gratuitous transfers of value would apply here.
Ongoing:
- The relevant property regime will not apply.
CGT
On creation/adding property:
- A transfer for value would be a disposal, and a gratuitous transfer would be a deemed disposal at market value, so the CGT position on any transfer would need to be checked in advance of any disposal.
Ongoing tax: corporation tax
The Foundation would be subject to UK tax on its worldwide income and gains if it was resident in the UK (broadly, if it was centrally managed and controlled in the UK). However, anti-avoidance provisions may apply, depending on precise facts, where the Foundation is not resident in the UK to attribute income to a UK resident founder as it arises.
Non-dom changes
As readers will be aware, plans were announced in the Spring 2024 Budget to abolish the current non-dom tax regime and move to a resident-based system from 6 April 2025. These changes are far reaching and could be relevant for a non-UK domiciled individual looking to set up or add to a Foundation.
However, it should be borne in mind that the Labour Party has since made comments that they would not implement all of the proposals contained in the Spring 2024 Budget. With an election set for 4 July 2024, there is much uncertainty in relation to these proposed reforms, both as to what the rules will ultimately look like and when they will come into force. The following are some points that should be borne in mind for those who currently use Foundations in their succession planning, or are planning to soon establish or add to a Foundation.
IHT
It is proposed that IHT will be charged on worldwide assets once an individual has been UK resident for ten years, and once within the IHT net, the individual will remain liable to IHT for ten years after leaving the UK. This is subject to consultation.
There are also proposed changes to the way in which IHT applies to trusts. The Conservative government announced transitional provisions which preserved the existing treatment of non-UK assets settled into a trust by a non-UK domiciled settlor prior to April 2025, i.e. these will remain outside the scope of IHT, but Labour recently announced that they would not implement these provisions. These provisions could significantly affect Foundations which fall to be categorised as trusts for UK tax purposes.
CGT and income tax
From April 2025, new arrivals who have not been UK resident in any of the previous ten UK tax years will be able to claim full tax relief in respect of their foreign income and gains (FIG) for their first four years of UK residence. This will apply irrespective of whether they bring the funds to the UK. Existing UK tax residents who have been tax resident for fewer than four tax years and are eligible for the scheme will be able to benefit from the relief until the end of their fourth year of tax residence.
There are also changes to the way in which income and gains arising in non-resident trusts can or will be attributed to a UK resident settlor of such trusts. It will mean that where a settlor retains an interest (which can be very widely defined particularly in relation to CGT) the worldwide income/gains of the Foundation may be taxed on the settlor/founder as they arise. These provisions could significantly affect Foundations which fall to be categorised as trusts for UK tax purposes.
This article was first published in the Tax Journal in June 2024.