Offshore Trusts And UK Resident Foreign Domiciliaries - Capital Gains Tax

Offshore Trusts Can Be Highly Tax Efficient For UK Resident Foreign Domiciliaries. There Are, However, Pitfalls As The Legislation Is Complex.

An offshore trust can provide a permanent shelter from inheritance tax (IHT) for the foreign situs assets of a foreign domiciliary provided the settlement into trust occurs at a time when he or she is not deemed domiciled in the UK (beware of a trap if an initial beneficial interest in possession for the settlor or his/her spouse/civil partner is established). Where a foreign domiciliary (who is not deemed domiciled) settles foreign situs assets into trust there can be no IHT charge (provided he or she is not deemed UK domiciled). This is not generally the case with UK situs assets (there are special rules for certain investments) and accordingly:

UK situs chattels should be exported prior to the settlement (thereby turning them into foreign situs assets);
cash gifts should not be made from a UK account.

Long-term trusts will shelter from IHT the foreign situs assets of a foreign domiciled settlor provided:

the settlor was not 'deemed' domiciled at the time that the property was settled; and
at the time an IHT charging event occurs the property on which the charge arises is foreign situs.

This will be the case regardless of whether any changes occur with respect to the domicile of the settlor (that is regardless of whether an actual or deemed UK domicile is acquired).

UK situs assets within trust structures settled by foreign domiciliaries are generally subject to IHT (with normal reliefs and exemptions being due).Where the trust is to hold UK land or other UK situs property interposing a foreign company between the trustees and the property will mean that the trustees have foreign situs shares rather than UK situated property for IHT purposes. There may, however, be other tax reasons why this is not desirable.

Remittance basis issues

It is important that any strategy that the trustees pursue is compatible with the individual strategies of the settlor and beneficiaries. Specialist advice and good communication is essential.

Actions by the trustees could result in an inadvertent taxable remittance by the settlor where:

the settlor is alive and UK resident;
the trustees are relevant persons in connection with the settlor (as will often be the case as most trusts are established to benefit the settlor and/or immediate family members such as spouse/civil partner, minor children and minor grandchildren); and
the trustees remit tainted property to the UK and no exemption or transitional provision switches off the remittance charging provision.

There can be an issue where the trustees have control over remittance basis foreign income or gains/deemed gains of the settlor. This will be the case in each of the following situations: (i) property representing or derived from remittance basis foreign income or gains is settled; (ii) a foreign situs chargeable asset pregnant with gain is settled into the trust; or (iii) income is within the trust and the trust is settlor-interested for income tax purposes.

Where such tainted property is within the trust structure there is a need for controls to be put in place to ring-fence it so that an inadvertent remittance cannot occur.

Anti-avoidance provisions

A non-resident trust is only subject to income tax with respect to UK source income and is outside the scope of capital gains tax (CGT). Extensive income tax and capital gains tax anti-avoidance legislation has been enacted to prevent UK resident individuals making use of offshore structures to avoid UK tax.

The various provisions, when triggered, result in income or gains (as relevant) being attributed to UK resident settlors/beneficiaries. The extent of the attribution and the mechanisms used differ. Some charging provisions attribute on the arising basis. Others employ a matching process such that there is only attribution if a benefit is received. To allow for potential tax efficient extraction, income and capital should be segregated at all times.

There are special rules for UK resident foreign domiciliaries. Whilst they are subject to the full range of income tax anti-avoidance provisions, foreign domiciliaries are not subject to the settlor charge CGT anti-avoidance provisions and can benefit from favourable transitional provisions where the beneficiary charge CGT provisions are in point. In addition if the UK resident foreign domiciliary is a remittance basis user he/she will:

be taxed on UK income attributed on the arising basis but only taxed on foreign income if it is remitted;
only be taxed on capital gains attributed if they remit the relevant capital payment.

Income tax

There are two anti-avoidance codes: (i) the settlements code; and (ii) the transfer of assets abroad regime.

Generally, where the trust is settlor interested and the settlor is alive, the antiavoidance provisions with respect to income tax mean that the trust structure is no more efficient than holding the property personally. Where the trust is not settlor interested (or the settlor is dead) the trust structure may enable funds to roll up free from income tax. If it means that for some tax years the remittance basis charge does not have to be paid this could be more advantageous than UK resident foreign domiciled beneficiaries holding the property personally, keeping the income offshore and accessing the remittance basis.

When dealing with trust/company structures one has to consider all the income within the structure. Where the settlements' code applies to the trust income both sets of legislation may be in point as there may be undistributed income at company level.

Capital gains tax (CGT)

The CGT provisions did not apply to UK resident foreign domiciliaries prior to 6 April 2008. Prior to that date capital distributions could be made offshore and remitted to the UK without a UK tax charge provided (i) actual income was not remitted; and (ii) there was no relevant income within the structure to attach to the capital distribution.

The beneficiary charge provision can apply where after 5 April 2008 the matching rules allocate a capital gain to a capital payment made to a UK resident foreign domiciliary. However, automatic transitional provisions mean that a foreign domiciliary is not subject to capital gains tax with respect to chargeable gains treated as accruing as the result of (i) a capital payment received (or treated as received) before 6 April 2008; or (ii) the matching of any capital payment with capital gains for the tax year 2007/08 or earlier tax years.

For these transitional provisions to be of maximum benefit it will be necessary to have an accurate picture of the capital payments and capital gains position as at 6 April 2008.

Where there is a capital payment after 5 April 2008 which is matched to gains realised after tax year 2007/08 there will be a potential tax charge where a UK resident foreign domiciliary is

taxed on the arising basis in the year that the matching event occurs; or
a remittance basis user when the matching event occurs and the capital payment is remitted to the UK.

Further transitional provisions apply if a valid one off irrevocable election (commonly referred to as the rebasing election though it is no such thing) has been made. A valid election must be made by 31 January following the first tax year (after 2007/08) in which a specified event takes place. Making the election switches on provisions which proportionally reduce the gain on which the foreign domiciliary is subject to CGT to provide relief for unrealised gains as at 6 April 2008. Urgent advice should be taken if the election has not yet been made.

The timing of distributions and disposals is crucial given:

the need to ensure the capital distribution does not represent or derive from remittance basis foreign income or gains;
the need to extract relevant income within the structure tax efficiently;
the arbitrary nature of the matching rules and how they interact with the transitional provisions.

Without specialist advice the potential to reduce/eliminate tax liabilities can be lost. Smith & Williamson would be pleased to advise trustees to ensure optimal use is made of the reliefs.

Further complications

Specialist advice should be taken (i) to deal tax efficiently with the extraction of offshore income gains; and (ii) prior to trustees' borrowing funds (as borrowing for an unallowable purpose when linked with a transfer of value will trigger penal provisions).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.