Justice and reason? Rogge v HMRCC summarises how the settlor-interested rules work in the UK and offshore
The First Tier Tax Tribunal case of Rogge and Others v HMRC concerned three appeals against assessments to income tax by HMRC, relating specifically to the income tax implications for settlors and trustees of settlor-interested trusts where the settlor pays income to the trust (for example, by way of rent or loan interest).
Notwithstanding the "absurdity" of such situations, the Tribunal confirmed that payments made by a settlor to a trust in which he has an interest can be taxed as the settlor's income, highlighting how the income tax rules can lead to seemingly illogical results.
The judgment also touched on the interaction between a settlor's liability to income tax and that of the trustees (and the complications which can arise as a result), raising some interesting points for private client practitioners to bear in mind when dealing with these issues, either in their advice to a settlor or to trustees.
The facts of the three appeals (which related to two separate trusts) concerned the former income tax provision set out in section 660A (1) of the Income and Corporation Taxes Act 1988 ("ICTA"). This section provided as follows:
"Income arising under a settlement during the life of the settlor shall be treated as the income of the settlor and not as income to any other person unless the income arises from property in which the settlor has no interest."
The provision was primarily introduced as an anti-avoidance measure, to prevent individuals seeking to use trusts to reduce their income tax exposure, at a time when the top rate of income tax for individuals was 60%.
Whilst the ICTA provisions have now been replaced by the Income Tax (Trading and Other Income) Act 2005 ("ITTOIA"), the position remains largely unchanged. Section 624 of ITTOIA now states:
"Income which arises under a settlement is treated for income tax purposes as the income of the settlor and of the settlor alone if it arises (a) during the life of the settlor and (b) from property in which the settlor has an interest."
The findings in the Rogge case, therefore, are relevant to the ongoing application of ITTOIA.
The case dealt with an appeal by Mr Olaf Rogge in respect of the Olaf Rogge Settlement ("the Rogge Settlement"), and appeals by Mr John Kent in his capacity as (i) settlor and (ii) trustee of the J M Kent Settlement ("the Kent Settlement").
The Rogge Settlement
The Rogge Settlement was a non-UK resident trust established by Mr Rogge (a UK resident, non-UK domiciled individual). Mr Rogge was named as one of the beneficiaries and as such, the trust was settlor-interested for income tax purposes.
In 2001, the trustees entered into a loan agreement with Mr Rogge under which they lent him the sum of £1million. It was subsequently agreed that Mr Rogge would pay interest on the principal sum, amounting to a total of £108,925 during the tax years 2001/2002 and 2002/2003. Mr Rogge was then assessed to income tax on those interest payments.
The Kent Settlement
The Kent Settlement was established by Mr Kent (a UK resident individual) in 1987 and, except for the period between 1991 and 1998, was a UK resident trust. Mr Kent had a life interest in the trust.
Over the course of a number of years, Mr Kent and his wife occupied certain properties owned by the Kent Settlement in return for regular rental payments to the trustees.
Mr Kent was subsequently assessed to income tax on the trust's income, which included the rental yield. As the persons receiving the income, the Kent Settlement trustees were also assessed to income tax.
The key questions before the Tribunal were as follows:
- Can a settlor of a settlor-interested trust be assessed to income tax on payments he has made to the trustees?
- If the settlor is assessed to income tax on this basis can the trustees also be so assessed?
Mr Morris (representing the appellants) argued that on a purposive reading of section 660A(1) of ICTA a settlor cannot be taxed on payments he has made to a trust in which he has an interest on the basis that an individual cannot be both payer and payee for income tax purposes.
Mr Morris referred the Tribunal to the case of Barclays Mercantile Business Finance Limited v Mawson, which reviewed the Ramsay principle of statutory construction:
"The ultimate question is whether the relevant statutory provisions, construed purposively, were intended to apply to the transaction, viewed realistically."
Mr Morris' contention was that the law could not realistically have intended settlors to pay income tax on their own payments. It was noted by the Tribunal, however, that no authority could be cited to support such a construction of the section.
In response, Mr Slater, Counsel for HMRC, referred the Tribunal to the cases of Commisioners of Inland Revenue v Leiner and Ang v Parrish (Inspector of Taxes) , in support of his assertion that section 660A(1) of ICTA simply could not be construed in any way which would avoid a settlor being assessed to income tax on a settlor-interested trust's income, regardless of whether the income had been generated by the settlor himself.
Accepting that both the Leiner and Ang v Parrish cases were binding authorities, the Tribunal went on to note some interesting points in relation to alternative statutory interpretations, in particular:
"If a literal construction would lead to injustice or absurdity, and the language admits of an interpretation which would avoid it, then such an interpretation may be adopted."
Whilst the Tribunal obviously sympathised with the appellants' argument that an income tax charge on a settlor on sums paid by him "cannot be right", it found that section 660A(1) simply did not admit any alternative construction that would allow the Tribunal to avoid the "absurdity" of Mr Rogge and Mr Kent being subject to income tax on sums they had paid. The Tribunal was clear that it could only interpret the relevant income tax provisions within the terms and restrictions of the legislation.
Settlor and Trustee Liability
In relation to the appeal by Mr Kent in his capacity as trustee of the Kent Settlement, the Tribunal rejected the argument that if the trust's income was assessed on Mr Kent (as was determined by the Tribunal) the income could not be assessed on the trustees.
The Tribunal held that the Kent Settlement trustees were still the "persons receiving" the income (for the purposes of section 21 of ICTA) and were, therefore, to be assessed on that income.
Points to Note
The Rogge case and the appeals heard raise some interesting points in the context of both domestic and offshore trusts.
Practitioners should always be alert to the income tax implications of a settlor retaining an interest in a trust. It should be remembered that the phrase "retained interest" in this context (section 625 ITTOIA) is widely drafted and catches trusts under which property can be applied for the benefit of the settlor's spouse, as well as those of which the settlor is a beneficiary himself.
It is also worth noting that even if the settlor does not otherwise submit a tax return, he will need to do so for the trust income, and to the extent that he does not actually receive the income, he has a statutory right to reimbursement from the trustees.
The settlor's liability for the income of a settlor-interested trust does not displace the trustees' own accountability as the recipients of the income.
This can lead to a somewhat cumbersome administrative process to avoid double taxation. For example, trustees of a discretionary settlor-interested trust in receipt of income will account for tax on that income at the 50% trust rate and the settlor will receive a credit for tax paid by the trustees, reclaiming any tax which has been overpaid (e.g. if he is not a 50% income tax payer). The settlor must then repay the reclaimed sum back to the trustees. This process can take some time to resolve and needs to be considered by both settlor and trustees when thinking about how to fund any tax due.
Despite calls for reform, the government declined to include these rules in its programme of consultations coming out of the 2012 budget, even though settlor-interested trusts were on the agenda in the context of trusts with corporate settlors.
The settlor-interested rules have implications for international trusts as well as those in the UK, given that they apply to all settlor-interested trusts, regardless of their residence.
The rules also apply regardless of the residence of the settlor, albeit that the liability of a non-UK resident settlor will only extend to UK source income arising to the trust, and bearing in mind that the 'disregarded income' rules should apply to limit his liability on interest and dividends to tax deducted at source.
Where a settlor of a settlor-interested trust is UK resident but non-UK domiciled, his liability will depend on the source of the income and whether he is a remittance basis user. The source of income is, therefore, important in this context; if, for example, My Rogge had done the same as Mr Kent and paid rent to the Rogge Settlement trustees on a UK property, that income would have been UK source and immediately taxable on Mr Rogge on an arising basis, regardless of his non-UK domicile status.
In the case of the interest paid by Mr Rogge on the loan, the Tribunal said that it would not consider the source of the interest during the hearing, and that this issue would be resolved by the parties; this would obviously be central in determining Mr Rogge's liability.
It is worth flagging these points with trustees who may be seeking to avoid the conferral of a benefit on a UK resident-settlor of a non-UK trust, possibly as a means to prevent a UK tax charge arising under other anti-avoidance provisions, for example under the transfer of assets abroad regime or upon receipt of a capital payment.
Not only does the case demonstrate how the settlor-interested rules work in both a UK and offshore setting, the Tribunal's decision serves as a reminder that legislation may sometimes trigger tax consequences that do not seem to be logical or rational in the circumstances.
As reluctantly noted by the Tribunal, however, if there is no alternative interpretation presented by the legislation itself, the court is unable to adopt a more realistic solution, however strange the outcome may seem. Unfortunately, "neither justice nor reason has any place in tax law."
This article first appeared in Trusts & Estates Law & Tax Journal July/August 2012.
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