When UK doms can use an offshore trust tax efficiently

We're often asked about when an offshore trust can be used tax efficiently. It can be very attractive for non doms - but what about UK domiciliaries? In this article we look at when offshore trusts can be used by UK doms. Using an offshore trust involves a number of UK anti avoidance rules. Firstly to establish the trust as non resident you would need to ensure that all of the trustees were non resident. If you establish a trust as non resident there are a variety of potential UK tax advantages, however the benefits will be heavily restricted. We'll look at the UK tax implications below Inheritance tax The transfer to a UK discretionary trust would usually be a chargeable lifetime transfer, and the trust itself would be subject to the inheritance tax regime for discretionary trusts. As such there would be a 10 year anniversary charge and an exit charge on the distribution of assets from the trust. However providing the settlor survives for 7 years from the date of the transfer the assets transferred would usually be excluded from their estate for IHT purposes. If you used an offshore trust, the inheritance tax implications would be similar. The transfer to the trust would be a chargeable lifetime transfer ('CLT') for IHT purposes, and therefore a transfer of value above your remaining nil rate band would be subject to a lifetime IHT charge. If the trust was a non resident trust you would not be able to defer gains on the transfer to the trust. If the trust was an excluded property trust it would be outside the scope of the UK IHT discretionary trust regime. However in order for it to be an excluded property trust it would need to hold non UK assets and be established by a non UK domiciliary. If you are a UK domiciliary the trust would therefore be subject to the usual regime of 10 yearly anniversary charges and exit charges. Capital Gains Tax There are some very far reaching anti avoidance rules that apply to UK domiciliaries establishing offshore, non resident trusts, especially in terms of capital gains. The non resident trust would be outside the scope of UK CGT, unless it held assets used in a UK trade. In addition it would be likely there would be no CGT levied in the overseas jurisdiction where the trust is resident. This gives the offshore trust a clear advantage over a UK trust. However there are two key anti avoidance rules that can apply. Firstly S86 TCGA 1992 which attributes gains of an offshore trust to UK resident settlors if defined people are actual or potential beneficiaries or receive a benefit. The term "defined person" included the settlor/their spouse, their children and their childrens spouses and their grandchildren and their grandchildrens spouses. This is a very wide anti avoidance rules and means that an offshore trust could only be used to shelter gains if your the spouse, children and grandchildren (and their respective spouses) were all totally excluded from benefiting from the trust. If they weren't then the settlor would be taxed on the gains of the trust during their lifetime. In the future after they were deceased the gains would effectively be taxed on distributions to the the beneficiaries (see below). Income As a non resident trust it would be exempt from UK income tax on foreign income. Therefore by retaining trust income producing investments overseas the trust could avoid a UK income tax liability. There are provisions to arttibute income to UK individuals if they transfer assets to an offshore trust and have the power to enjoy or benefit from the trust. Therefore in order for the settlor to avoid being taxed directly on the income of the trust they would need to ensure that they and their spouse was totally excluded from benefiting from the trust. If the trust beneficiaries were UK resident children and grandchildren, the trust could therefore initially operate as an effective shelter for foreign income. On the settlors death it could then become a CGT shelter. It should be noted that a distribution to the UK beneficiaries would be subject to UK income tax. However the scope of the tax charge would vary. Broadly speaking there are two options to extract cash from the trust: • Income distribution • Capital distribution Income distributions Distributions of income to a UK beneficiary are subject to UK income tax. Capital distributions Capital distributions from an offshore trust will be taxed under the anti avoidance rules. There are two sets of rules that could apply. Firstly there's the transfer of asset provisions that can apply to tax capital distributions as income where there is accumulated 'relevant' income in the trust. 'Relevant' income for this purpose means income that arises to the offshore trust which can be used to provide a benefit for the beneficiary concerned. Income is only taken into account once for this purpose. Therefore rental income for instance received by the trust and held in the trust would be treated as relevant income for this purposes. If there is any relevant income in the trust and a capital distribution is made the capital distribution could be taxed on the UK resident beneficiary as income to the extent of the relevant income. This is subject to the motive exemption. If there is no relevant income in the trust or if the motive exemption applied there would be no tax charge under this provision. However, in this case the beneficiary would be subject to CGT if there are capital gains in the trust. The capital gains tax charge on the beneficiary effectively looks to tax capital gains that have arisen to the trust (but were exempt as it's non resident) on the beneficiary. There would need to be a separate pool to match the gains with capital payments to beneficiaries. The gains are only allocated to capital payments once. Why make an income distribution? Lots of offshore trusts distribute trust income as income. This has some advantages including: • Withholding tax borne by the income is set against UK tax charged on the beneficiary • The income could be directed at low or nil income beneficiaries (eg children) • UK tax is avoided if the beneficiary is non resident or non domiciled and claims the remittance basis (and retains the income abroad). Complexity of capital distributions Capital distributions can be very complex. It's essential that the trustees provide a full computation of their income and gains for each year. It is necessary to know the total since inception of the trust less any previously allocated to income or capital payments. If there is no relevant income or capital gains in the trust there would be no tax on the receipt, at least at the date of the payment. If relevant income or capital gains arose in the future a tax charge could well apply in the future. One option to wash out gains in the trust could be to distribute the trust fund to a non resident or a non dom beneficiary. These distributions would not be taxed either for offshore income or capital gains (subject to the non dom claiming the remittance basis & retaining the receipt abroad). If the entire trust fund or an amount equal to the net trust gains to date was distributed there should be no further UK tax. In the latter case they could then wait a year and distribute the other trust assets to UK beneficiaries free of UK tax. In terms of whether to use an offshore or UK based trust, this is something that you would need to consider. However, if the beneficiaries are to remain UK resident the income/gains would be subject to UK tax on the trust distributions. The tax treatment of offshore trusts is also very complex and you would incur substantially higher charges in terms of the initial set up and ongoing trust management expenses (including appointing non resident trustees etc).