HOW SHOULD TRUSTEES DEAL WITH FOREIGN TAX ISSUES
Anthony Thompson looks at the increasing difficult area of payment of foreign
taxes by trustees
(taken from Issue No 21 – October 2002
Trustees, whether in the UK or in one of the offshore financial centres, are having to become increasingly sophisticated in the way they deal with foreign taxes. Settlors and beneficiaries are much more internationally mobile than in the past; tax anti-avoidance legislation is becoming ever more wide reaching; anti-money laundering legislation now covers foreign taxes; and in the UK, we have s.134and Schedule 39 Finance Act 2002, which give direct tax enforcement powers in the UK to EC member states. So where does this leave trustees?
There are three main areas where trustees need to be concerned:-
- a tax liability of a beneficiary receiving a distribution;
- a foreign tax liability falling on the trustees directly; and
- a foreign tax liability of a non-beneficiary who seeks reimbursement (under the law from where the tax is due) from the trustees.
Using the UK tax system as an example, where there is an offshore trust the liability for UK tax will fall on one (or more) of, the settlor, the beneficiaries and/or the trustees. Typically, income tax (IT) and capital gains tax (CGT) liabilities fall on the settlor and/or beneficiaries and are not the liability of non-resident trustees (there are of course exceptions). Inheritance tax (IHT), on the other hand, is less concerned with the residence of the trustees and therefore a liability to IHT could well fall on them. The liability of the trustees is a personal liability and they therefore need to consider whether they can, if they pay the tax, be reimbursed out of the trust fund.
In this article, I have used the example of UK tax liabilities and how they may fall on overseas trustees, as I believe that this helps to clarify the difficulties they have. Nevertheless, the law as stated is the English law on the position and English-based trustees will have to ask themselves exactly the same questions in relation to non-UK tax issues as those being asked by the offshore trustees in the examples that I have given. English resident trustees will also have to consider the provisions in the Finance Act 2002.
Government of India v Taylor
What should the trustees do if they have a liability to tax in a foreign jurisdiction and there is no express power to pay foreign taxes in the trust deed?
Under the Government of India v Taylor1 principles, the courts in the jurisdiction where the trustees are resident will not entertain an action to enforce the taxes of a foreign State. This means that on the face of it the trustees have no obligation to pay the tax as it cannot be enforced against them and to pay the tax would reduce the value of the trust fund. In what circumstances might it be appropriate for the trustees to pay that tax due?
The tax liability of a Beneficiary
Consider the situation where, unknown to the trustees at the time the settlement is created, the settlor is still UK domiciled and creates for the benefit of himself and his children an offshore discretionary trust. He dies three years later. Under this scenario IHT liabilities will have arisen. There are beneficiaries in the UK and elsewhere. Under the legislation, any IHT due can be collected from the trustees and from any beneficiary who receives a distribution. Can, or should, the trustees pay the UK inheritance tax? Much of the case law in this area deals with the administration of deceased’s estates, rather than trusts but we can get some guidance from these.
In the above example, the case of Scottish National Orchestra Society Limited v Thomson’s Executor2, is helpful. The case concerned the estate of Mrs Thomson, who at her death had assets in Scotland, Canada and Sweden. She had lived, for many years before her death, in Sweden. She left a number of pecuniary legacies, all of which were expressed to be free of government duties. Some of the legatees were resident in Sweden. The executors paid over sufficient to the administrator in Sweden to enable him to meet Swedish estate duties. Some of the beneficiaries under the will objected to this payment. The court held that, as the executors’ duty was to pay all the legacies free of all government duties, they had acted appropriately in remitting the sums to Sweden, so that tax could be paid and the Swedish legatees could receive their legacies free of Swedish tax. Returning to my example above, I would argue that if the trustees wish to exercise their discretionary powers to benefit the beneficiaries equally then it is vital that they pay the UK IHT first. Otherwise, the UK beneficiaries will have to pay tax on what they receive, whereas the beneficiaries outside the UK will not.
Could this argument be extended, so that the trustees are obliged to look at the tax position of each of the recipients in their respective countries? The answer may well be a qualified yes. Although the IHT liability in the example above is not a personal liability of the beneficiaries as such (it is the liability of either the settlor or trustees and the legislation is simply looking to enforce it against the beneficiaries) each beneficiary’s personal tax position needs to be considered. In deciding how to make a distribution, the trustee should consider the most appropriate way of doing so. It is highly unlikely that all the beneficiaries will end up with the same amount net, but the trustees should seek tax advice themselves or at least alert the beneficiaries to the fact that tax might be payable and allow the beneficiaries to seek tax advice. In this way, it might be possible for the trustees to adopt a more tax-efficient distribution policy. For example, the trust fund of an offshore discretionary trust is going to be distributed to two beneficiaries, one is UK resident and domiciled, the other is resident in Monaco. It might well be possible to reduce the tax liability of the beneficiary in the UK, without prejudicing the beneficiary in Monaco, by making a distribution to the beneficiary in Monaco in one tax year (thereby sweeping out retained income and stockpiled gains) and to the UK beneficiary in the next tax year.
The tax liability of non-resident Trustees
In the previous scenario, there was a beneficiary potentially subject to a tax that could also have fallen on the trustees. However, there may be a foreign tax liability that falls on the trustees but without there being any beneficiaries within the taxing jurisdiction. Can, or should, the trustees pay the tax in this scenario?
If the liability is unenforceable on the trustees, then on the face of it they should not pay the tax3 as to do so would unnecessarily reduce the trust fund. Are there circumstances when it might be appropriate for them to do so? Re Lord Cable4lends authority to the proposition that, if the governing law of the trust is the same as the taxing State and/or the trustees may have a personal liability, then it may be appropriate for the trustees to settle the tax. If the governing law is English law and the trustees visit the UK regularly, payment of UK tax out of the trust fund would probably not be a breach of trust.
There may also be another very significant reason for the trustees to pay the tax. The anti-money laundering legislation which applies not only to the UK but also to many offshore financial centres considers tax evasion a money laundering crime, so that knowingly dealing with the proceeds of tax evasion is a money laundering offence. If trustees are personally liable for the foreign tax but the liability is unenforceable where the trustees are resident, would a court, in the light of the anti-money laundering legislation, still say to the trustees that the tax should not be paid? I think that a court would consent to the payment, as it would be treated as one of the special circumstances suggested in Re Sidney Walmsley where the tax should be paid but as we have no direct authority for this at present, trustees who find themselves in this position should make an application to court for guidance on how to proceed.
The other aspect to the anti-money laundering legislation is that trustees cannot simply ignore the fact that the assets settled represent the proceeds of tax evasion (e.g. the settled funds were kept offshore and were not declared in the settlor’s home jurisdiction). A full analysis of this topic is beyond the scope of this article but I have set out a few brief issues for trustees to consider. The test as to whether the trustees should have known about the tax evasion is likely to be: in the circumstances should a reasonable professional trustee have been suspicious that these were the proceeds of a money laundering offence? If the answer is `yes`, then the trustees should make a report to the appropriate authority and seek directions from them in relation to how to deal with those funds but must not tip-off the settlor. This is a somewhat knotty problem for trustees and there may also be a further knock-on effect. If a beneficiary in a State with anti-money laundering legislation receives a distribution knowing there is an outstanding tax liability due, he/she is not guilty of a money laundering offence if he/she does not report the trustees to the appropriate authorities but if the distribution is paid into the beneficiaries’ bank account and the private banker is aware of the tax liability then that private banker will need to report the matter to the appropriate authorities.
For trustees in the UK, the decision on whether to pay a foreign tax liability has been made easier (for once!) by the Finance Act 2002. Under the provisions ofs134 and Schedule 39 to that Act, it will now be possible for an EU Member State to enforce a tax judgement in the UK. This means that if UK trustees have a liability in, say, France, it can be paid without fear of breach of trust, as that liability is enforceable against the UK trustees. However, inheritance tax (and similar EU succession taxes) are not included so that care will need to be taken to determine the nature of the tax liability the trustees are seeking to pay.
Tax liability of the settlor
A further situation where trustees might find themselves in some difficulty is the case where a non-beneficiary has a tax liability based on the assets within the trust fund – for example, a UK domiciled and resident settlor who has created an offshore trust for the benefit of his/her children but has excluded him/herself from benefit. Gains made by the trustees are taxable on the settlor. The settlor has a right of reimbursement from the trustees under UK tax law, but how does that interact with trustees who are outside the UK? Following Re Lord Cable, it might be appropriate for the settlor to be reimbursed from the trust fund if the proper law of the trust is English law. However, if the proper law of the settlement is not within the UK and there is no power to reimburse the settlor under the terms of the deed, what can the trustees do?
The recent Jersey case of the T Settlement5 gives an interesting example of just such a situation. The settlor, Mrs T, lived outside the UK when she and her husband created an offshore settlement. When she returned to the UK in 1980, she was specifically excluded from all benefit under the trust, primarily to avoid UK income tax liabilities. Following the Finance Act 1998, as her children were able to benefit from the trust, Mrs T became liable to tax on the capital gains made by the trustees. The trustees applied to the court for a variation to allow them to reimburse Mrs T for the UK tax due. The court commented that:-
`It could be argued that Mrs T might well have a statutory right of reimbursement from the trustees but we have some doubt that this court is able to give effect to an English statutory right of reimbursement against a Jersey trust.`
The court did consent to the variation to allow the trustees to reimburse Mrs T. However, much was made of the fact that it was a very close family; all the adult beneficiaries who were capable of consenting to the variation did so and Mrs T would be unable to pay the tax if it were levied upon her. Therefore, the court consented on behalf of the minor and unborn beneficiaries, saying that what was a benefit to the adults should also be considered a benefit to those who could not consent.
Would the result have been the same if Mrs T had been independently wealthy and/or some of the beneficiaries had objected to her being reimbursed?
Specific clauses in trust deeds
Clearly, the problems that I have outlined above, both in relation to trustees paying tax assessable only on themselves and the reimbursement of a non-beneficiary for tax due by him/her, need to be avoided if possible. Most modern trust deeds will contain provisions allowing payment of foreign tax, but will they work as intended? Often, the clause will simply give the trustees power to pay the tax. As with any discretionary power, this needs to be exercised in the best interests of the beneficiaries. It may well not cover a tax liability due only on the trustees or on a non-beneficiary. Therefore, when drafting such a clause:-
- It must be clear that the trustees can pay the tax for which they alone are liable and therefore benefit themselves.
- Drafting the power to reimburse a non-beneficiary for tax paid is even more difficult. In the case of a UK settlor, great care needs to be taken to ensure that all the settlor is entitled to is his/her statutory right of reimbursement and that there is no question of any other benefit being provided to the settlor, as such benefit could result in the settlor having retained an interest in the trust, which would of course give rise to other tax problems.
There has been a significant shift in attitude towards payment of tax, particularly following the introduction of money laundering legislation. No longer is it possible for trustees simply to put `their heads in the sand` and ignore the issue. Enforceability of tax on trustees and beneficiaries is now a real issue. This means that trustees should ensure that tax advice is taken in all the relevant jurisdictions. Particularly at the outset, tax advice needs to be taken in the jurisdiction where the settlor is resident and consideration should also be given to the tax liabilities of the beneficiaries because planning ahead in this way may be essential in order to reduce tax on ultimate distributions. In this way, trustees will help to minimise the risks of walking unsuspectingly into very difficult tax situations.
1  AC 491
2  SLT 325
3 Re Sydney Walmsley (deceased)  JJ 35
4  1 WLR 7
5 6th February 2002 – unreported