Where offshore trusts are established prior to an individual being deemed domiciled in the UK under the new 15 out of 20 year rule, they enjoy certain protections so that the settlor will only be subject to tax when benefits are received from the trust by the settlor or by close family members. The protections do not apply to those born in the UK with a UK domicile of origin, even if they have acquired a domicile of choice elsewhere.
However, the protected trust status will be lost, for both income tax and capital gains tax purposes, if further property or income is added to a protected trust by a settlor who has become deemed domiciled. The protections will be lost if the addition of property is by the settlor, or by the trustees of any other trust of which the settlor is a beneficiary or settlor ("related trusts").
Given the importance of protected trust status there are concerns over what constitutes an addition to trust property, particularly in the context of loans.
Exclusions
There are specific exclusions in the legislation. For example, a trust will not be tainted simply because the settlor enters a transaction with the trustees on arm’s length terms. Similarly, property or income added in pursuance of a legally binding commitment incurred by any person before 6 April 2017 will not taint a protected trust. Neither will property added to a trust to cover the trust's[1] tax and administration expenses for a tax year where such expenses exceed its income, provided the addition is limited to the deficit.
Repayable on demand loans
There have been particular concerns around whether or not an outstanding uncommercial (e.g. at a low or nil rate of interest) repayable on demand loan entered into before an individual becomes deemed domiciled on 6 April 2017 will taint a protected trust.
To deal with these concerns, HMRC has specifically extended the legislation. The legislation also confirmed that there will be a transitional one year grace period, so that the trust will not be tainted provided that the loan is either:
- repaid in full together with any outstanding interest by 5 April 2018
- made subject to fully commercial terms, including a commercial rate of interest payable at least annually, for the year ending 5 April 2018 and subsequent years.
The one year grace period also applies to repayable on demand loans between related trusts. For example where Trust A has lent to Trust B (or perhaps an underlying company of Trust B) on uncommercial terms.
Arm’s length/commercial terms
The legislation provides that a loan will be regarded as being on arm’s length terms (and hence tainting will not apply) if, and only if:
- in the case of a loan made to trustees, interest at the official rate of interest (set at 2.5% for 2017/18) or more is charged and actually paid annually
- in the case of a loan made by trustees, interest at no more than the official rate is charged and actually paid annually.
Relevant event
Even if a loan is made on arm’s length terms, tainting can still occur on the occurrence of a “relevant event”. A "relevant event" occurs whenever:
- interest is capitalised
- there is a failure to pay interest when due
- there is any variation of the loan which results in it no longer being commercial.
Trustees will need to be careful to ensure that they pay all interest on the date it is due in order to avoid tainting the trust.
Fixed term loans
Following on from the above, the question arises as to whether uncommercial fixed-term loans need similarly to be made subject to commercial terms within the one year grace period. With a term loan, the lender doesn’t have the same leverage to renegotiate the terms, so it may not be possible to increase the interest rate as there is no incentive for the borrower to agree to pay more.
HMRC seems to share this view and it has confirmed that there will be no tainting where a settlor has made a fixed term loan to a trust or its underlying company where the loan:
- predates 6 April 2017 (if the settlor is deemed domiciled from that date)
- predates the tax year in which the settlor becomes deemed domiciled (if this is later than 6 April 2017).
This is on the basis that the addition to the trust occurs prior to the settlor becoming deemed domiciled. In this context the commerciality or otherwise of the loan is not relevant. The loan can be interest free or it can be rolled up.
Equally there will be no tainting where a fixed term loan is made, prior to a settlor becoming deemed domiciled, by the trustees of a related settlement.
Inheritance tax and fixed term loans
Although the lack of commerciality in the context of a fixed term loan might not be problematic from a tainting perspective, it could have immediate inheritance tax consequences for the lender. For example if the settlor lends the trust £1 million repayable on demand, the value of the debt in the in the settlor's estate is at or close to £1 million so there is usually no transfer of value for inheritance tax purposes. However, if the settlor lends the trust £1 million repayable in 10 years' time, then the value of the debt in the settlor’s estate will be discounted for the time value of money. The present value of £1 million in 10 years’ time might only be (say) £745k when discounted for the time-value of money. So in this transaction, the settlor’s estate has diminished by £225k and this could give rise to a 20% entry charge.
What happens at the end of the fixed term?
If the fixed term is uncommercial, there will be an issue if the repayment date falls due after the settlor is deemed domiciled and the loan is not repaid when the fixed term ends. Tainting will occur from and after the expiry of the fixed term unless it is repaid or renewed on fully commercial terms effective from that date.
What action should trustees take?
Trustees need to be extra vigilant in reviewing any arrangements or transactions, with settlors who are about to become deemed domiciled, and with other trusts of which the settlor is a beneficiary or settlor. In particular they should consider the following:
- Ensure that no additional settled funds (unless covered by an exclusion) are received from settlors once they become deemed domiciled.
- Review the terms of all existing loans (made to and by the trustees) to check whether these might taint the trust once the settlor becomes deemed domiciled.
- Think very carefully before agreeing the terms of any new loans.
- Ensure that all interest is paid when due.
It is not possible to give generic advice to trusts affected by these changes and specific advice should always be obtained.
Update on the Finance Bill
"Washing out" capital gains and the "Anti-conduit" rules
The Finance Bill was published on 20 March 2017. However, certain sections of the legislation covering trusts were missing from the Finance Bill. The missing sections included the sections aimed at preventing “washing out” capital gains to non-residents, and the sections introducing the “anti-conduit” or "anti-recycling" rules.
HMRC has published a technical note outlining how it will treat this going forward. While HMRC notes that it cannot "give any guarantees", it goes on to state that "it is implicit in the technical note published yesterday that any future legislation will take effect from the start of the relevant tax year as backdating it to April 2017 would be retrospective in its effect – and it is standard practice to avoid retrospective legislation wherever possible."
It therefore seems that trustees will no longer need to rush certain transactions through ahead of 6 April to get ahead of these changes. However, it will be important to make sure that planning is in place well ahead of 6 April 2018 and ideally ahead of the Autumn Budget.
[1] HMRC has been asked to clarify whether this also includes the expenses of an underlying holding company.