Extensive reforms to the taxation of offshore trusts in recent Finance Acts were meant to protect foreign domiciled settlors from arising basis taxation, with respect to foreign income and gains of trusts they have created. Unfortunately, poor statutory drafting means that in many situations this objective has not been achieved. Arguably, the most serious defect in the legislation concerns gains arising on the disposal of certain non-UK collective investment schemes, which are common trust investments. It was widely hoped that this defect would be amended. However, the Government has just announced that, for the time being at least, it is going to do precisely nothing about it.
(Not so) protected settlements
Sweeping changes to the taxation of non-UK resident trusts with UK resident settlors were effected by the Finance (No2) Act 2017 and the Finance Act 2018. As part of these reforms, the so-called “protected settlements” regime was introduced in relation to offshore trusts created by foreign domiciliaries. This was intended to protect non-UK domiciled settlors from arising basis taxation in relation to non-UK income and gains of the trust.
Under this regime, a non-UK domiciled settlor of a “protected settlement” is not subject to tax on the arising basis in respect of “protected foreign source income” (PFSI) of the trust, even if the settlor has become deemed domiciled in the UK due to long-term residence. Instead, the settlor may be taxed on benefits received from the trust by reference to trust income, including PFSI.
It had been anticipated, based on stated Government policy, that the PFSI concept would encompass all non-UK income and deemed non-UK income arising within a protected settlement. In fact, the legislation contains various drafting defects and anomalies, such that certain types of non-UK income do not appear to be included within the definition of PFSI. The particular issue addressed by this briefing note is only the tip of the iceberg. There are other areas of significant concern, including non-UK income arising to underlying companies.
There be gremlins
Non-reporting funds, i.e. offshore collective investment schemes without reporting fund status, are a very common investment for offshore trustees. Disposals of interests in these non-reporting funds can give rise to “offshore income gains” (OIGs) which are deemed to be non-UK income for tax purposes.
On the basis of Government announcements during the gestation of the legislation, and indeed on the basis of common sense, one would have expected OIGs realised within “protected settlements” to be PFSI, so that such deemed income would not be capable of giving rise to immediate tax charges for non-UK domiciled settlors. However, a drafting glitch seems to mean that, in fact, immediate tax charges can arise if OIGs are realised within such a settlement.
In brief, the problem is as follows. Trust income can only be PFSI if it would be “relevant foreign income”, were it received by the settlor personally. OIGs can only be relevant foreign income of an individual who is non-UK domiciled and a remittance basis user. Where an individual is deemed UK domiciled, he clearly cannot be a remittance basis user. Therefore, taking the legislation at face value, OIGs of a settlement with a deemed domiciled settlor are not PFSI and, typically, give rise to arising basis income tax charges for the settlor.
This is obviously very unfortunate for a non-UK domiciled settlor who has become deemed UK domiciled. However, the drafting may be problematic even where the settlor has not yet become deemed domiciled: such a settlor will, if the legislation is taken at face value, need to claim the remittance basis in order for trust OIGs to qualify as PFSI and so not give rise to tax for him on the arising basis. This may require the settlor to pay remittance basis charges that, but for the issue with trust OIGs, would not need to be incurred.
There is probably scope to address some of the other deficiencies in this legislation by means of purposive or creative construction. However, arguably, there is little room for this kind of creativity where trust OIGs are concerned. There is no real ambiguity in the exclusion of OIGs from the definition of PFSI – the position is clear, although doubtless unintended. Although a court might wish to interpret the legislation in accordance with Parliament’s intention, it is likely to feel confined by the clear wording of the statute, and may feel reluctance to engage in what might be considered judicial redrafting.
Promises, promises …
Published Government policy has always been that, under the new regime, non-UK domiciliaries would be protected from arising basis tax on non-UK income and gains of non-resident trusts created by them. In their initial technical briefing in July 2015, HMRC stated: “Non doms who have set up an offshore trust before they become deemed domiciled here under the 15 year rule will not be taxed on trust income and gains that are retained in the trust”. This broad intention was repeated in HMRC guidance released in January 2018.
There is no possible policy justification for treating OIGs differently from other gains of a protected settlement. The effect of the legislation conflicts with stated Government policy. It cannot have been intended.
It seems clear that corrective legislation is needed to remedy this defect and bring OIGs within the definition of PFSI. Professional bodies have accordingly made representations to the Government and have compiled compelling evidence of the scale of the problem. The findings of a survey which indicated that around 40% of offshore trusts with deemed domiciled settlors hold interests in non-reporting funds have been presented to HMRC. However such attempts appear, thus far, to have been in vain.
It had been hoped that changes to the legislation would be announced in the Autumn Budget. Instead, HMRC have issued the following, highly disappointing, statement:
“A decision has been made not to amend the current legislation to include income arising in offshore non-reporting funds in the foreign trust exemptions at this time.
The current demands placed on Parliamentary resource make it difficult for the government to justify returning to the legislation at this time to add to the generous package of protections which the government has already legislated for in the extensive reform of the non-dom rules last year.
Going forward, HMRC will continue to monitor this situation and engage with stakeholders."
Not only does this statement demonstrate an unwillingness to address the problem, it also suggests a misunderstanding of the issue; the problem concerns OIGs realised on disposals of interests in non-reporting funds, not income arising within such funds.
The suggestion that the rectification of the drafting error in relation to OIGs would “add” to the trust protections seems disingenuous, or at least misguided. The change which professional bodies had been pressing for would not extend the scope of the trust protections beyond what was originally proposed by the Government; it would simply fill a hole of the parliamentary draftsman’s making, and ensure that the Government’s objectives are met.
It is likely that, in many cases, lack of awareness as to the detail of the legislation and (perfectly understandable) reliance on the Government’s stated policy will have led to offshore trustees investing in, or continuing to hold interests in, non-reporting funds – without appreciating the implications for the trusts’ UK resident non-UK domiciled settlors. Such settlors are now facing an impending deadline of 31 January 2019, by which date they need to decide how to report OIGs realised in 2017/18, the first tax year in which these new rules applied.
Those non-UK domiciled settlors who became deemed domiciled in the UK for income tax and CGT purposes on 6 April 2017 have two options when completing their 2017/18 tax return: (1) report the OIGs and pay the tax due, or (2) include a “white space” statement in the return, including the value of OIGs realised by the trust but asserting that they should qualify as PFSI and so should not be taxable on the arising basis.
It is difficult to see what could be lost in opting for the second approach, but equally it is questionable how much it can achieve. Given that HMRC’s statutory duty is to collect tax that is legally due, in the absence of case law or clear official guidance to the contrary, it would seem difficult for HMRC’s staff to do anything other than to assess the tax due on the OIGs.
In the case of a non-UK domiciled settlor who is not yet deemed domiciled, the position will turn on (1) whether he has any personal non-UK income or gains in respect of which he would claim the remittance basis in any event, and (2) whether the remittance basis charge will be payable. If a remittance basis claim can be made without incurring the remittance basis charge, it should be made. The claim should ensure that trust OIGs qualify as PFSI and so cannot be taxed on the arising basis.
In other cases, a non-deemed domiciled settlor may wish to use the arising basis of taxation and make a “white space” statement regarding OIGs realised by the trust - bearing in mind the scope to make a retrospective claim to use the remittance basis up to four years from the end of the relevant tax year.
These are difficult questions which require consideration on a case by case basis. It goes without saying that expert professional advice should be sought.
HMRC have said that they will “continue to monitor this situation and engage with stakeholders” but it is not clear what this means. It is possible that, once HMRC appreciate how widespread the issue is in practice (perhaps following a review of 2017/18 tax returns), this information will be fed back to the Treasury and parliamentary time will be found for an amendment to the legislation. But it must be noted that there is a profound conflict of interest here - given that leaving the legislation as it is will, at least in the short term, result in a higher tax take than correcting the current drafting error.
In light of this latest statement from HMRC, this issue may now lead to litigation, if there is a foreign domiciled settlor with sufficient tax exposure and sufficient temerity. As discussed above, it would be a stretch for the court to reach a conclusion in favour of the taxpayer, but it is not altogether impossible that a creative interpretation of the legislation would achieve the desired outcome.
If you fail to plan …
In the meantime, trustees of settlements affected by this issue should review their investment strategy and consider workarounds, making the assumption that the drafting defect won’t be corrected any time soon.
An obvious approach would be to move from interests in non-reporting funds to interests in reporting funds, disposals of which give rise to normal chargeable gains rather than OIGs. Such gains are covered by the “protections” afforded to non-UK domiciled settlors.
Perhaps less obviously, and not suitable in all cases, the trust could continue to invest in non-reporting funds but indirectly, via a non-UK single premium life insurance policy (sometimes known as an offshore life bond). Gains realised on the disposals of investments held “within” the policy cannot, in this situation, be taxed on the settlor. If this structure is adopted, there will be scope for the settlor to be taxed if value is extracted from the policy while the settlor is living and UK resident, although there is an annual tax-free “allowance” for such extractions. (The advantages and downsides of offshore life bonds are discussed in greater detail in our recent “Sweet Surrender” briefing note.)
Alternatively, the trustees could follow the traditional approach to portfolio investment and hold a managed portfolio. If such a portfolio is directly held, and avoids non-reporting offshore funds and UK assets, the income arising within it should be PFSI and so protected from arising basis tax for the settlor.
In some cases, the simplest solution may be to exclude the settlor and any spouse or civil partner from benefiting from the trust. However, in most cases the settlor will want to be a beneficiary. Where exclusion is an option, expert advice will be needed on whether it will, in fact, preclude tax charges for the settlor on trust OIGs. In some cases the settlor will continue to be assessable on OIGs, even if and he any spouse / civil partner are excluded.
It is regrettable that the tax treatment of offshore trusts created by foreign domiciliaries has, no doubt despite the best intentions, become a minefield. It is hoped that, before too long, parliamentary time will be found to correct the defects in the legislation and defuse some of the fiscal ordnance – in the interests of taxpayers and in the interests of a coherent tax system.
However, the recent announcement regarding trust OIGs is not encouraging. Individuals affected by these issues may continue to hope for the best, whilst fearing the worst …