1 U.K. tax obligations of people connected to trusts
Part 1 of this article, appearing in last quarter’s Cayman Financial Review, looked at the main situations in which a non-U.K. resident trustee might have direct U.K. tax obligations arising in respect of the trust. This Part 2 focuses on situations in which others might have their own U.K. tax obligations, arising out of their connections to the trust.
These rules are directly relevant to settlors and beneficiaries of non-U.K. resident trusts but are also of significance to Cayman trustees who are responsible for those trusts. In many cases the settlor and the beneficiaries will turn to the Cayman trustee for information to allow them to correctly calculate their U.K. tax liability. In some cases, the tax position of the settlor and beneficiaries will impact the way in which the trustee runs the trust.
The settlor is the name given to the person who establishes a trust. In the U.S., that person is called the grantor. In some cases, the settlor of a trust will be directly charged to U.K. taxes. This treatment applies where the trust is considered to be “settlor interested.” The question of whether or not a trust is settlor interested is not a simple one, particularly because the definition is different for U.K. income tax and U.K. capital gains tax (CGT) purposes.
For income tax purposes, a trust will be settlor interested if the settlor or his/her spouse has an interest in the trust or is able to benefit in any way from the trust. So, for example, all revocable trusts will be settlor interested under this test as the settlor’s power of revocation is an “interest” in the trust and can be used to confer significant benefit on the settlor.
Two different regimes apply to attribute income arising in trusts, to the settlors of those trusts, potentially creating income tax liabilities for the settlors. The first is the “Settlement’s Code” and it applies whether or not a settlor is U.K. resident. By virtue of these rules, a settlor will be charged directly to U.K. income tax on U.K. source income whenever U.K. source income arises within the trust. In other words, the settlor is treated as though he or she received the trust income, even though he or she may not actually receive it from the trustee, and may not even be entitled to receive it under the terms of the trust. However, the Settlement’s Code applies only to income arising at trust level and so for most Cayman trusts, it is unlikely to be in point given the prolific use of underlying companies to hold most trust assets.
The second set of rules is known as the “transfer of assets rules” and may apply if an offshore trust holds 100 percent of shares in an underlying non-U.K. company. The transfer of assets rules can also to apply to beneficiaries, as we will consider below, but there is also a section dealing with the taxation of a “transferor of assets abroad” (i.e., relating to a settlor of a non-U.K. trust). The substance of these rules is that if a trust does not receive U.K. source income, but the underlying company does, an income tax liability can still arise to the settlor of a settlor interested trust. In contrast to the Settlement’s Code, the transfer of assets rules only apply to U.K. resident settlors. If a company receives U.K. source income, a U.K. resident settlor of the trust which owns the company may be subject to a U.K. source income tax on the U.K. source income arising within the company. We say may, as this particular rule is subject to what is known as the “motive defence.” To claim the motive defence, a settlor would need to demonstrate to an officer of HM Revenue & Customs that the transfer of assets by the settlor into the trust structure was (a) not for the purpose of avoiding a U.K. tax liability; or (b) was for a bona fide commercial transaction.
To the extent that a settlor is liable for a U.K. income tax charge (whether or not the remittance basis applies), this will apply instead of the charge on the trustee; there is no double charge to U.K. income tax.
There is one further complication that Cayman trustees should be aware of regarding U.K. source income arising at the level of the trust, where a trust is settlor interested. Even though the settlor has the liability to pay the tax, the trustees are still obliged to report and pay income tax on all U.K. trust income at the trust rate of 45 percent. The settlor must include the income on his self-assessment return but will receive a credit for any tax paid by the trustees. If the trustee has paid more tax than the settlor would have done, the settlor can claim the overpaid tax from HMRC. The settlor must then pay the repayment back to the trustee. This is an overly complicated series of steps but is something that a trustee of a trust that is subject to this regime must not overlook.
U.K. capital gains tax
What constitutes a settlor interested trust for U.K. CGT purposes is both narrower and wider than the definition for U.K. income tax purposes. This may sound oxymoronic, but let us try and explain. The definition is narrower, because a settlor must be U.K. domiciled and U.K. resident in the year in which gains accrue to the trustees. Assuming the settlor is U.K. domiciled and U.K. resident, the definition is then wider, because if any of the settlor’s immediate family can benefit (which extends even to stepchildren, spouses of children or stepchildren or a company controlled by such settlor’s immediate family) the trust will be settlor interested.
Non-U.K. residents can not be subject to U.K. CGT, apart from in one limited circumstance; on the disposal of U.K. residential property. Therefore, a settlor of a settlor interested trust will only be subject to U.K. CGT if he or she is U.K. resident (or the limited exception applies). If a settlor is generally subject to U.K. CGT, he or she will be subject to U.K. CGT on all gains realized by trustees (for example on a sale of investments) and regardless of whether or not the gains are U.K. or non-U.K. gains, as such gains arise and whether or not he/she receives a benefit.
Many Cayman trustees will be trustees of trusts created by settlors who are not U.K. domiciled, but are U.K. resident – so called “res non-doms” (RNDs). If an RND settlor settles a trust, he or she will not create a settlor-interested trust for U.K. CGT purposes, because he/she will not be U.K. domiciled. Accordingly, such a settlor will not be subject to U.K. CGT on an arising basis. There is one nasty trap to look out for and that is if an RND settles a trust with assets comprising income/gains (i.e., not “clean capital”). If a benefit is then remitted to the U.K. from such a trust (and the topic of “what is a remittance” could take up a separate article!) by a relevant person in connection with the settlor (for example his/her spouse or minor child), this may trigger a U.K. CGT charge, which falls on the settlor. To add to the ever-growing trustee action list, the Cayman trustee needs to know what is going into the trust in the first place and how such funds are characterized under U.K. law, to determine how it will be taxed going forward.
The above deals with the potential liabilities of settlors to U.K. tax, but what about beneficiaries?
In respect of income tax, the transfer of assets rules outlined above also have a section dedicated to the taxation of beneficiaries. The rules only apply to U.K. resident beneficiaries, and so non-U.K. resident beneficiaries cannot be liable for U.K. income tax. A charge will arise if a U.K. resident beneficiary receives a “benefit” from a trust which is “matched” to “relevant income” in the trust. These rules are informally known as the “matching rules” and are complex. The italicized words above require some explanation so that this matching regime can be understood.
A “benefit” is very broadly defined and can include things like an outright distribution of trust property, a loan which is not subject to HMRC’s Official Rate of interest or rent-free occupation of trust property etc. In the case of a loan, the taxable value of the benefit will be the difference between the Official Rate of interest and the rate of interest charged (if any) and in the case of rent-free occupation, the value of the benefit will be the value of the rent forgone.
So, we now know what a benefit is, but what is meant by “relevant income”? This is essentially all foreign income in a structure that has not been spent, for example, in trustee expenses. Also, we do not need to worry about U.K. income as this will already have been subject to tax by the settlor, or alternatively, the trustee. If income is accumulated by the trustees, that income is still relevant income (it does not become capital for U.K. tax purposes, even if it becomes capital for trust law purposes). Relevant income forms what is called an “income pool” in the trust, which is available for matching.
When a U.K. resident beneficiary receives a benefit, the taxable value of the benefit is “matched” to the same amount, if available, in the income pool (or as much as possible if the amount in the income pool is less). The beneficiary is liable for U.K. income tax on the matched amount (at the beneficiary’s marginal rate), subject to the remittance rules discussed below, and the amount available in the income pool for matching against future benefits is reduced accordingly. Trustees should note that benefits conferred on non-U.K. residents are not matched and so such distributions do not reduce the income pool available for matching against future benefits to U.K. resident beneficiaries.
To add a further level of complication, beneficiaries may be RND’s and so whether or not such beneficiary is then a remittance basis user (RBU) needs to be considered. Whether or not an RND has to actually pay the beneficiary charge to U.K. income tax depends on (a) whether or not the RND is an RBU; and (b) if so, whether the benefit on which the charge arises is “remitted” to the U.K. The position can be summarized as follows:
If he/she is not an RBU: on the value of the benefit, to the extent there is relevant income in the structure to match to the value of such benefit; and
If he/she is an RBU: on the value of the benefit only to the extent that the benefit is actually remitted to the U.K. and to the extent there is relevant income in the structure to match to the value of the benefit which has actually been remitted to the U.K. The concept of a remittance is also a complicated one which broadly means that the income in question is brought into the U.K., or used in the U.K., by the beneficiary, or various other people connected to him.
U.K. capital gains tax
A matching regime similar to the U.K. income tax regime also applies for U.K. CGT purposes. One important difference is that the term “benefits” is used in relation to U.K. income tax and the term “capital payment” is used for U.K. CGT. Broadly speaking, a capital payment is the same as a benefit, but a benefit is chargeable to U.K. income tax and a capital payment is subject to U.K. CGT. A charge to U.K. income tax is always applied in priority to U.K. CGT.
Just as a trust has an income pool, it also has a “gains pool.” Gains in the gains pool comprise the total untaxed gains arising to trustees on the disposal of trust assets, although losses are taken into consideration and trustees can also carry forward losses in certain circumstances. Gains might be realised by trustees selling assets or distributing an asset out to a beneficiary. In addition to this, a gain may be generated if a Cayman trustee transfers assets to another trust (even if both sets of trustees are the same) or a trustee makes a transfer of value which is linked to trustee borrowing. Yet more actions which need to be carefully considered by the Cayman trustee! There is also anti-avoidance legislation which means that gains realised by an underlying company form part of the trust’s gains pool so all assets held by an underlying company need to be taken into account.
As with income tax, an RND who is an RBU will only be chargeable to U.K. CGT to the extent that the capital payment is remitted to the U.K. If a U.K. resident beneficiary is charged to U.K. CGT, as for settlors, it will be at his/her marginal rate (which for U.K. CGT purposes will be 10 or 20 percent, unless in relation to residential property). However, if gains are not matched in the year they arise, a supplemental charge arises, bringing the tax charge up to potentially 32 percent.
So, what if a capital payment is made to a non-U.K. resident beneficiary? Under current law, capital payments can be made to non-U.K. resident beneficiaries which “match” against the gains pool, reducing the amount which can be matched to future capital payments. However, as such beneficiaries are not U.K.-resident, they are not subject to U.K. CGT and so no charge arises in respect of the capital payment, albeit the gains pool is reduced. The current rules therefore afford an opportunity to “wash-out” gains by making capital distributions to non-U.K. resident beneficiaries. This will no longer be the case with effect from April 6, 2018.
There is therefore a limited time period for Cayman trustees to wash out gains and reduce the gains pools in their trusts. Once these new rules some into force, the treatment of capital distributions to non-U.K. resident beneficiaries will be more in line with the treatment of benefits conferred to non-U.K. resident beneficiaries. U.K. income tax and U.K. CGT charges will therefore arise in similar circumstances.
2 Practical points
So, we have cantered through the various taxes and who they might apply to, but what does this mean for a Cayman trustee, on a practical level?
Keep good records – as you now know, U.K. taxation is incredibly complex and undoubtedly, settlors and beneficiaries will need to turn to the trustee for information to allow them to calculate their U.K. tax bill. What is income (or capital) for trust law purposes is not necessarily income (or capital) for U.K. tax purposes.
Consider timing – distributions whilst someone is resident in the U.K. are likely to have a very different tax profile to distributions when that person is not resident. If someone is about to move to the U.K., or about to leave, can the timing of a proposed payment be changed to improve the tax treatment?
Consider the beneficiary’s own tax position – are they claiming the remittance basis in a given year, or not? How is that relevant? Do they plan to come to or leave the U.K.? Is there some planning that can be done around that?
Are there any other steps that the trustee can take to legitimately mitigate the U.K. tax payable in respect of a given transaction?
Keep in contact with settlors and beneficiaries. Their residence and domicile status is vital to determining the tax treatment of any distribution. Help them to understand why you need to know about planned moves before they take place.
Take appropriate advice on matters of U.K. tax law. There are some well-trodden paths for dealing with Cayman trusts that have U.K. tax connections, whether that’s through the residence or domicile of the settlor or the beneficiaries, or because of the holding of U.K. assets within the trust.
What Paul Krugman said of economics – “if you can’t explain it to your mother … there’s a good chance that you yourself don’t really know what you’re doing” – is equally true of tax. Trustees cannot be experts in everything, but they do need to have a general awareness of a lot of different problems. U.K. tax is among those problems and the fact that a large number of the world’s wealthiest individuals and families continue to be attracted to the U.K. by the benefits of the “res non dom” arrangement mean that even trustees, sitting 4,800 miles away in the Cayman Islands, cannot escape the U.K. tax man’s influence.
Disclaimer: The aim of this article is to make the general reader aware of the range of situations in which the actions of a Cayman trustee might impact on some U.K. tax liability. It is not intended as a substitute for specialist advice.