BRIEFING FOR TCSPs - Inheritance tax changes in the Finance Act 2020 and the tax impact upon trustees and settlors.
What is the background and principle involved?
Non-UK assets held by the trustees of an excluded property trust settled by a non-UK domiciled individual are generally outside the scope of Inheritance Tax (IHT). This means that non-UK assets such as investments or UK situated investments, excluding residential property, held in an offshore company remain free of IHT charges, even where the settlor becomes UK domiciled or deemed domiciled in the UK, at a later date.
HMRC has long since held the view, and contained in their published guidance, that trust additions made after the acquisition of a UK domicile or deemed domicile, will be construed as a separate trust, which cannot be excluded property. In effect, HMRC considered that every subsequent addition to an existing trust, following the acquisition of a UK domicile, constituted a new settlement and did not qualify for IHT protection under the excluded property rules.
How did the issues arise?
Largely because of the Barclays Wealth Trustees v HMRC case in 2015, which went up to the Court of Appeal in 2017 (where HMRC ultimately lost the case) and a general long standing disagreement over the technical issues above.
The key facts:
- The settlor established an excluded property trust whilst he was non domiciled, in 2001.
- In 2003 he transferred UK company shares into the same trust.
- In 2008, when the settlor had become UK domiciled, he jointly settled a new trust with his brothers (as co-settlors).
- The settlor had a one-quarter share in the trust, which was a life interest trust.
- Subsequently, the trustees of the 2001 trust transferred the shares in the UK company to the new trust.
- The trustees of the new trust sold the shares and in 2011 transferred the ¼ share of the proceeds back to the 2001 trust; the trustees transferring the cash to a Jersey bank account so that they held non-UK property, i.e. excluded property.
- HMRC tried to argue that the transfer of funds back to the 2001 settlement from the new settlement created a new settlement at a time when the settlor had become UK domiciled. The key issue arising that the added property could not be excluded property and therefore subject to the ten-year IHT anniversary charge.
- The Court of Appeal reversed the High Court’s decision and agreed with the taxpayer that the transfer to the 2001 trust did not constitute a new settlement, and the cash proceeds were excluded property.
Following their loss at the Court of Appeal, HMRC declared their intent to counteract the Law Courts’ decision and in doing so the Government legislated for certain changes to take affect from the date of Royal Assent to the Finance Bill – early July 2020. The effect of the new legislation is to enshrine HMRC’s long held view into law that whenever a settlor or trustee adds property to an existing trust, at a time that the settlor has become UK domiciled, it constitutes a separate settlement and cannot be excluded property. Although it is worth mentioning here that leading commentators generally disagreed with this view and doubted its validity in law.
What changes will be imposed by the change in law?
Draft legislation published in 2019 and forward in the Finance Bill proposes the following:
- Where property is added to an existing excluded property trust, the domicile of the settlor must be considered at the time of the addition of property, not just at the time of the original settlement.
- Loss of excluded property status will only affect added property not original property settled.
- If property is transferred from one settlement to another after the enactment of FA 2020, the settlor must be domiciled outside the UK at the time of each transfer, in order for the transfer to be one of excluded property.
- Where income has been accumulated within the trust, for example, where income has arisen from excluded property and the settlor has become UK domiciled between the original date of settlement and the date of accumulation, that accumulated income should remain excluded property.
What do trustees need to look for and consider?
Since the legislative change is retrospective, trustees will need to carefully analyse all additions to trust and inter-trust transfers where the settlor has become UK domiciled or deemed domiciled since the trust was settled:
- This point is particularly important as it is necessary for UK tax purposes to retain adequate records that demonstrate that any new funds have been kept entirely separate from funds settled whilst non-UK domiciled.
- In terms of trustee records – the trustees of a settlement should keep adequate records to enable any necessary attribution of the settled property to be made.
- Mingling of trust funds can lead to a situation where trust funds are tainted for UK tax purposes, new bank accounts etc should be used in situations described earlier, noting, this type of situation can be avoided with straightforward trust record keeping, reflected in trust accounts.
This situation includes loans made to trustees, not just outright gifts, since the loan proceeds are trust property; this can include unconnected, third party loans.
Inter-trust loans would also need to be examined in more detail on the same basis as inter-trust transfers.
What are the UK tax consequences for trustees and settlors?
If the current proposed legislation is enacted this could mean that:
- Subsequent additions, transfers, loans etc as above, become relevant property for the purposes of inheritance tax, in other words they are no longer excluded property within the trust.
- This could mean that, on ten-year trust anniversaries and exits of capital, there would be an IHT charge.
In addition, where the settlor has reserved a benefit in the trust or trusts, also known as a reservation of benefit and assuming they remain a beneficiary of the trust, the value of those assets that are no longer excluded property can be included in their estate on death for the purpose of IHT. This would mean IHT payable on his/her death of 40% for the assets no longer protected in trust:
- Furthermore, if the settlor is excluded from benefiting in certain situations where there is a reservation of benefit, the lifting of the benefit will result in a deemed potentially exempt transfer at that time. This means a 7-year run off will apply for the transfer to become fully exempt for IHT.
Key message and conclusion
- The law changes are retrospective and therefore, historic gifts, transfers and loans will need to be reviewed in light of these legislative changes and trustees should consider what if any remedial action can be taken and/or an assessment of the tax consequences/risks involved and fiduciary responsibilities of the trustees.
- Going forward, it will be necessary to test the domicile of the settlor every time funds are transferred between excluded property trusts, loans are made directly to or between trusts and direct gifts are made into trust.