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Settlor-interested trusts

The pitfalls of tax planning with trusts

One of the questions that is frequently asked by clients of Technical Connection relates to the liability to tax of the settlor of a trust. Many questions appear to stem from a misunderstanding of the term "settlor". This month we seek to clarify some of the issues using a case study. It is particularly relevant toUKsettlors of offshore trusts.

The case study

This is based on a recent enquiry related to an actual situation. Briefly, the facts were as follows:

Some years ago Mr A, a friend of Mr X, created a discretionary trust with a sum of £10 in an offshore jurisdiction. Mr A and his brother (both non-UK resident) were appointed as trustees of the trust and both were excluded from all benefit under the trust. The beneficiaries of the trust were the children of Mr X and anybody else that the trustees appointed as beneficiaries. Neither Mr X nor his spouse were excluded from benefit under the trust.

Mr X, (UK resident and domiciled at all times), in his quest to mitigate his potential IHT,  income tax and CGT  liabilities, proceeded to transfer several properties to this trust, including his principal residence and some buy-to-let properties.

The questions posed were: Has Mr X improved his tax position? Has he achieved his tax objectives in relation to income tax, CGT and IHT?  In other words, did his "planning" work? What were the tax results of the transfers he had made to the trust and what were the subsequent income tax and CGT consequences?

The rules and the definitions

First, who is a settlor?

A settlor is a person who 'makes a settlement', that is someone who puts or gifts money or other assets into a settlement. This is known as 'settling' property and it can be done directly or indirectly.

A 'settlor-interested trust' is one where the settlor has an interest, as defined in s625 of the Income Tax (Trading and Other Income) Act ('ITTOIA") 2005. A trust will be 'settlor-interested' if the settlor or his/her spouse (or civil partner) can benefit from the trust propertyin any way. In practice, this means that the settlor and spouse are not specifically excluded from all benefit, even if they are not specificallyincludedas named beneficiaries.

The 'settlements' provisions treat trust income of a settlor-interested trust  as belonging to the settlor for income tax purposes (ITTOIA 2005, s 624).

For CGT purposes, a settlor is treated as having an interest in a settlement if any of the followingmaybenefit from the trust (TCGA 1992, s 169F)

  1. The settlor 
  2. The settlor's spouse;
  3. A "dependent child" (or stepchild) of the settlor (aged under 18 and unmarried and not in a civil partnership).

Capital gains tax holdover relief is not available on a transfer of chargeable assets to the trustees if the settlor has an interest in the settlement (TCGA 1992, s 169B).

For IHT purposes, if a settlor creates a discretionary trust and is not specifically excluded from the discretionary class in a way that they cannot benefit at any time, they would still be able to benefit from the property given away. This will be regarded as a gift with  reservation of benefit (FA 1986, s 102, Sch 20).

This will be the case regardless of whether the settlor actually receives any benefit from the discretionary trust - the fact that the settlor is capable of benefiting means that the gift with reservation rules will apply

The outcome

So has Mr X achieved his objectives? 

Given the definition of "settlor" for tax purposes, Mr X will clearly be considered as the settlor in relation to all the assets he has transferred to the trust. This was everything except the initial £10 - the settlor of that sum was Mr A. 

Let us now look at each tax in turn. 

Inheritance tax

Despite the fact that Mr X is not listed as a beneficiary under the trust, the fact that he has not been specifically excluded from all benefit and that the trustees have the power to add any beneficiary (other than Mr A and his brother) means that any gifts made by Mr X into this trust would have been gifts with reservation of benefit (GWR).This means that the value of the trust fund representing those assets remains in Mr X's estate for IHT purposes. Of course, the GWR is not the only IHT complication. 

Every time Mr X transferred an asset to the trust, he made a chargeable lifetime transfer for IHT purposes which, depending on values involved, could have resulted in lifetime charges at 20% increasing to 40% on death within 7 years. To prevent a double charge to tax, relief under the Double Charges Regulations may be available if the original gifts took place less than 7 years ago.

And there are also the periodic and exit charges to consider. 

In short, not only did Mr X not achieve any IHT mitigation, he is potentially in a worse position from a tax point of view than he would have been had he done nothing.

Income tax

The settlement made by Mr X clearly falls within the definition of a   'settlor-interested trust'. This means that all the trust income as it arises will be taxed on Mr X. But again, this is not the end of the story. Since 2006 the fact that a trust is a settlor-interested trust does not absolve the trustees from paying tax on the trust income (effectively on the settlor's behalf). In the case of Mr X the trustees are non-UK resident but the trust income is generated fromUKbuy-to-let properties. This means that the non-resident landlord rules will apply (broadly speaking, this requires the tenants to deduct 20% tax from any rent payments and pay it over to HMRC).

So again Mr X's income tax position has not improved but got more complicated.

Capital gains tax

Again, the settlor-interested trust provisions will apply. This means that CGT hold-over relief would not apply to any transfers to the trust (resulting potentially in immediate CGT liabilities when the assets were transferred to the trust). There could also be potential complications with claiming principal residence relief (PPR) on the property occupied by Mr X on any subsequent disposal given that to qualify for the PPR exemption S225 TCGA1992 requires that the property is occupied by a person entitled to occupy it under the terms of the settlement. As Mr. X is not actually listed as a trust beneficiary, that could be difficult to argue.

COMMENT:

As can be seen from the above, there are various potentially adverse tax implications where an individual settles cash or other assets on trust but is capable of benefiting under the trust. Various anti-avoidance rules exist for income tax, capital gains tax and inheritance tax purposes, which can give rise to unforeseen tax problems for the unwary.

In the above case study Mr X has unfortunately only made his tax position more complicated and quite possibly incurred unnecessary tax liabilities. And it's not like he could just pretend that none of these transactions ever happened. To unscramble the arrangement there will potentially be further tax consequences depending on the values involved.

Of course, professional advisers should be able to point out these potential problems and ensure that any planning that may be implemented avoids them.