After the Storm: The UK Taxation of Offshore Trusts Post-Finance Act 2008

The new rules for taxing UK resident non-domiciliaries were finalised in July in the Finance Act 2008. The original draconian proposals, published in January, were tempered in the months after they were first published and during the bill's passage through Parliament. Nevertheless, the changes are significant and wide-ranging in their impact on both individuals and offshore trusts.

This article does not cover all the provisions included in the proposed rules, but focuses primarily on the measures likely to be most relevant to settlors and beneficiaries of offshore trusts who are resident but not domiciled in the UK, and to trustees of the offshore trusts in which they are interested.

Remittance – The New Rules

An individual who is resident but not domiciled in the UK pays tax on their UK income and capital gains as it arises in the same way as a UK resident domiciliary. This is known as the ‘arising basis’.  

For income and capital gains arising outside the UK, for example, on a foreign bank account or other offshore asset, a UK resident non-domiciled individual may choose to claim the ‘remittance basis’ of taxation, whereby they pay UK tax only when they bring in or ‘remit’ the income or gains to the UK. Such an individual does not have to pay UK tax on ‘clean’ foreign capital brought to the UK. Under the new rules, an annual charge of £30,000 will, with certain exceptions, be payable to claim the remittance basis once an individual has been resident in the UK in seven of the preceding nine tax years.  

The new rules have widened the meaning of ‘remittance’. A remittance may now occur if money or other property which is, or derives from, foreign income or capital gains of a UK resident non-domiciled individual is brought to, received or used in the UK by or for the benefit of a ‘relevant person’, or a service is provided in the UK to or for the benefit of such a person. The application offshore of foreign income or gains or property deriving from them in payment for services in the UK or to satisfy a debt in the UK is likely to constitute a remittance, subject to certain specific exemptions. Relevant persons include not only the non-domiciled individual to whom the income or gains originally arose, but also their spouses, civil partners or those living together as such, and their minor children or minor grandchildren. 

Trustees of a settlement of which the individual or another relevant person is a beneficiary are also classed as relevant persons, as are certain companies in which another relevant person is interested. This means that funds brought to or used in the UK by offshore trustees, for example, for investment purposes or as payment for UK services, may be caught by the rules. There is an exemption for services provided in the UK which relate to property outside the UK. However, this is subject to a number of conditions and will not always apply. Accordingly, care will be needed to avoid remittances if trust funds include assets which are, or derive from, income and capital gains of a UK resident non-domiciled individual.

The Attribution of Gains to Beneficiaries of an Offshore Settlement.

Under the capital gains tax (CGT) anti-avoidance rules, which apply to offshore trusts, gains made within foreign trusts may be attributed to beneficiaries who receive capital payments from the trust. Under the old rules, a CGT charge was only imposed when a UK resident and domiciled beneficiary received a capital payment. Under the new rules, a charge may also be imposed on a UK resident non-domiciled beneficiary (including a settlor) who receives a capital payment from an offshore trust (subject to rules which attribute gains to UK resident and domiciled settlors with an interest in an offshore settlement).

Capital payments received and trust gains realised before 6 April 2008 are not taxable on a UK resident non-domiciled beneficiary. This is the case whether the beneficiary is taxed on the remittance basis or the arising basis after 5 April 2008.

Where capital payments to UK resident non-domiciled beneficiaries are received after 5 April 2008 and matched to post-5 April gains, the remittance basis of taxation will apply for gains on both UK and non-UK assets if the beneficiary is claiming it in the tax year in which he receives the payment. This may make holding UK assets within trust structures (via offshore holding companies for inheritance tax reasons) preferable to holding them directly or via a company in future.

Trustees of an offshore trust may elect to ‘rebase’ trust assets, including those held in underlying companies, to market value at 6 April 2008. If a rebasing election is made, trust gains, including offshore income gains, which accrued to the trustees but were not realised prior to 6 April 2008 will not be chargeable if matched to capital payments made after 5 April 2008 to non-UK domiciled beneficiaries.

Rebasing will not have any effect in relation to payments to UK resident and domiciled beneficiaries but an election, if made, will be irrevocable and will apply to all trust assets (including those of its underlying companies). The deadline for an election is 31 January following the tax year in which the first of two possible events occurs. These are either a capital payment being received, or treated as received, by a UK resident person, whether domiciled in the UK or not, or a transfer of all or part of a trust fund to a new settlement where gains are attributable to the transfer. Rebasing is not available for assets held through companies owned directly by individuals rather than trustees.

Careful records of trust gains and losses should be kept by trustees to ensure that UK resident beneficiaries who receive capital payments can obtain the information they require to complete their tax returns. Events which may trigger the start of the time period for an election should also be noted so that the deadline is not accidentally missed.

Rebasing will not be appropriate in all circumstances, but it would nevertheless be advisable where possible, to obtain valuations of trust assets as at 6 April 2008 in order to assist with a future decision.

Whilst the CGT benefits of trusts for UK resident non-domiciled beneficiaries have been reduced, at least where beneficiaries cannot avoid remitting payments they receive to the UK, it may be some comfort that from 6 April this year, the CGT rate has been reduced from a maximum of 40 per cent to 18 per cent. For offshore trusts, a supplementary charge applies where time elapses between the time a gain is realised and when it is distributed. This now results in a maximum charge of 28.8 per cent, which compares favourably with up to 64 per cent under the old rates. Generally, capital gains, in contrast to offshore income gains, are now taxed at a much lower rate than income, on which trustees and higher rate taxpayers continue to be taxed at 40 per cent.

Transfer of Assets Abroad – Income Tax Anti-Avoidance Provisions

Where assets have been transferred abroad and are held through offshore entities, including trusts, there are provisions which apply to tax income arising in the offshore structure. If the ‘transferor’ (broadly the settlor) is ordinarily resident in the UK and has power to enjoy the income of the settlement, the rules treat such income as his. Otherwise, individuals are taxed on income treated as theirs when they receive payments or other benefits from the trust. The rules have been extended to incorporate the new remittance rules.

Other Significant Changes

Accrued income scheme

The accrued income scheme, which deems a proportion of the proceeds of sale of certain securities, including bonds, to be income in certain circumstances and which has been extended to UK resident non-domiciliaries from 6 April 2008, also applies to offshore trusts. Accordingly, the proportion of the proceeds of sale of relevant securities which are deemed to be income under the scheme will be treated as income of the settlor for UK tax purposes. The remittance basis will be available in these circumstances but, if such deemed income is remitted to the UK, the settlor will be taxable.

Offshore income gains arising to offshore trustees

The treatment of offshore income gains arising to offshore trustees is relatively complex, as both the provisions attributing trust gains to beneficiaries of offshore settlements and those relating to transfers of assets abroad may be relevant depending upon circumstances.

Broadly, if a capital payment has been made to a UK resident or ordinarily resident beneficiary in a tax year in which offshore income gains arise or in an earlier tax year, the offshore income gains will be taxed under the provisions attributing gains to beneficiaries who receive capital payments. If not, the offshore income gains become taxable under the transfer of assets provisions, either on a UK resident transferor with power to enjoy the income of the trust or, if there is no such person, on someone who receives a benefit from the trust in a subsequent tax year.

Whichever provisions apply, however, offshore income gains are taxed to income tax rather than CGT.

Where We Are Now

The new rules have not eliminated all the tax advantages available to UK resident non-domiciled settlors and beneficiaries, and those who continue to claim the remittance basis are still in a relatively privileged position for UK tax purposes (subject to the £30,000 annual charge where it applies).

The income tax and CGT benefits of holding assets via an offshore trust have been eroded, although by no means to the extent originally feared. Going forward, if it will be difficult to avoid remitting funds to the UK under the new rules without UK tax charges arising, it may be preferable for trustees to invest for capital growth, to take advantage of the new lower rates of UK CGT, subject, of course, to investment considerations. In doing so, trustees will need to take account of the application of the accrued income scheme and its potential impact on income segregation.

The option to rebase assets to 6 April 2008 and the availability of the remittance basis for trust gains of both UK and non-UK assets may make holding assets within trust structures preferable to holding them directly via a company and, of course, the benefits for UK inheritance tax of holding assets via an offshore trust are, for the time being at least, unaffected.

In any event, the non-UK tax advantages of holding assets in trust remain. The flexibility offered by trusts in succession planning, particularly for settlors from civil law jurisdictions with forced heirship rules or those jurisdictions where Sharia law prevails, is unaffected by the changes. Trusts continue to offer benefits for asset protection, for example, in the context of divorce of a settlor or beneficiary. Tax considerations in other jurisdictions, and the possibility of avoiding probate, otherwise required on the death of an outright owner of assets, continue to make trusts a valuable planning tool.