Mar 27 2020

I say Settlor…

The popularity of lifetime trust giving in the UK has been on a downward trend since April 2006 when the Labour government introduced reforms specifically aimed at stopping trusts “being used to shelter wealth from inheritance tax”.   Subsequent UK governments continued in the same vein through the blurring of legitimate tax avoidance with criminal tax evasion, the introduction of new criminal offences targeting wealth advisors and increases to the tax rates paid by trustees.

Beneficial ownership registers have been established to record who can benefit from trusts, who ultimately owns or controls companies and more registers are in the pipeline for foreign owners of UK residential property. Some of these registers are freely available to the public and others, for the time being at least, are only available to regulatory and law enforcement agencies.    

Broadly, when a UK person transfers assets into a trust during their lifetime, there is an immediate lifetime inheritance tax charge at the rate of 20% on the value being transferred in excess of the nil-rate allowance (currently £325,000) unless the assets qualify for relief (the principal reliefs are for qualifying business assets or agricultural property).  In addition, the trust will be subject thereafter to periodic ten yearly charges (at rates of up to 6%) as well as exit charges whenever assets leave the trust.

It is not surprising that as a result, according to the latest data published in September 2019, the total number of trusts and estates registered for tax in the UK has fallen since April 2006 by almost one third to 150,000.   

Taxation is not though the only reason why people are reluctant to set up trusts.  When an individual transfers property to trustees, they cede control of the assets to the trustees who are bound by duties of prudent and conservative investment.  Whilst loss of control over an investment portfolio earmarked for future generations may be acceptable, the loss of control over “crown jewels” assets such as shares in a family business may not be so acceptable.

… You say Grantor

In the USA, on the contrary, trusts are generally viewed in a more benign manner, are not so heavily tainted by association with tax evasion or even avoidance.   

US living trusts have several advantages over UK lifetime trusts: they are transparent for tax purposes, there is no immediate tax liability upon creation and the grantor can retain control over the trust property.  "Crown jewels" can safely be held within the trust without any loss of control. Upon the grantor's death, the trustees either distribute the trust property to the named beneficiaries or continue to hold and manage it for their benefit according to the terms of the trust.  

US living trusts can also be used in a similar way to a UK lasting power of attorney when the grantor loses mental capacity and so one US living trust takes the place of both a UK will and a UK lasting power of attorney.

Let's just tax them out of existence

Individuals migrating between the USA and the UK will find some similarities between the two tax regimes (for example, the notion that it is possible to be resident in one place for income tax but domiciled elsewhere for inheritance tax purposes) but there are plenty of mismatches.  Issues frequently arise where wealth has been structured through companies and trusts which are considered as transparent here but opaque there causing the same income or gain arising in such structures to be treated as having different sources or as belonging to one person for US tax purposes but to another for UK tax purposes. 

Living trusts are a good example of this and the UK tax treatment of a living trust whose US grantor-trustee-beneficiary has become UK resident is rarely fair and hardly ever simple depending on whether the living trust in question is treated for UK tax purposes as a 'settlement' or not.  Not all trusts are settlements and vice versa.  Although what exactly is a settlement is not clearly defined for UK tax purposes, it is clear that a 'bare trust' is not a settlement and that a bare trust arises where the beneficiaries are all absolutely entitled to the trust assets.

Where the living trust of a now UK-resident US grantor qualifies as a bare trust, the income and gains of the trust will be subject to taxation in both the US and the UK as if they arose directly to the grantor and any US tax paid by the grantor can be used as a credit against any UK tax payable.  The trust income and gains will be taxable in the UK on the remittance basis, at least for the first seven years that the grantor is resident in the UK and thereafter if he claims the remittance basis and until he becomes deemed UK-domiciled.  

If the living trust is qualified as a settlement, and if the trustees are the grantor and the grantor's spouse, the trust will be UK resident for UK tax purposes once the grantor and spouse become UK resident and so fully subject to UK tax on all trust income and gains arising wherever the trust assets are situated.  As the grantor will remain a US person, the grantor will also be taxable in the US on all trust income and gains arising wherever the trust assets are situated.  If the grantor and spouse return to live in the USA, then a potential UK capital gains tax charge will be triggered by the trustees becoming non-UK resident.

Differences in how income and gains are taxed in the UK and US and rules on how distributions from trusts are treated also contrive to make it harder to obtain double tax relief.  Whereas a grantor is subject to US income tax on gains in the year in which they arose, a UK beneficiary is only subject to capital gains tax on the trust’s gains to the extent that they are matched under complex rules with a capital payment to the beneficiary from the trust.  Where a US person who claims the remittance basis does not remit the income or gain to the UK, there will be no UK taxation of that income or gain and so no foreign tax credit to set against the US tax paid.  

The US/UK Treaty provides some relief to avoid double taxation.  The notes to the Treaty provide that where the same income or gains are taxed in the US as belonging to the grantor and taxed in the UK as belonging to a beneficiary, the tax paid by the beneficiary is to be treated as if it had been paid by the grantor.  

Complications also arise because the US and UK tax years do not coincide (for some obscure reason, the UK tax year runs from April 6th one year to April 5th in the next) and so income or gains can be treated as arising in different tax years in the UK and in the USA.  If the income or gain is distributed to a beneficiary or remitted to the UK in the year in which the US liability arose or in the subsequent calendar year, the UK tax payable can be claimed as a foreign tax credit against the US tax liability. If the income or gain is remitted to the UK in a later year, the UK tax paid cannot be used as a foreign tax credit and so the IRS and HMRC will each happily keep hold of the tax which they have been paid.   To avoid a double charge, the taxpayer should remit the income or gains to the UK shortly after receipt but that will likely defeat any advantage gained from using the remittance basis.

Issues can also arise for a UK person who moves to the USA and then sets up a living trust whilst they are still UK domiciled.  If the living trust does not qualify as a bare trust, there will be an immediate 20% UK inheritance tax charge on the value of the assets within the trust and then periodic ten yearly charges as well as exit charges whenever assets leave the trust with no relief available under the US/UK Treaty.

Wouldn't it be wonderful 

If UK persons could establish transparent tax-neutral trusts which would have a similar tax treatment to US living trusts!  They could be called "Settlor Trusts" and would not only encapsulate the transparency, fairness and simplicity the UK government is apparently looking for but also massively simplify the position of trans-Atlantic families. 

This is an abridged version of an article by Edward Stone originally published in Trusts & Trustees, 16 January 2020, Oxford University Press