Tax is a tricky subject at the best of times. Whilst it is difficult to get accurate figures, some estimates of the length of the U.K. tax code suggest that it consists of more than 10 million words. That’s over 11 times the length of the complete works of Shakespeare, which contains just 884,867 words. It is difficult for someone who spends their whole life advising on U.K. tax matters to keep up with the details and the changes, so spare a thought for the poor Cayman trustee.
A trustee of a trust, amongst a raft of other responsibilities and obligations, needs to make sure that it is aware of and complying with its tax payment and reporting obligations around the world. This is an obligation that is easy to summarize but difficult to discharge. Different jurisdictions have different rules about when they are interested in the affairs of a Cayman trust. Furthermore, the trustee typically needs to ensure that it keeps appropriate records to allow settlors and beneficiaries to comply with their reporting and tax-payment obligations and even that it makes distributions in the most appropriate way and at the appropriate time.
This two-part article does not attempt to tackle the question of how a trustee can possibly keep on top of all of that. Instead it focuses on one small corner of the problem: when and why does a Cayman trustee need to care about U.K. tax? As we hope to make clear, whilst there are a narrow range of circumstances in which a non-resident trustee will be directly liable for U.K. tax, the settlor and beneficiaries will be liable to U.K. income tax, capital gains tax and inheritance tax in a much wider range of circumstances.
In this first part, we start by looking at the situations in which the trustees of a non-resident trust are directly liable to U.K. taxes. In Part 2 we will look at various attribution and matching rules by which others (settlors and beneficiaries) are liable for U.K. taxes because of their connection to the trust.
In this article, we are looking specifically at a trust, governed by Cayman Islands law, with a single trustee. That trustee is a Cayman Islands company, holding an unrestricted trust license. For U.K. tax purposes, this trust will be considered to be a non-resident trust (in all but a very limited set of circumstances).
When we talk about an underlying company, we are referring to a Cayman Islands exempted limited company, established to hold the substantive assets of the trust and of which the trustee owns all of the issued shares.
UK Income tax – non-resident trustee liability
A trustee of a non-U.K. resident trust will typically be liable for U.K. income tax in a very limited range of circumstances. Broadly, this charge arises where the trust receives U.K. source income. U.K. source income includes rental income arising on U.K. real estate, interest on U.K. bank accounts and dividends arising on U.K. companies. Where the settlor of the trust is also liable to income tax on the same income (an issue that will be covered in Part 2 of this article), the interaction between these two regimes is very complicated but the trustee does still have a tax liability in respect of that income.
The rate of U.K. income tax payable by the non-resident trustee depends on the type of income and on the type of trust.
If the non-resident trust has no U.K. resident beneficiaries in a given tax year (the tax year running from April 6 in one year to April 5 in the following year), the trust’s U.K. income tax liability is further limited and U.K. bank interest and dividends paid on shares held in U.K. companies also escape the charge to U.K. income tax. A potential trap here is that if a single beneficiary then moves to the U.K., the tax position changes and the trustee can find itself with a U.K. tax liability in respect of that income. As every trustee knows, beneficiaries do not always consult the trustee before deciding to move.
Any foreign source income received by the trustee is outside the scope of U.K. income tax.
UK situs blockers
In most cases, non-resident trusts are advised not to directly hold U.K. investments. Instead, U.K. investments are held through an underlying company. In a typical trust and company structure, the Cayman trustee owns the shares in a Cayman company and the Cayman company owns the U.K. investments. This company plays the role (amongst other things) of a “situs blocker”: it changes where the trust assets are considered to be legally situated, for some U.K. tax purposes.
The use of an underlying company as a situs blocker is not always effective. In order for an underlying company to protect a trust from U.K. tax charges a company must be a genuine company and it must be properly funded. If a company acts merely as a nominee of the trustee, or if it has not been properly funded then for U.K. tax purposes, the company is irrelevant and will be ignored. In those cases, the company will be “looked through” and any income arising within such a company will instead be attributed to the trust. Reference to an underlying company throughout the remainder of this article is to a genuine company, not a nominee.
Any U.K. source income arising on U.K. investments made through the underlying company, rather than the trust, does not result in a direct charge to U.K. income tax for the trustee as the trustee is not the one entitled to that income. However, the various attribution and matching rules (to which we turn in Part 2 of this article) are relevant to the overall U.K. tax profile of such a structure.
In practice, most non-resident trustees already make their U.K. investments through an underlying company, largely due to the inheritance tax advantages, to which we also turn later.
UK capital gains tax – non-resident trustee liability
Generally speaking, U.K. capital gains tax (UK CGT) is only charged to U.K. residents. Therefore, on the face of it, a Cayman trustee will not have a UK CGT liability: the trustee is not, by definition, a U.K. resident. There is a significant exception to this. From April 6, 2015, non-U.K. residents (including non-U.K. trustees) have been subject to gains arising on the disposal of U.K. residential property. If a Cayman trustee disposes of U.K. residential property, any gain will be subject to UK CGT at the trustee’s rate of 28 percent. Where the property in question was acquired before April 6, 2015, the trustee only pays UK CGT on the portion of the gain arising after that date.
The interaction between this trustee liability to UK CGT and other potential charges to UK CGT – to which we turn in Part 2 of this article – is complicated. However, where the trustee and the settlor of the trust could both be liable to UK CGT in respect of the same gain, the charge to the non-resident trustee will apply in priority to a charge to the settlor and there is no double charge.
We also know that U.K. residential real estate will often be held by an underlying company, rather at the level of the trust, so what happens in those circumstances? Here the charge to UK CGT will still apply to gains made on sale, but the charge will apply at company level, rather than trust level. There is no avoiding this charge.
UK Inheritance Tax
A U.K. Inheritance Tax (UK IHT) liability will also be levied on trustees if, when the settlor created the trust (or later added funds to it) he or she was domiciled or “deemed” domiciled in the U.K. for IHT purposes or had elected to be treated as U.K. domiciled for IHT purposes for a period that includes the date on which he/she created the trust.
Domicile is a nebulous and complicated concept in the U.K. (and was the subject of an article by David Cooney, “Long-term Cayman expats and inadvertent tax charges,” included in the 2Q/2017 edition of Cayman Financial Review, Issue 47). For English law purposes, domicile is not just based on where a person is resident at a given time, even if they have been there for a long time. A detailed consideration of domicile is beyond the scope of this article, but some key red flags for trustees to look out for are if a settlor was born in the U.K., their parents were born in the U.K., or they have lived in the U.K. for 15 out of the last 20 tax years (the magic number used to be 17 out of the last 20 tax years, but this is also set to change in the Finance Bill (No.2) 2017). In these circumstances, the trustee will be subject to UK IHT on all of the worldwide assets of the trust, including the value of the shares in any underlying company (the value of which shares will be intrinsically linked to the value of the assets held by the company).
A specific UK IHT issue now arises where trustees own U.K. residential property, even where the property is held through an underlying company.
For many years, non-resident trustees wishing to acquire U.K. residential property acquired that property through a “non-resident” company. For UK IHT purposes, the trustee owned the foreign company shares, not the underlying property. This arrangement allowed the U.K. residential property to remain outside the scope of UK IHT indefinitely. This was a major benefit of using trust and company structures to own U.K. residential property.
This is set to change when the Finance Bill (No.2) 2017 passes later this year. Once introduced, the relevant provisions are expected to be back-dated to April 6, 2017. The new rules only apply to residential property, so structures may still be effective for other types of U.K. real estate. Under the new rules, and for this specific purpose, the underlying company is treated as transparent (i.e.it is “looked through” for UK IHT purposes) in calculating the trustee’s UK IHT liability. The precise nature of the UK IHT charge then depends on the terms of the trust and the position of the settlor of the trust. However, this change does mean that charges to UK IHT can thereafter arise: (i) on a periodic basis, every 10 years; (ii) when value leaves the trust; and (iii) on the death of the settlor of the trust, in some cases.
The key here is that Cayman trustees holding U.K. residential real estate within trust and company structures would be well-advised to review those structures to ensure that they are still “fit for purpose.” Miscalculations involving inheritance tax can be very expensive as it applies based on the value of the asset itself, not by reference to any income or gains arising.
It is hopefully now clear to the Cayman Islands trustee that there are various ways in which they can find themselves directly liable to pay U.K. taxes. Penalties for non-compliance are harsh and getting harsher and it will be no defense for a professional trustee to say that they were simply unaware of the rules.
In Part 2 of this article, in the issue of the CFR, we will explore the complicated area of the attribution and matching rules. These rules exist to charge the settlor and the beneficiaries of a trust to U.K. taxes, in situations where the trustee falls outside the scope of those taxes. We will also explore how these important rules are relevant to Cayman trustees.