On Friday 18th August 2016 the government released a further consultation document on the proposed changes to the taxation of non-domiciled individuals due to take effect from 6 April 2017.
For a summary of the reforms and how non-domiciled individuals affected by these proposals may benefit from settling an offshore trust before 6 April 2017, please refer to our briefing entitled 'Non-Dom Reforms to Go Ahead'.
It is essential that offshore trustees have an understanding of the proposals and, in particular, an awareness of the transactions that may give rise to UK tax liabilities not only for themselves but also for the settlor and beneficiaries, so that professional advice can be taken where appropriate.
This briefing provides an overview of the most relevant points that offshore trustees need to be aware of and highlights the impact the new rules may have on offshore trustees' UK tax liabilities and filing obligations.
The new rules also serve to reinforce the importance of maintaining and retaining accurate records.
Summary of the new rules
From 6 April 2017, non-domiciled individuals who have been resident in the UK for 15 out of the past 20 tax years will be regarded as 'deemed domiciled' for all UK tax purposes from their 16th year of residence, even though they may remain non-UK domiciled under general law.
Under the new rules, a deemed domiciled individual will be liable to UK tax on all overseas income and gains on an arising basis, and will no longer be eligible to use the remittance basis of taxation. UK inheritance tax (IHT) will also apply to their overseas assets from the date they become deemed domiciled.
There is a small window of opportunity for tax planning before 6 April 2017. Offshore trusts settled by non-domiciled individuals before they become deemed domiciled will be 'protected', and will have the following benefits:
- Income and gains arising in the trust after the settlor has become deemed domiciled can roll up tax free.
- Non-UK assets within the trust will remain 'excluded property' for IHT purposes (provided there is no underlying UK residential property), and will therefore remain outside the scope of IHT.
- Where the trust is settlor-interested (i.e. where the settlor can benefit), the Gift with Reservation of Benefit rules will not apply to the trust assets, and will therefore be excluded from the settlor's chargeable estate on death.
A trust will lose its protected status, however, if any property is added to the trust or if a benefit is received by the settlor, his spouse, or a minor child after the settlor has become deemed domiciled. A benefit for these purposes can include a capital distribution, provision of an interest free (or low interest) loan and rent free occupation of trust property.
Trustees of protected trusts will therefore need to familiarise themselves with the types of transactions that could cause the trust to lose its protection; understand the UK tax implications of loss of protection, and ensure that they fulfill any additional reporting obligations that loss of protection may create.
It is therefore essential that trustees seek UK tax advice before making a distribution (or providing any other form of benefit) from a protected trust and also before accepting further settlements into a protected trust.
Tax Implications of losing protection
The Consultation document indicates that where a trust loses its protection, any future gains arising within the trust become taxable on the settlor, regardless of whether the settlor receives any distributions.
There may also be income tax liabilities for the settlor where a benefit is provided to the settlor, their spouse or a minor child and it can be matched to foreign income arising in the trust.
Therefore, a distribution from a protected trust to a non-settlor beneficiary (who is a spouse or minor child) could have wide-reaching tax implications for the settlor.
If, on the other hand, the trust is comprised solely of assets that do not produce income or gains (such as life insurance bonds), and the trustees do not make withdrawals in excess of the annual 5% tax-deferred allowances, it is possible to make distributions without triggering UK income tax or capital gains tax charges. This is a complex area which will require specialist tax and investment advice.
It appears that, for IHT purposes, the trust will retain its excluded property status even where it has lost protection for income tax and capital gains tax purposes.
UK residential property
One of the most significant changes for trustees is the change to the UK IHT treatment of UK residential property held through an offshore company, or similar offshore entity.
Currently, where trustees (of a trust settled by a non-domiciliary) own UK property through an offshore company, the property is excluded property for UK IHT purposes, and is not subject to IHT 10 yearly and exit charges (payable under the 'relevant property regime') since the trustees are viewed as owning non-UK situs assets (the overseas shares). The current rules do not allow a look-through to the underlying UK property.
However, as far as UK residential property is concerned, this will change from 6 April 2017. Under the new rules, the shares in an offshore company owning UK residential property will be treated as UK situs assets (to the extent that the value of the shares is attributable to UK residential property). As a result, the shares will become relevant property for IHT purposes and will no longer qualify as excluded property.
For trustees, this will result in potential IHT charges, under the relevant property regime, on each 10 year anniversary of the creation of the trust, and IHT exit charges when property leaves the trust. This will also create additional compliance and reporting obligations, and the trustees will need to establish the value of the property each time a chargeable event occurs.
Note that it is only UK residential property that is affected by these new rules, not UK commercial property. However, all UK residential property is affected, regardless of its use (whether rented commercially or not), and regardless of the value of the property (there is no de minimis).
Individuals born in the UK with a UK domicile of origin
Under the proposals, individuals born in the UK with a UK domicile of origin who have acquired a non-UK domicile whilst living overseas will be regarded as UK deemed domiciled when they resume UK residence.
Trusts set up by these individuals (referred to in the draft legislation as formerly domiciled residents) at a time when they were non-UK resident and non-UK domiciled will lose their excluded property status when the settlor returns to the UK (once the 'grace period' has ended – see below). This means that if a trust reaches a ten year anniversary at a time when the settlor is UK resident, the trustees will have to account for UK IHT. Similarly, if a capital distribution is made when the settlor is UK resident, the trustees will need to consider whether this gives rise to an IHT exit charge.
It is proposed that there will be a grace period, for IHT purposes only, for individuals who are returning to the UK for a short period of time. During the grace period, non-UK assets within the trust will remain excluded property and will not be chargeable to IHT under the relevant property regime. The grace period applies for the tax year in which the settlor resumes UK residence, and ceases from 6th April of the following tax year. After the grace period ends, the trust will fall within the relevant property regime and trustees will need to ensure they are fulfilling their UK IHT liabilities and filing obligations where relevant.
If the settlor becomes non-UK resident again, the trust's IHT status will revert to excluded property status from the first full year of the settlor's non-residence.
Trustees will therefore be required to keep a track of the settlor's residence status, as their IHT payment and filing obligations will be determined by the residence status of the settlor.
In addition, the protections from income tax and capital gains tax that apply for non-domiciled settlors who were not born in the UK are not available for settlors born in the UK with a UK domicile of origin. From the point at which such an individual becomes UK resident, all income and gains arising within the trust (where the trust is settlor-interested) will be taxable on the settlor as they arise.
It is essential that trustees keep accurate records and flag any changes that will affect the UK tax status of the trust. The following information will be required for all trusts:
- The settlor's domicile of origin
- The settlor's residence status and any changes to this
- The residence and domicile status of the beneficiaries
- The date a settlor or beneficiary will become deemed domiciled in the UK under the 15 out of 20 year residence rule
- Whether the settlor has previously been deemed domiciled in the UK
- Details of all income and gains arising in the trust since its inception
- Details of all additions to and distributions from the trust
- Note of each ten year anniversary so that any planning can be undertaken in advance
Key Red Flags
Particular care will need to be taken if the trust falls into any of the categories listed below, and the trustees should consider taking professional advice before certain transactions are undertaken:
Trust is protected
- Particular care will need to be taken when considering making distributions, not only to the settlor but to his spouse or minor child. This could result in loss of protection and give rise to income tax and capital gains tax liabilities for the settlor.
- Similarly, trustees should seek advice before accepting additions to a protected trust.
Settlor was born in the UK with a UK domicile of origin (formerly domiciled resident settlors)
- If the settlor returns to the UK, and once the grace period has expired, trustees will potentially have IHT charges and filing obligations at each ten year anniversary of the creation of the trust, and at any time that property exits the trust.
- From the date the settlor becomes UK resident, he will be taxable on income and gains arising within the trust if he retains an interest in the trust. Trustees will need to keep records of such income and gains to provide to the settlor for inclusion on his UK tax returns.
- Where the trust is settlor interested, the assets of the trust will be deemed to fall into the settlor's estate on death under the Gift with Reservation of Benefit provisions. Trustees will need to provide asset valuations to the deceased's Personal Representatives.
UK Residential Property held in Trust
- The shares of an offshore company holding UK residential property will become relevant property for IHT purposes and subject to UK IHT charges. Trustees may be liable for IHT on the occasion of each ten year anniversary, and when property exits the trust. Trustees will need to ensure they meet their compliance and filing obligations.
It is essential that trustees familiarise themselves with the new rules, to understand where the potential pitfalls lie and so that they can take appropriate action or professional advice where necessary.
Trustees will need to ensure procedures are in place to keep track of the residence and domicile status of settlors and beneficiaries, and understand the effect that any changes to the settlor's residence or domicile status may have on their own UK tax and reporting obligations.
In particular, it will be important for trustees to identify settlors born in the UK with a UK domicile of origin, and any new IHT liabilities and reporting obligations that may arise from 6 April 2017 where UK residential property is held through an offshore company or other similar vehicle.
All existing trusts settled by individuals who will become deemed domicile at 6 April 2017 (whether under the 15 out of 20 year rule, or by virtue of being born in the UK with a UK domiciled of origin) should be reviewed and professional advice sought where relevant.
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.