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Inheritance tax and trust considerations for non-UK domiciled individuals

Changes to the UK tax rules concerning individuals who are not domiciled in the UK but are either resident in the UK or own property here were announced in the Summer Budget. This was followed by the publication of the consultation paper "Reforms to the Taxation of Non-Domiciles" on 30 September 2015 and further details are expected in the December Finance Bill.

Readers will be aware that assets situated outside the UK, and held in a trust set up by a non-UK domiciled settlor, do not attract the usual IHT charges applicable to trusts - the trust has excluded property status. A recent decision of the High Court in Barclays Wealth Trustees (Jersey) Ltd v HMRC [2015] EWHC 2878 (Ch) has confirmed some important points on how HMRC interprets legislation affecting such trusts.  This month we will look at excluded property trusts as well as the latest proposals affecting non-domiciles.

Take care with your excluded property trusts

One of the key planning strategies for non-UK domiciled individuals, who are likely to become deemed domiciled because of their residence in the UK and who are keen to protect their offshore assets from IHT, is to create an excluded property trust (EPT). As long as the property remains excluded, even if the settlor is one of the beneficiaries (as would normally be the case) the trust property will remain outside of the UK IHT net even after the settlor has become UK domiciled.

The above-mentioned case was  an appeal by Barclays Wealth Trustees (Jersey) Ltd and Michael Dreelan (the settlor of the trust in question) against a determination by HM Revenue and Customs pursuant to section 222(3)(b) of the 1984 Inheritance Tax Act of a liability for inheritance tax said to arise in relation to the ten-year charge applicable to trusts.

The facts were as follows. The  property in the Michael Dreelan Trust ("MDT") was "excluded property" for the purposes of the Act, settled by a non-domiciled settlor, and would have been free from the ten-year charge had it remained there. Some of the property was transferred from MDT to another trust, the Dreelan Bros Joint Trust, which had the same settlor but who, by the time of that transfer, had become domiciled in the UK. The property was no longer excluded at that point. It was then transferred back to the MDT. The basic issue was whether that property re-acquired excluded property status.

The judge decided that at the time of the transfer back into the MDT trust the property had lost its status as excluded property for the purpose of the ten-year charges and rejected the appellants' arguments that what mattered was only the domicile of the settlor when he created the first settlement and the fact that the property was situated outside the UK at the time of the ten-year anniversary. Their appeal was dismissed albeit that leave to appeal was granted so we may not have heard the last of this. The important conclusion from this case is that great care needs to be exercised when dealing with EPTs in order to ensure that their excluded property status is protected.

Although, in the context of the proposed changes to the taxation of non-domiciles, the Government has said that the assets of an EPT will generally remain outside the scope of IHT, there are plans to introduce an exception to this rule, for a particular type of settlor, as explained below.

Proposed changes to the tax treatment of non-domiciled individuals

Broadly, these changes consist of:

  • amending the deemed domicile rule for long-term residents to 15 out of 20 (from 17 out of 20) tax years for all tax purposes from 6 April 2017, i.e. extending it to CGT and income tax;
  • amending the "returning to the UK domicile rule" so that anyone who returns to the UK will reacquire their UK domicile from the date of  return; and
  • bringing UK residential property owned by a non-UK domiciled individual into the IHT net.

The new rules, which are intended to take effect from April 2017, will mean that the remittance basis charge of £90,000 (that currently applies to those who have been resident for at least 17 of the past 20 tax years) would no longer be applicable from the tax year 2017/18; and an individual will become deemed domiciled for IHT at the start of their 16th consecutive tax year of UK residence, rather than at the start of their 17th tax year of residence as is the case under the current rules.

In order to allow non-domiciles, who are internationally mobile, to continue to benefit from "non-dom" status in a way that is not appropriate for those who are firmly based in the UK, the legislation will allow someone who has lived in the UK for 15 consecutive tax years and who then leaves the UK for 6 or more consecutive tax years, to return here and claim non-dom status again for another 15 years (assuming they still had a foreign domicile status under general law).

However, this would mean that, while an individual who has become deemed-UK domiciled and ceases to be resident in the UK will continue to be deemed-UK domiciled for up to 6 years following their departure, an individual who is domiciled in the UK who leaves and acquires a domicile of choice in another country could potentially become non-domiciled for IHT purposes more quickly. This is because the current IHT rules provide that an individual who ceases to be domiciled in the UK will only continue to be treated as domiciled in the UK if they have been domiciled in the 3 years immediately preceding the chargeable event.

To address this disparity, the government is proposing to introduce a rule which treats a UK domiciliary as non-domiciled on the later of the date that they acquire a domicile of choice in another country, and the point when they have not been resident in the UK for 6 years. A similar situation arises in respect of non-domiciled spouses of UK domiciles who elect to be treated as UK domiciled for IHT purposes. Under the current rules, such an election will cease to have effect if the electing spouse is resident outside the UK for more than four full consecutive tax years. It is proposed that this period is also aligned to 6 tax years under the new rules.

What are the proposed rules for offshore trusts created by non-domiciled settlors?

As indicated above, in principle the government does not intend to change the rules which will apply to EPTs where a person has become deemed-UK domiciled under the new rule. However, an exception to this rule will operate as follows.

If someone with a UK domicile of origin acquires an overseas domicile and sets up an offshore trust while non-UK domiciled then, once that individual subsequently becomes UK resident (and their UK domicile is revived) the assets in that trust will cease to qualify as excluded property and will be liable to IHT charges. Since the residence criteria will be based on the statutory residence test, under which individuals are either resident or non-resident for the whole year, this could create situations in which property will switch from being excluded property to being liable to IHT under the 'relevant property' regime for periods of one or more tax years and trustees will therefore need to consider whether a ten- year charge arises at any point during each period the settlor is UK resident.

In addition, it is proposed that an individual with a deemed UK domicile who had established an offshore trust (from which they can benefit, i.e. a settlor-interested trust) would not be taxed on the income and gains of the trust on an arising basis (as might be expected, if the concept was that such an individual should be treated in exactly the same way as a UK domiciliary). Instead, fiscal impositions for the settlor in respect of the trust would be limited to tax on any UK source income of the trust, and tax on any benefits received from the trust. This, however, may give rise to some peculiar consequences.

The consultation document suggests that a deemed domiciled individual receiving a benefit from an offshore trust should be taxed on the value of the benefit received, whether they receive the benefit in the UK or not (which is to be expected), and  without any reference to the income and gains of the trust. This would mean, for example, that a capital payment which had not originated from income or capital gain (but, say, from the original capital settled into the trust) would be taxed at income tax rates on the settlor.  This is a completely new approach and it remains to be seen how this provision, if indeed it passes into legislation, will translate into practice.

Conclusions

Clearly, we need to wait and see what the final shape of the proposed legislation will be but, on the basis of the current proposals, there should still be scope for offshore trusts to be used as roll-up vehicles for the benefit of foreign domiciled families and to protect excluded property from IHT. Any advisers with clients falling into this category need to be aware of the proposals and discuss them with their clients. As always professional advice will be necessary in all such cases.