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How do offshore trusts work?
A trust or settlement is a legal relationship between three parties; the settlor, the trustees and the beneficiaries. The settlor transfers funds or assets to the trustees, who then administer those assets (known as the ‘trust corpus’) for the current or future benefit of the beneficiaries.
Today, trusts are settled for a number of reasons, including asset protection, flexibility, confidentiality and for tax planning reasons.
But what makes a trust ‘offshore’?
An offshore trust is one where the trustees are not resident in the UK for tax purposes. The residence of the trustees as a body may be different from their own individual tax residence status.
If all of the trustees are resident in the UK, the trustees as a body are, unsurprisingly, UK resident for tax purposes.
Similarly, if all of the trustees are not resident in the UK, the trustees as a body are not UK resident for tax purposes.
If at any time at least one trustee is resident in the UK and at least one is not, the body of trustees is resident in the UK only if any settlor of the trust (there may be more one) was resident, ordinarily resident or domiciled in the UK at any time when he or she introduced property into the trust.
Most modern offshore trusts have a single corporate non-resident trustee so these rules are relatively rarely seen in practice.
The vast majority of offshore trusts are established under foreign laws. Those laws may require that a protector is appointed to oversee the exercise of certain powers that are vested in the trustees. The role of the protector is not to act as a trustee and his or her main powers usually consist of a veto over the trustees’ power to make distributions to trust beneficiaries and a power to remove the current trustees and to appoint new trustees.
Difficulties may arise where the settlor or protector is reserved certain rights over the administration and disposition of trust assets. If the nature and extent of those reserved rights mean that the settlor or other party is effectively acting as a trustee, it is possible that the non-resident status of the trust may be compromised.
The obvious first point is that a trust should be established in a jurisdiction where little or no tax will be suffered on its income and assets. Other considerations will be the legal system in the chosen jurisdiction, for example the local laws affecting trusts, which may have an impact on such matters as confidentiality and protection of assets from creditors. Such matters as the physical location of the underlying assets, time zone, language and, of course, the reputation and security of the jurisdiction will all be relevant factors. Similar considerations will be necessary in choosing professional trustees. The competence of the trustees, the strength of the regulatory framework in the jurisdiction, practical communication issues and the trustees’ likely fees will all need to be considered.
Offshore trusts can be effective tax planning vehicles for people who are UK resident for tax purposes but are not domiciled in the UK (so-called Resident Non-Doms).
Capital gains tax
If the settlor of an offshore trust is a resident non-dom, capital gains that arise within the trust will not generally be taxable on them, even if they or their family can benefit from the trust. However, capital gains tax may be payable by a UK resident beneficiary, if and when the gains arising within the trust are matched with capital payments made to, or benefits received by, that beneficiary.
However, if that UK resident beneficiary is also not domiciled in the UK, they may be able to elect to be taxed on the remittance basis, in which case any trust gains matched with capital payments or benefits will only be taxable in the UK if they are brought into or enjoyed in the UK.
Until 5 April 2017, it was possible to “wash” gains within an offshore trust by distributing them to non-resident beneficiaries. This would mean that any pool of undistributed gains which could be matched with capital payments made to, or benefits enjoyed by, UK resident beneficiaries would be reduced without any UK resident incurring a UK tax charge. With effect from 6 April 2017, it will no longer be possible to wash gains in that way.
Offshore trusts may also be an effective way of deferring tax on foreign source income when the settlor is a UK resident non-dom. If the settlor is a resident non-dom and they and/or their spouse or civil partner cannot benefit from the trust, the settlor will only be taxed on foreign source income actually remitted to the UK, provided that they claim the remittance basis. Even if a resident non-dom settlor, their spouse or civil partner can benefit from a discretionary trust, it may still be possible in certain circumstances for tax to be deferred on foreign source income, provided that the income is not brought into or otherwise enjoyed in the UK.
Offshore trusts can be useful planning tools in avoiding UK inheritance tax. Non-doms are not liable to UK IHT in respect of their overseas assets. However, once an individual has been resident in the UK for a certain period of time – before 5 April 2017, this was seventeen years but from 6 April 2017, the period has been reduced to 15 years – they are treated as deemed domiciled in the UK (see below).
However, foreign assets comprised within a trust settled while the settlor was non-UK domiciled, remain “Excluded Property” for inheritance tax purposes and are not subject to IHT – even if the settlor subsequently becomes domiciled or deemed domiciled in the UK. This makes such trusts extremely useful and attractive for long term UK residents with substantial foreign situs assets.
The answer is rarely, as the opportunities for UK domiciled individuals to use offshore trusts tax-efficiently are much more limited than they are for resident non-doms.
Where a UK resident and domiciled settlor, their spouse, children, grandchildren and their spouses can benefit from an offshore trust, the settlor will be taxed on any gains as they arise.
It is rare that the class of beneficiaries of an offshore trust will exclude such a wide category of individuals. If, however, either the settlor is deceased or there are no close family members who can benefit from the trust, then UK tax on any gains arising within the trust will not arise until distributions are matched with distributions to UK resident beneficiaries.
Tax on the foreign income of a discretionary trust settled by a UK resident and domiciled individual will be deferred if the settlor and their spouse or civil partner are excluded from benefiting, for instance in the case of a trust for the benefit of the settlor’s children or grandchildren.
If a UK domiciled settlor is excluded from all benefit from a trust, whether it is an offshore trust or not, the assets comprised within the trust will be outside the settlor’s estate for IHT purposes, although the trust will be subject to 10-year charges and exit charges and there may be a charge on the value of assets or funds gifted into the trust. There may be further IHT to pay if the settlor does not survive the period of 7 years from the gift or gifts into trust or the time he is excluded from benefit, whichever arises later.
Recent changes to the taxation of non-doms have necessitated consequential changes to the taxation of offshore trusts. Most of these are taken into account in the preceding paragraphs. However, there are specific provisions which affect “Protected Settlements”.
These provisions apply where an individual who settled an offshore trust while not domiciled in the UK becomes deemed domiciled for UK tax purposes under the 15-year rule effective from 6 April 2017. They ensure that such an individual is not taxable on income or gains of their offshore trust until they receive a distribution. However, this protection is lost if the trust is “tainted” by any addition to the trust fund after becoming deemed domiciled.
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