Capital Gains Tax on Offshore Trusts
Some Recent Developments
David Rowell examines some recent developments which have turned the taxation of
non resident trusts into a minefield
(taken from Issue No 18 – January 2002
Where trustees are not resident in the United Kingdom it would usually be difficult for the Revenue to recover tax from them and the capital gains tax legislation does not seek to impose liability on them. What can more easily be done is to charge tax by reference to the gains of the trust on the settlor or the beneficiaries, if he or they are resident here. From its earliest days the legislation has contained provisions for that purpose but, over the last four years, these have been made a great deal more stringent.
What is a Non-resident Trust?
It may be desirable to remind ourselves first as to what is a non-resident trust for this purpose. For capital gains tax (`CGT`) a settlement is regarded as a separate entity and the trustees as a single continuing body of persons, distinct from the actual persons who from time to time hold that office. This body is regarded as not being resident in the UK in three situations.
(1) Where all or a majority of the trustees are neither resident nor ordinarily resident in the UK and the general administration of the trust is ordinarily carried on abroad. There is no definition of what constitutes `general administration.` Presumably it includes such things as the management of the trust investments, the keeping of accounts and records and taking decisions about the distribution of the trust income and capital. If non-resident trustees wish to employ agents in the UK while keeping the trust offshore they should exercise sufficient control over the agents and take sufficient decisions abroad to ensure that the general administration continues to be carried on there. Particular care will need to be taken about this if the trust fund consists mainly of money and quoted investments and the trustees wish to employ investment managers in the UK on a discretionary basis – a course which is becoming the most satisfactory way to manage large funds and is facilitated by the Trustee Act 2000.
(2) A professional trustee acting in the course of his business as such is deemed to be non-resident if the whole of the trust fund consists of or derives from property provided by a person who was not resident, ordinarily resident or domiciled in the UK at the time he provided it. Where this rule applies with the result that the majority of the trustees are, or are deemed to be, non-resident the general administration is deemed to be carried on abroad so that the trustees as a body are non-resident.1
(3) Where although the trustees would be treated as resident under normal UK law a double tax treaty requires them to be treated as non-resident.
Where a trust with a foreign element is involved, the effect of any double tax treaty should always be considered but, in practice, such treaties seldom have much to say on the treatment of trans-national trusts.
Settlements where the Settlor has an Interest
The major distinction in the tax treatment of offshore trusts is between those where the settlor is regarded as having an interest and those where he is not. In the former case, provided that the settlor is domiciled and either resident or ordinarily resident in the UK, the gains of the trust are treated as accruing to him and he is taxed on them. For this purpose, the gains on which the trustees would be taxed if resident, are calculated and that amount is then taxed as if it formed the highest part of the amount on which the settlor is chargeable to CGT in the year.2 Rather strangely this rule does not apply for the year in which the settlor dies. A person is a `settlor` for this purpose if the settled property consists of or includes property originating from him. So there can be more that one settlor in relation to a single settlement but each is only taxable on gains from the property originating from him.
The definition of the circumstances in which the settlor is regarded as having an interest is extraordinarily wide. He has an interest if property or income from the settlement is or will or may become applicable for the benefit of a `defined person` in any circumstances whatsoever or if any `defined person` enjoys a direct or indirect benefit from property or income in it. In relation to settlements created before 17th March 1998 the class of defined persons consists of:-
- the settlor
- his spouse
- the children of the settlor or his spouse and the children’s spouses and
- any company controlled by any of the above and
- any company associated with one so controlled3
Stepchildren count as children in this context.
Originally this wide definition of the settlor’s interest applied in general only to settlements created on or after 19th March 1991 (though there were certain exceptions) but the Finance Act 1998 has extended it to all settlements whenever made.
To this, there is one exception, namely protected settlements. A settlement can be a protected one if it was created before 19th March 1991 and at all times since 6th April 1999 the beneficiaries have been limited to children of the settlor who are under 18, possible unborn children and future spouses and persons who are not defined persons at all4.) A child counts as being under 18 if he was under that age at the end of the preceding tax year. So, if it is desired to protect the settlor from liability, the trustees must exclude each of his children from all benefit before the end of the tax year in which the child attains 18 or (if the trustees have no such power) the child must renounce his interest before then. The child will need to have independent legal advice if such a renunciation is to be beyond challenge since he is presumed to be under his parent’s influence and he personally derives no benefit from it. In any case the status of a protected settlement will be lost if:-
(a) property or income is provided directly or indirectly for the purposes of the settlement otherwise than under an arm’s length transaction on or after 19thMarch 1991
(b) the trustees, having previously been resident, become non-resident after that date
(c) the terms of the settlement are varied on or after that date so that a defined person becomes for the first time able to benefit from it or
(d) such a person enjoys a benefit for the first time from the settlement on or after that date in a case where under the terms of the settlement immediately before that date he was not capable of benefiting5
In the case of settlements created on or after 17th March 1998 the class of `defined persons` has been extended still further by s.131 Finance Act 1998 to include grandchildren of the settlor or his spouse, the spouses of such grandchildren and companies controlled by them or associated with companies so controlled. This extended definition also applies in relation to a pre-17th March 1998 settlement in four events. These are similar to those set out above in which the status of a protected settlement is lost save that the event must have occurred on or after 17th March 1998.
Moreover under s.10A TCGA 19926 if the settlor is non-resident for a period less than five complete tax years the gains, which have accrued to the trustees during his absence, are treated as accruing to him in the year of his return. There are complex provisions in s.86A TCGA 1992 to deal with the position if such gains have already been attributed to beneficiaries.
It might be thought that the best course in cases where it is not intended that defined persons should benefit is to have a general clause excluding them from all benefit and such clauses are now common. However they may cause unexpected problems bearing in mind that anyone in the world of the appropriate sex and age might, in principle, marry a child or grandchild of the settlor. A clause providing that no capital or income from the trust fund shall be paid to or applied for the benefit of any `defined person` would operate to forfeit the interest of any existing beneficiary who married such a child or grandchild. It is a condition subsequent which falls to be strictly construed in favour of the person whose interest may be defeated. It will be void for uncertainty unless the Court can determine from the start both the exact event on which forfeiture will occur7 and what is to happen to the property or income concerned following the forfeiture.8
Consider also this case. Trustees appoint a fund to such of the children of X (not a descendant of the settlor) as attain 25 in such shares as the trustees may appoint and in default in equal shares with the income being accumulated or applied for maintenance in the meantime. Any of the children of X could, if the ages and sexes are right, marry a child or grandchild of the settlor before attaining 25. If the effect of the exclusion clause is to forfeit the interest of any child of X on such a marriage it cannot be said of any of them that he will on or before attaining 25 become beneficially entitled to a share in the fund or to an interest in possession in it. The condition in s.71(1)(a) Inheritance Tax Act 1984 therefore appears not to be met and the trust will not qualify as an accumulation and maintenance one. Even if X’s eldest child is too old to marry a child of the settlor before the age of 25 the power to vary shares prevents that condition being satisfied in relation even to his share.
The problem cannot be solved simply by providing that if one child forfeits his share it is to accrue to the others. If the youngest child married a child of the settlor his share would accrue to his older siblings who might well be over 25 so that the condition in s.71(1)(a) would still not be met. There may be room for arguing that such a forfeiture should be ignored for the purposes of s.71 on the same basis that the possible vesting of a beneficiary’s share on bankruptcy is ignored but that is very doubtful and the Revenue have indicated that they may take this point. The best course may be to limit such forfeiture clauses so that they do not apply to an interest which a beneficiary may take under the terms of the settlement or of any appointment executed before he becomes a defined person. That obviously involves some risk to the settlor but at least it will allow the creation of an accumulation and maintenance trust.
Settlements with no Settlor Interest
The basic rule here is that the gains which would be chargeable in the trustees’ hands if they were resident (`the trust gains`) are calculated and tax in respect of them charged on beneficiaries domiciled and resident in the UK who receive `capital payments` from the trust. There is provision for a surcharge if a capital payment gives rise to a CGT liability in respect of gains realised some time before which can result in the beneficiary paying tax equal to 64% of the payment received by him.
Originally this rule only applied if the settlor is or was when he made the settlement domiciled and resident or ordinarily resident in the UK but s.130 Finance Act 1998 removed this limitation in respect of trust gains realised on or after 17th March 1998. Now a UK beneficiary who receives a capital payment from a foreign trust is at risk of having to pay tax on it even if the trust has no other connection with this country. This change can cause serious problems. Consider the case of an Australian beneficiary under a discretionary trust with no UK connection. If he or she acquires a domicile of choice and takes up residence in the UK (perhaps on marriage to an Englishman) and then receives a capital payment from the trust he or she is potentially liable to CGT on it but will almost certainly not have the information on which to determine the tax payable. Even if the trustees are willing to make their records available, information highly relevant to the beneficiary’s liability may not be readily apparent from them, e.g. the values of trust assets on 31st March 1982 or the value of `capital payments` previously made to other beneficiaries. In a few cases a double tax treaty may help but that presently in force with Australia makes no specific provision about the taxation of capital gains.9 Negotiations for a new treaty with that country began earlier this year but no one can say when they will be completed or whether they will do anything about this problem.
Not unexpectedly `capital payment` is widely defined. It includes any payment which is not chargeable to income tax on the recipient and includes also `the transfer of an asset and the conferring of any other benefit and any occasion on which settled property becomes` nominee property.10 It does not include a payment or presumably the transfer of property or the conferring of a benefit, under a transaction at arm’s length.
Recently the Court of Appeal in Cooper v Billingham11 has upheld a decision that a beneficiary is taxable as the recipient of a capital payment when he receives an interest-free loan from the trustees even if it is repayable on demand. In that case the trustees had made interest-free loans from the trust fund to the life tenant which were expressed to be repayable on demand but were in fact left outstanding for years. While recognising that any construction of the legislation gives rise to problems, the Court preferred the view that in the case of a loan repayable on demand the trustees confer a benefit on the borrower by leaving it outstanding for any period even for a single day. By conferring such a benefit day by day or over a longer continuous period the trustees make a capital payment within s.97(1) TCGA 1992. It made no difference that the borrower was the life tenant who would have been entitled to the income from the money lent had it been invested by the trustees.
The implications of this decision are far from clear. First, although Lloyd J. said at first instance that there would be no difficulty in quantifying the value of the benefit12, one can foresee horrendous problems of quantification when it is necessary to determine how much benefit the borrower received before or after a particular date, e.g. if it is necessary to apportion trust gains between X who received an interest-free loan in April which remained outstanding until December and Y who received an outright advance in money in May. Trustees in the real world do not decide whether to leave loans outstanding from day to day. Robert Walker L.J. suggested13 that in such situations beneficiaries faced with assessments might be advised to ask their trustees for minutes of their meetings or other details of their decision-making process, so that these could be put in evidence. Such material though will obviously not be available to the Revenue when they make the assessment and, when produced, its effect may be far from clear. The dispute may in substance be between X and Y with Y seeking to show that it was always the intention to leave the loan outstanding for eight months so as to reduce his own liability but the procedure for challenging assessments is not really suitable for resolving disputes between two or more taxpayers.
Secondly the decision will obviously extend to cases where the trustees allow a beneficiary the free use of a chattel. One might expect it to apply also if they allow him rent-free occupation of a house. However a beneficiary with an interest in possession has at least a prima facie right to occupy vacant land comprised in the trust fund14. If trustees make an appointment giving a beneficiary an interest in possession in an empty house that normally carries with it the right to occupy it. Is the making of such an appointment and the leaving of it unrevoked to count as a `capital payment`? In the past the Revenue have conceded, after some initial hesitation, that an appointment creating an interest in possession does not constitute a capital payment15. Will that attitude now change at least in some cases? Or will an irrational distinction be drawn between cases where the trustees grant a beneficiary a licence to occupy a house rent-free and those where they appoint an interest in possession in it? Or between interest-free loans and the rent-free occupation of property?
On the other hand this decision means that an interest-free loan to a beneficiary resident and domiciled outside the UK can be used to `wash out` CGT on trust gains so that tax in respect of them is not charged on UK beneficiaries who receive capital payments subsequently. One wonders how the Revenue will react when such a loan is made to a person resident in a country where interest rates are much higher than here and it is sought to value the benefit from the loan on the basis of what it would have cost to borrow the money locally.
An offshore trust is one of the cases where the rules about trustee borrowing introduced by the Finance Act 2000, and now embodied in Sch. 4B TCGA 1992, apply. (The other is where the settlor or his spouse may benefit from a resident trust.) These rules treat the trustees as making a complete or partial disposal of the trust assets (so giving rise to trust gains) if they make a `transfer of value` at a time when there is `trustee borrowing` outstanding.
Trustees are treated as borrowing if money or any other asset is lent to them or an asset is transferred to them and in connection with the transfer they assume a contractual obligation (whether absolute or conditional) to restore or transfer to any person that or any other asset.16 Trustee borrowing remains outstanding so long as the loan obligation remains outstanding and the proceeds of the borrowing have not been applied for `normal trust purposes` or taken into account in relation to a transfer of value.
`Normal trust purposes` are elaborately defined in Sch.4B paras. 6 to 9 but basically they are limited to the use of the proceeds of the loan in three ways.
(i) In making a payment in respect of an ordinary trust asset provided the transaction is on arm’s length terms and certain other conditions are met. Ordinary trust assets are defined as shares and securities, tangible property (including immovables), property used for a trade, profession or vocation carried on by the trustees or a beneficiary with an interest in possession and rights in or over, or an interest in, tangible or business property.
(ii) In meeting bona fide current expenses incurred in administering the settlement or the settled property or
(iii) In repaying another loan which was itself used for normal trust purposes.17
It will be seen that many perfectly normal and proper purposes for which trustees may wish to borrow money are not `normal trust purposes` within this definition e.g. paying premiums on a life assurance policy held as an investment or lending money to a company which the trustees control. Moreover while `trustee borrowing` includes the loan of an asset other than cash, it is difficult to see how the thing lent can ever be used for `normal trust purposes.` The Treasury has power to amend this unsatisfactory definition by regulations18, and it is to be hoped that it will soon be substantially extended.
The other crucial definition is that of `transfer of value` which bears a very different meaning from its familiar one in an inheritance tax context. Such a transfer occurs if the trustees:-
(a) lend money or any other asset to any person
(b) transfer an asset to any person for no consideration or a consideration less than its value or
(c) issue a security of any description to any person for no consideration or a consideration less than its value.19
An asset for this purpose includes a sum of money in sterling.20 A distribution by the trustees to a beneficiary even of money therefore falls within the definition of a transfer of value. Moreover no distinction is drawn between payments of capital and of income and there seems no escape from the conclusion that if the trustees of a discretionary or accumulation and maintenance trust make a payment of income to a beneficiary at a time when there is trustee borrowing outstanding that triggers a partial disposal of the trust assets. If that results in a chargeable gain, tax will be payable on it by the settlor (where he is regarded as having an interest) or by beneficiaries who receive capital payments. Even if little or no tax is payable, the burden of computation and compliance if there is a part disposal on every distribution of income will be very onerous. The case where a beneficiary has an interest in possession is different because he is regarded as entitled to the income as soon as it arises and even if it passes through the trustees’ hands it cannot be said that they are thereby transferring an asset to him.21
The only sensible advice to trustees of non-resident trusts is to avoid `trustee borrowing` altogether unless the proceeds are used straight away for `normal trust purposes` as defined.
Disposal of a Beneficial Interest
It is widely known that the exemption from CGT for the disposal of beneficial interests does not apply where the trustees are non-resident but this provision has been widened in two ways in recent years.
(a) Since 1998 tax has been chargeable on such a disposal if the settlement has at any time in the past been offshore22
(b) Normally if the settlement has in the past been resident the beneficiary is treated as having acquired his interest at market value at the time it left the UK but this no longer applies if at that time it had `stockpiled gains`, that is gains accrued during a previous non-resident period which have not yet been attributed to beneficiaries receiving capital payments.23
Once more there is no exception for cases where the trust has no connection with the UK except that a beneficiary has happened to acquire an English domicile and residence.
There is no space here to deal with the charges that result when a settlement migrates from the UK or with the complications where trustees own an offshore company. Enough has been said though to show that CGT on non-resident trusts has become a minefield for trustees, their advisers and the beneficiaries. The spirit of the legislation seems to be that all such trusts are vehicles for avoiding UK taxes but the net is now wide enough to catch ones set up with no thought of the UK but where one of the beneficiaries has subsequently acquired a UK connection.
9 Stone Buildings
1 see s.69(2) Taxation of Chargeable Gains Act 1992 (`TCGA 1992`)
2 s.86 TCGA 1992
3 Sch. 5 para. 2(3) TCGA 1992
4 Sch.5 para. 9(10A) TCGA 1992
5 Sch.5 para. 9(1B) – (6) TCGA 1992
6 inserted by Finance Act 1998
7 see Clavering v Ellison (1859) 7H.L.C. 707 at 725 and Clayton v Ramsden (1943) A.C. 320
8 see Re Whiting (1905) 1 Ch. 96 at 118 and Rochford v Hackman (1852) 9 Hare 475 at 481-3
9 See the Double Taxation Agreement of 7th December 1967 between the United Kingdom and Australia: SI 1968/305
10 s.97(1)(2) TCGA 1992
11 (2001) STC 1177
12 (2000) STC 122 at 134e
13 (2001) STC at 1186h
14 see s.12 Trusts of Land and Appointment of Trustees Act 1996
15 see Practical Tax Planning with Precedents looseleaf edn. Vol. III para. F5.0370
16 Sch.4B para. 4(1) TCGA 1992
17 Sc h. 4B paras. 6 and 7 TCGA 1992
18 Sch. 4B para.9
19 Sch. 4B para. 2(1)
20 Para. 13(1)
21 see Baker v Archer-Shee (1927) A.C. 844
22 s.76 (1A) TCGA 1992
23 s.95 Finance Act 2000