Just over 18 months since the changes were first announced, we now have a fairly final draft of the legislation giving effect to one of the most fundamental reforms to the way nondomiciliaries are taxed in the UK. This confirms and clarifies many of the points which have been announced by HMRC over the last few weeks as well as containing some significant changes which have not previously been publicised.
The big news, however, is the surprise announcement on the day after the publication of the Finance Bill that most of the anti-avoidance provisions which were to be included as part of the changes to the way in which offshore trusts are taxed (and which would in many cases apply to all offshore trusts and not just those with non-domiciled settlors) are to be deferred until a future Finance Bill as the legislation has proved too complicated to finalise in the time available. HMRC has confirmed that these anti-avoidance provisions will only become effective from the start of the tax year to which that Finance Bill relates and will not be backdated to 6 April 2017.
This does mean that some of the transactions planned for the period before 6 April 2017 can now safely be deferred. However, there is still plenty which needs to be done before that date.
1 Clarification / changes in the revised legislation
1.1 Inheritance tax on UK residential property
1.1.1Collateral / loans The legislation has been tightened up to ensure that any loan which relates to the acquisition, maintenance or improvement of UK residential property will be within the scope of UK inheritance tax. The previous draft had contained some loopholes.
There had, for example, been some uncertainty as to whether the new rules would apply where the loan is made to an individual who acquires the residential property in his own name (rather than, for example, through a company). It is clear that this is caught and that any trust or individual which is the ultimate owner of the debt (whether directly or through a company) will be subject to inheritance tax.
As promised, the exposure to inheritance tax in relation to collateral which is provided in respect of a loan which is used to acquire UK residential property will be limited to the amount of the loan so that the full value of the collateral will not be exposed to inheritance tax.
Whilst this is welcome, it does still mean that the total exposure to inheritance tax may not take into account the existence of the debt (i.e. in substance there will be no deduction for the debt) and in some circumstances may exceed the value of the UK residential property.
For example, assume a bank makes a loan of 1m to an individual to buy a property worth 2m. The individual is the settlor of a trust which gives security to the bank for the loan over assets worth 2m. The loan may not be deductible from the value of the property if it is not secured over the property and so the full 2m value of the property may be subject to inheritance tax. In addition, 1m of the collateral (the value of the loan) will also be subject to inheritance tax.
Care will therefore need to be taken in structuring loan arrangements where the proceeds are going to be used (directly or indirectly) to acquire UK residential property.
Additional anti-avoidance provisions have been included to try to make sure nothing slips through the net, despite the existence of a widely targeted anti-avoidance rule in the legislation. For example, if a loan is taken out to buy an asset other than UK residential property but that asset is sold and the proceeds reinvested into UK residential property, the original loan will be within the scope of the new rules.
1.1.2Discretionary trusts exit charges The previous legislation had the effect that where the new rules apply to property held by a discretionary trust, there would be an inheritance tax exit charge when the property in question was disposed of or the loan was repaid, even on a genuine sale to a complete third party.
This is no longer the case. Instead, if the company which owns the property is sold, the proceeds of sale will remain within the scope of inheritance tax for two years after the sale. On the other hand, if the property itself is sold, the exposure to inheritance tax ceases immediately and there is no two year shadow.
1.1.3Enforcement The legislation imposes a charge over the UK residential property if there is tax due under the new rules which is unpaid. As currently drafted, this could work in quite a draconian way where loans are involved as a charge could be imposed over the property in respect of unpaid inheritance tax relating to the loan, even though the owner of the property is not liable for the inheritance tax on the death of the holder of the debt.
Hopefully, there will be some relaxation of this before the legislation is finally passed.
1.2.1Tainting protected trusts Even after an individual becomes deemed domiciled in the UK as a result of having been UK resident for more than 15 years, he / she will not be taxable on the income or gains of an offshore trust unless he / she receives a distribution from the trust. The rules which normally tax a UK-domiciled settlor on income and gains of an offshore trust are disapplied.
However, these protections are lost if an addition is made to the trust by the settlor, or by another trust of which the settlor is also the settlor, or of which he is a beneficiary at a time when the settlor is deemed domiciled in the UK.
Given the catastrophic consequences of even a small addition to a trust (the trust protections are lost in their entirety), this has caused a great deal of concern. As a result of representations which have been made, there have been a number of clarifications and changes (some helpful and some not so helpful):
It has been made clear that increasing the value of an asset owned by the trust is treated in the same way as an addition of property to the trust.
HMRC has also confirmed that, in the case of a life interest trust, failure by the trustees to require a company which they own to pay a dividend (and so depriving the life tenant of income) will not constitute an addition by the life tenant.
1.2.2Loans Loans can cause particular problems when it comes to tainting given the difficulty of knowing whether a loan is on arm's length terms. The legislation is therefore helpful in specifying what is to be treated as arm's length in these circumstances.
Where a loan is made to a trust, the loan will only be treated as being on arm's length terms if the trustees have to pay interest at a rate which is no less than the "official rate" (currently 3 per cent but reducing to 2.5 per cent from 6 April 2017) at least annually. It is not enough that the loan agreement specifies that interest must be paid annually. The terms of the loan agreement must be adhered to and the interest must not be capitalised.
If a loan is made by the trustees to the settlor, the interest charged must be no more than the official rate of interest (but could be less) and there is no requirement that the interest must be paid annually. If the interest rate is less than the official rate or the interest is not paid annually, the settlor will be in receipt of a taxable benefit (see below).
Except in the case of a loan, an inadvertent addition will not taint the trust (where there is no intention to confer a gratuitous benefit). It may be thought that one result of this new provision is that there is no need to consider the use of adjustment agreements to try to ensure that transactions take place on arm's length terms. However, such agreements provide good evidence that there is no intention to confer any gratuitous benefits and so may well still be useful.
Cash can be added to a trust in order to pay trust expenses if the expenses exceed the available trust income or, even if there is surplus income available, if the expenses are properly payable out of capital rather than income. It is still unclear whether cash can be added to pay the expenses of a company owned by the trust as opposed to the expenses of the trust itself.
HMRC has confirmed that failure by a settlor to exercise a power of revocation will not be treated as an addition and will not therefore taint the trust. No comment has been made in relation to other trust powers retained by the settlor but there is no reason to think that the same principles should not apply.
If the settlor has made a loan to the trust which is not on arm's length terms (as defined above) and which is repayable on demand, the legislation specifically provides that the trust will be tainted (and will therefore lose the trust protections) on the day the settlor becomes deemed domiciled. Fixed term loans are not a problem as long as they are repaid at the end of the fixed term (or put on to commercial terms).
There is however a 12-month grace period for those settlors who are becoming deemed domiciled on 6 April 2017 during which loans which are made to a trust and which would otherwise cause the trust to be tainted, can be sorted out.
During the 12-month grace period, offending loans can be dealt with either by repaying the loan or by putting it onto arm's length terms (as defined). If the loan remains outstanding but is converted to arm's length terms, an amount equal to interest must be paid with effect from 6 April 2017 and not just from the date on which the loan is reorganised.
It is important to note that the grace period only applies to loans which are made to a trust. It does not apply to loans which are made by a trust and where the interest rate which is being charged may be more than the official rate of interest. This is
only a problem if the loan is made to the settlor or to another trust set up by the settlor or of which the settlor is a beneficiary. However, if there are any such loans, they need to be dealt with before 6 April 2017.
The statutory arm's length definition only applies to loans made by or to a trust. It is not clear whether the same rules apply to a loan made by or to a company which is owned by a trust. Until we receive clarification on this (and guidance on all of the changes is expected in May), the safest course is to assume that the same rules apply.
1.2.3Taxation of trust income The rules for taxing income of offshore trusts are being changed for all trusts with non-domiciled settlors and not just those where the settlor becomes deemed domiciled in the UK as a result of having lived here for more than 15 years.
Foreign income of the trust structure will no longer be treated automatically as the settlor's income. Instead, it will only be taxed if the settlor receives a distribution and that distribution can be matched against the pool of accumulated income in the trust. UK source income will continue to be taxed as it arises.
Income which has arisen prior to 6 April 2017 and which has been retained in the structure will form part of the pool of income which can be matched against future benefits.
It is clear that benefits received by a settlor before 6 April 2017 will not be brought into account for matching purposes as far as income retained in the structure is concerned (although any unmatched benefits can still be matched against future capital gains and so having significant unmatched capital payments where the settlor is becoming deemed domiciled in the UK is generally not advisable).
Any income which has previously been treated as the settlor's income but which has been retained in the structure will no longer be taxed on the settlor if it is remitted to the UK by the trustees. This means that the trustees could, for example, use income to acquire a UK asset such as shares in a UK company or a house for the settlor to live in without that being treated as a taxable remittance (although the settlor may of course be receiving a taxable benefit if he does not pay rent to live in the house).
This change in treatment does raise the question as to whether there remains any point in keeping capital and income separate within a trust structure established by a non-domiciled settlor. Clearly, it will simplify the administration of the trust and the
management of any investment portfolio if income and capital can be mixed.
Going forward, the only real benefit in keeping income separate is that income which has arisen over a number of years could be distributed to a non-UK beneficiary if it has been kept separate whereas this would not be possible if the income and the capital have been mixed.
For income tax purposes, the provisions taxing a UK resident settlor on income matched with distributions received by a spouse or minor child have been retained. If the settlor is a remittance basis taxpayer, he / she will still get the benefit of the remittance basis of taxation. This means that if the spouse or minor child remits the benefit to the UK, the settlor will pay tax.
Rather surprisingly, this close family member rule has not been included in the capital gains tax legislation and is one of the measures which has been deferred.
Where the settlor is taxable on a distribution which is made to a close family member, the settlor will have the right to require the family member to reimburse him or her for the tax which he / she has paid.
One trap with the existing legislation is that, if the trustees make a distribution to a non-domiciled beneficiary who pays tax on the remittance basis and that distribution is matched against trust income which has been remitted to the UK within the trust structure, the non-domiciled beneficiary may be taxable in the UK even though the distribution has not been remitted to the UK.
It had been understood that the draft legislation would remedy this anomaly but, so far, nothing has been added to the legislation to deal with this point.
2Valuation of benefits
The Finance Bill contains a first draft of the promised legislation which puts on a statutory footing the quantification of benefits involving loans, moveable property and land.
The legislation is intended to deal with what the government sees as two shortcomings in the existing rules:
Taxpayers being able to argue that the value of the benefit is very low, even where capital values are high.
Arrangements which are said to be on arm's length terms but where payment of any consideration by the taxpayer is deferred until the arrangement comes to an end.
The legislation deals with three specific areas:
assumptions as to what is paid for by the landlord and what is paid for by the tenant.
As with moveable property, the benefit is then reduced by anything paid by the beneficiary to the trustees in the relevant tax year for his occupation of the land and anything paid by the beneficiary for the repair, insurance or maintenance of the land.
From 6 April 2017, the recipient of a loan will be treated as receiving a benefit for each year the loan is outstanding equal to the official rate of interest, less the amount of any interest actually paid by the beneficiary to the trustees in the tax year in question.
This means that if interest is rolled up until the end of the loan, the beneficiary will still be treated as receiving a taxable benefit each year, even though the loan could be argued to be on arm's length terms.
2.2 Use of moveable property
This will apply principally to assets such as works of art, yachts and aeroplanes.
The main purpose of this provision is to ensure that rent is paid each year.
These new provisions do have the benefit of providing certainty to taxpayers as to what their tax liabilities will be where they receive benefits from the trust. They do, however, also mean that tax may now be payable where this was not previously the case or that there may be a significant increase in the amount of any tax payable.
The changes only apply to benefits received after 5 April 2017 and so there may be situations (particularly where clients are becoming deemed domiciled on 6 April 2017) where it is worth considering, for example, granting fixed-term benefits before that date.
The quantum of the benefit is based on a formula which involves applying the official rate of interest to the price paid by the trustees when they acquired the asset in question or, if greater, the market value of the asset when it was acquired. This means that the tax charge could be relatively low if the asset was acquired many years ago.
The amount of the benefit is reduced by anything paid by the beneficiary to the trustees for the use of the asset and also by any amount paid by the beneficiary in respect of the repair, insurance, maintenance or storage of the asset.
The beneficiary is only taxed by reference to the number of days on which the asset is "made available" to the beneficiary. There is no guidance in the legislation as to whether this means the number of days on which the asset is actually used by the beneficiary or whether it includes any days where the beneficiary could have used the asset even though he / she did not do so. HMRC will no doubt adopt the latter interpretation although, with assets such as yachts and planes, it may well be possible to argue to the contrary, especially if they are also chartered to third parties.
3 Cleansing mixed funds
There will be a two year window for non-domiciliaries to extract clean capital from overseas funds which contain a mixture of capital, gains and / or income. It will, however, be necessary to identify how much clean capital is contained in the fund. The amount which is paid out as clean capital must not exceed the actual amount of clean capital in the account as this will prevent the attempted segregation from working at all and instead will simply be treated as a proportionate part of each element of the original fund. If it is difficult to calculate exactly how much clean capital is contained in the account, it is therefore important to err on the side of caution and to take out less rather than more.
HMRC has confirmed that mixed funds can be segregated even where the account contains income / gains which arose before the current mixed funds rules were introduced in April 2008. The legislation has not, however, been amended to make this clear and so it may be that HMRC intend to deal with this in further guidance rather than by making changes to the legislation.
4Business investment relief
The amount of the benefit where land is made available to a beneficiary is the open market rent based on certain
The improvements to business investment relief do not go as far as everybody had hoped. However, there are two helpful changes:
Relief will be available for the acquisition of existing shares as well as the subscription for new shares.
trust level income being taxed on the settlor when he / she receives a benefit.
Relief will only be clawed back if the investor receives a payment which is somehow linked to the original investment. Under the existing rules, relief can be clawed back if a payment is received from an associated company which may have nothing at all to do with the original investment.
5Deferred anti-avoidance provisions
The government had proposed a number of anti-avoidance provisions, some of which would have applied to all offshore trusts and not just those with non-domiciled settlors.
We still expect these to be included in a future Finance Bill (presumably the Finance Bill relating to the tax year starting 6 April 2018). The measures which have not been included are as follows:
Rules preventing the pool of accumulated capital gains in an offshore trust being reduced by distributions to nonresident beneficiaries.
As mentioned above, these changes will not now apply for the tax year 2017/18 and will only be introduced on 6 April 2018 at the earliest.
Clearly, most people will have made their plans as to what action should be taken prior to 6 April 2017. The draft legislation may result in some refinements to what is being proposed but should not require major changes.
It is only after 5 April that we will all understand the full implications of the changes which are being made, not least as HMRC will not release guidance until May 2017.
It will be important to check that there are no arrangements in place which will result in a protected trust being tainted when the settlor becomes deemed domiciled on 6 April 2017. The good news is that there is a 12-month grace period to deal with most loans (which are likely to be the most common source of problems).
Provisions taxing a settlor on gains matched with distributions to close family members who are either nonresident or non-domiciled and who do not therefore pay tax.
Conduit rules designed to tax gifts to UK individuals made out of distributions received by beneficiaries who are either non-UK resident or who are non-UK domiciled (and who do not therefore pay tax on the distribution) in circumstances where the ultimate recipient would have been taxable had he / she received the distribution direct from the trust.
Matching of trust level income against distributions to the settlor or a close family member of the settlor. This has been proposed so that tax will still be payable even if the motive defence applies which would otherwise prevent the
The deferral of some of the anti-avoidance provisions will also mean that some actions which have been planned for the period before 6 April 2017 can now take place at a later date so those who thought the pain would be over as they disappear for a well-deserved rest on 6 April may still find that they have plenty to do when they get back to the office.
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This note is intended to provide general information about some recent and anticipated developments which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained.
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