NON-DOMICILIARIES DEEMED DOMICILE TRUST PROTECTIONS
This note deals only with the proposed new tax regime applicable to trusts settled by non-UK domiciliaries prior to becoming deemed domiciled in the UK. It does not deal with the inheritance tax treatment of residential property held through such trusts (for which see separate note here), nor does it deal with the regime applicable to returning former domiciliaries.
against trust capital gains. If the beneficiary is UK tax resident, then the matched capital gain is within the scope of UK tax (albeit that the remittance basis might apply if the beneficiary is non-domiciled). This charge to tax applies to non-domiciled trust settlors (if the settlor is a beneficiary) instead of the settlor charge.
Given the differing regimes and overlapping terminology, it might be helpful first to define the terms that will be used in this note:
Domiciliary an individual who has a UK domicile under the common law (ignoring any tax deeming rule).
Non-domiciliary a non-UK domiciled individual with a non-UK domicile of origin (or born outside the UK with a UK domicile of origin) who is not yet deemed domiciled in the UK under the new income / capital gains tax regime (so, until 6 April 2017 this term will apply to all non-UK domiciliaries who are not returning former domiciliaries, since the new regime does not yet apply).
Income tax Where the settlor of a foreign trust is UK resident (whether or not domiciled in the UK), trust income will be deemed to belong to the settlor under two regimes:
The transfer of assets abroad regime, which applies to income arising anywhere within an offshore structure (whether or not trust-owned), but to which there may be a defence (known as the "motive defence") if it can be shown that there was no UK tax avoidance purpose to any of the relevant arrangements.
The settlements regime, which applies only to income arising to trustees of the trust, and to which there is no motive defence.
Deemed domiciliary a non-UK domiciled individual with a non-UK domicile of origin (or born outside the UK with a UK domicile of origin) who is deemed domiciled in the UK under the new income / capital gains tax regime.
Where the settlor is non-domiciled, then the remittance basis of taxation can apply to the extent that the income deemed to belong to the settlor under either of these regimes is non-UK source.
Returning former domiciliary an individual born in the UK with a UK domicile of origin who, with effect from 6 April 2017, will be treated as domiciled in the UK for all tax purposes if they are UK resident.
THE CURRENT REGIME
Currently, the income and capital gains tax treatment of foreign trusts is as follows:
Capital gains tax Where the settlor of a foreign trust is a UK resident domiciliary, all capital gains arising to the trustee (including gains deemed to arise to the trustee via corporate structures) will be taxable on the domiciled settlor. Currently, this settlor charge does not apply to non-domiciled settlor.
Where capital gains arise within a foreign trust structure which are not deemed to arise to the trust's settlor, they are instead deemed to arise to any beneficiaries of the trust (whether or not UK resident) who receive any distribution or benefit in kind (known as a "capital payment") from the trust structure. This is done by "matching" the value of the benefit
The transfer of assets abroad regime can also impose a charge to income tax on non-settlor beneficiaries in respect of income arising within foreign trust structures (to the extent that the income has not already been taxed on the trust settlor, and the motive defence does not apply). The charge operates by "matching" the value of any benefits or distributions received by UK resident beneficiaries (but, unlike the capital gains tax matching rules, not benefits or distributions received by non-UK resident beneficiaries) against income arising within the trust structure. Again, the remittance basis of taxation can apply but, unlike the capital gains tax charge, only to the extent that the benefit is matched against non-UK source income.
In its original announcement of the non-domiciliary tax changes on 8 July 2015, the Government promised a measure of protection for trusts settled by non-domiciliaries before they became deemed domiciled. Although the announcement contained minimal detail, it stated the Government's intention not to tax a deemed domiciled settlor on trust income / gains arising within the trust structure (as would be the case for a domiciled settlor or returning former domiciled settlor).
However, since 8 July 2015, there have been a number of changes to how the proposed trust taxation rules will work.
The publication of the draft Finance Bill 2017 (Finance Bill) on 5 December 2016 has provided a measure of clarification of the regime that will apply with effect from 6 April 2017 but frustratingly, still does not include the draft income tax legislation applicable to trusts from this date (although the accompanying "response to further consultation" document contains further detail on the Government's intentions in this regard).
TAXATION OF TRUSTS UNDER THE NEW REGIME
Based on the draft legislation and response to further consultation document, the tax treatment of trusts settled by a deemed domiciliary prior to becoming deemed domiciled is as set out below. It should be noted that a number of these changes apply to all offshore trusts and not just those with a deemed domiciled settlor.
Capital gains tax Settlor charge the starting position is that rules
attributing capital gains of foreign trusts to domiciled settlors now applies to deemed domiciled settlors of foreign trusts. This is, however, subject to the trust protections described below.
Protected settlements the Finance Bill introduces a new exemption from the settlor charge. These rules can be summarised as follows:
- Protected settlement status will apply to any trust settled by a non-domiciliary, so including trusts: (i) settled before 6 April 2017 by any non-domiciliary (including one who has been UK resident for more than 15 out of 20 tax years prior to settlement, or who was already deemed domiciled for inheritance tax purposes at the time of settlement); and (ii) settled after 6 April 2017, provided that the settlor was not yet deemed domiciled at the time of settlement.
- Where protected settlement status applies, the trust gains will be outside of the scope of the settlor charge, and so will not be taxable on the deemed domiciled settlor as they arise.
- However, protected settlement status will be lost if property or income is added to the settlement either by the settlor or by the trustees of any other trust of which the settlor is settlor or beneficiary in a tax year on or after 6 April 2017 when the settlor is deemed domiciled. This will not include:
property or income provided under an arm's length transaction;
property or income provided pursuant to a pre-6 April 2017 liability (this will cover payments of liabilities incurred before the introduction of the new regime, but not the payment of any liabilities incurred after 6 April 2017, even if incurred before the trust settlor became deemed domiciled); or
property or income provided in order to pay trust tax or expenses to the extent not capable of being met out of trust income for the year.
There is some uncertainty as to how this rule would apply to pre-6 April 2017 interest free loans owed to a deemed domiciled settlor (or another trust of which that individual is settlor or beneficiary). HMRC may well take the view that failure to call for repayment of an on demand loan is the "addition" of property if the loan is interest free.
"Washing out" capital gains to non-residents and nondomiciliaries in the course of the consultation process, HMRC had expressed concerns that trust capital gains could be washed out by means of being matched against capital payments to persons who would not pay tax on such capital payments, leaving tax-free trust capital to be distributed to deemed domiciled settlors / beneficiaries. To deal with this concern, the scope of section 87 has been amended as follows:
- With regard to all foreign trusts (whether or not the settlor is non-domiciled, deemed domiciled or UK domiciled), with effect from 6 April 2017, capital payments to nonUK resident beneficiaries will not be matched against (and so will not wash out) trust capital gains.
This will be the case even if the capital payment is received before 6 April 2017, but would otherwise not have been matched against capital gains until after that date (because at the time the capital payment was received, there were insufficient unmatched capital gains to fully match the capital payment).
So for foreign trusts with unmatched capital payments to non-UK resident beneficiaries as at 6 April 2017, post-6 April 2017 capital gains will not be "matched back" to these capital payments and will instead only be capable of being matched against capital payments to UK resident beneficiaries or non-UK resident close family members of UK resident settlors (see below).
- There is also a carve-out where a trust is being wound up by means of trust capital distributions to both UK resident and non-UK resident beneficiaries. In this situation, rather than treat all of the trust capital gains as arising to the UK resident beneficiary, they will be apportioned between UK resident and non-UK resident beneficiaries in accordance with the existing (pre-6 April 2017) rules. This is clearly fair and sensible.
- If a non-UK resident beneficiary comes within the scope of the temporary non-residence rules, any capital payment received during the beneficiary's period of non-UK residence will be treated as having been received on his / her return to the UK (and so can be matched against the available capital gains of the trust in that or subsequent tax years).
- "Migrating beneficiaries" where a capital payment has been made to a UK resident beneficiary, but that beneficiary becomes non-UK resident before the capital payment has been "matched" against capital gains, the capital payment cannot subsequently be matched against capital gains. This rule only applies post-6 April 2017, but applies irrespective of whether the beneficiary ceased to be UK resident prior to 6 April 2017.
Capital payments to close family members of a UK resident settlor will be taxable on the settlor, not the beneficiary, if the beneficiary in receipt of the capital payment is either: (i) non-UK resident; or (ii) claims the remittance basis of taxation and does not remit the capital payment in the same tax year.
This applies to all offshore trusts with a living settlor whether non-domiciled, deemed domiciled or UK domiciled (and so where the UK resident settlor is a non-domiciliary, the remittance basis can be claimed).
Where this results in a charge to tax on the settlor, then (s)he will be entitled to reclaim the tax paid from either the beneficiary in receipt of the capital payment, or the trustee of the trust from which the capital payment was made.
It is not entirely clear what happens if both settlor and beneficiary are on the remittance basis but before any remittance is made, the beneficiary ceases to be a "relevant person" by reference to the settlor (and so is no longer capable of making a taxable remittance on behalf of the settlor of capital gains deemed to belong to the settlor for UK tax purposes).
Perhaps slightly surprisingly, there is no transitional rule protecting pre-6 April 2017 distributions to non-domiciliaries from a charge to tax on the arising basis to the extent matched against trust capital gains arising after the beneficiary becomes deemed domiciled. This seems unfair, and could catch out a lot of non-domiciliaries who have received trust distributions in the past, and who become deemed domiciled on or after 6 April 2017.
"Anti-conduit" rules in order to avoid capital payments made tax-free to non-UK residents or non-domiciliaries from finding their way back to UK residents by way of onward gifts, Finance Bill introduces an "onward gift" rule. Again, this applies to all offshore trusts, not just those with a deemed domiciled settlor.
- The onward gift rule applies where a capital payment has been made to a beneficiary (the "original beneficiary"), and within three years that beneficiary has made an onward gift, directly or indirectly, to a UK resident individual. A gift made in anticipation of the capital payment can also be caught in certain circumstances.
- The rule applies only where in any tax year from and including the date of the original capital payment and the date of the onward payment to a UK resident individual, capital gains arising in the foreign trust would not have been taxable on the original beneficiary, either because (s)he was non-UK resident, or because (s)he claimed the remittance basis of taxation.
- The rule does not apply where the original beneficiary is a close family member of a UK resident settlor at the time the capital payment is received (since in that scenario, the gain will be attributed to the settlor although the remittance basis may apply).
- The rule seeks to catch a chain of gifts, but only where both the original distribution and the eventual receipt by a UK resident individual occur within three years of one another (although it is not entirely clear that the legislation fully meets this aim).
- There is an indefinite extension to the three year rule where there are "arrangements" in place for a UK resident individual to receive sums directly or indirectly from the original beneficiary. The rule seeks to avoid a charge to double taxation by reducing the amount of the deemed capital payment received by the UK resident individual by any amount that is charged to tax, either on the original beneficiary or any other recipient of a gift which falls within the onward gift rules in respect of the same original capital payment.
- Critically, the onward gift rule applies to any onward payments made on or after 6 April 2017, even if the original payment was made before that date. If non-UK resident or domiciled trust beneficiaries who have received distributions are contemplating making gifts to UK individuals, they should therefore make the gifts before 6 April 2017.
- The term "gift" includes any benefit, so would (for example) include an interest-free, or below market rate of interest, loan.
Income tax The HM Treasury draftsmen then seem to have run out of time, as there is no draft legislation regarding the changes to the tax treatment of income arising in foreign trust structures. However, we are told the following in the response to further consultation document:
For foreign trust-owned structures only (but not in relation to structures not held through a trust), it is intended that provisions which deem income arising within such structures to belong to the trust settlor will no longer apply, except in relation to UK source income. This will be the case whether the settlor is non-domiciled or deemed domiciled. In effect, foreign trust-owned structures become completely tax opaque, other than in relation to UK source income.
This has a potentially quite significant impact on investment structuring for foreign trust-owned structures settled by non-domiciliaries. Currently, UK investments are generally avoided in such structures because of the risk of inadvertent taxable remittances within the structure of foreign income deemed to belong to the trust settlor for UK tax purposes. If, however, such income is no longer deemed to belong to the settlor, this risk falls away (although income arising from such investments will generally have a UK source, and so will remain taxable on the arising basis).
Any pre-6 April 2017 foreign source income which has already arisen within foreign trust structures will, from 6 April 2017, be taxed on this "matching" basis, rather than being deemed to belong to the settlor for tax purposes. This appears to be the case irrespective of whether or not the settlor has yet become deemed domiciled. However, pre-6 April 2017 capital payments to a trust settlor will
be subject to the existing rule, so will not be subject to the matching rule, even with regard to post-6 April 2017 income (although it should be noted any such capital payments will be still be capable of being matched against trust capital gains under both the pre and post-6 April 2017 regimes).
As with capital gains, from 6 April 2017 benefits received by close family members will be taxable on a UK resident settlor unless taxable in the hands of the beneficiary (so, presumably, where the close family member is non-UK resident or a remittance basis user).
A trust settled by a non-domiciliary who subsequently becomes deemed domiciled will benefit from (and can lose) protected status for income tax purposes in the same manner as it will benefit from (and can lose) protected status for capital gains tax purposes.
Although it is not clear, we expect that there will be similar "anti-conduit" rules as for capital gains tax.
The changes to the rules on the tax treatment of foreign income arising within trust structures are to be welcomed. In effect, they eliminate the risk of inadvertent remittances within trust-owned structures.
Going forward, a non-domiciled settlor will be taxable in respect of foreign source trust income only to the extent that (s)he receives any benefit from the trust, and then according to his / her tax status (so, if (s)he is a remittance basis user, the benefit will be taxable only if remitted to the UK it would appear irrespective of whether the trust income against which the benefit is matched has previously been remitted to the UK within the trust structure itself). This is a sensible simplification of the existing rules.
Valuation of benefits Finally, the response to further consultation document states that a new rule for the valuation of trust benefits in kind (including use of trust assets such as art, yachts, planes or other chattels and interest-free loans, or below market rate of interest loans, including where interest is payable but is rolled up and left unpaid) will be introduced. This will impact existing benefits received prior to 6 April 2017 but which continue after that date and will have a significant (adverse) impact on some beneficiaries.
Summary It is disappointing that details of the proposed changes to the income tax treatment of foreign trust structures has not been published (and may not be published until Easter 2017). Nonetheless, many of the proposed changes to the trust taxation rules are to be welcomed, particularly in relation to the simplification of the income tax treatment of trusts with nondomiciled settlors, which opens up the scope for investment in UK situs assets without triggering an inadvertent remittance.
However, the lack of transitional rules regarding historic unmatched capital payments is unfair, and the drafting of the onward gift rules leaves several questions unanswered.
Next steps In terms of steps that trustees and non-domiciliaries should be considering taking prior to 6 April 2017, these could include the following:
Consider existing loans owed by trustees, and whether these might give rise to "additions" (and therefore loss of protected settlement status) once the settlor becomes deemed domiciled.
Where any non-UK resident or non-domiciled beneficiary of historic trust distributions is intending to make any gifts to a UK resident individual, consider accelerating these gifts so that they are made before 6 April 2017.
Consider making trust distributions to non-UK resident beneficiaries before 6 April 2017 to ensure that they are matched against (and so "wash out") historic trust capital gains.
Consider accelerating capital payments to close family members of settlors who will become deemed domiciled from 6 April 2017.
Consider accelerating the realisation of trust capital gains where there are unmatched capital payments to beneficiaries about to become deemed domiciled.
Individuals who are becoming deemed domiciled on 6 April 2017 should consider what assets it would be appropriate to transfer into trust prior to that date.
Consideration should be given to existing benefit in kind arrangements with trust beneficiaries (e.g. beneficial loans, rent-free use of trust assets) and how they might need to be reorganised before 6 April 2017.
The proposed changes to the trust income tax regime for non-domiciled as well as deemed domiciled settlors could significantly change the way in which trust investments are managed and / or the way in which income is handled. This will need to be reviewed for all trusts with a nondomiciled settlor who is a beneficiary.
Consideration should be given to whether multiple trusts might offer tax benefits through the ability to access underlying capital more readily.
There will be no "one size fits all" solution to trusts affected by these changes and specific, timely advice should always be obtained.
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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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