Finance Act No.2 2017 creates a new category of “Protected trusts”, where the settlor is not actually UK domiciled, but becomes UK deemed domiciled under the changes in this Act.
This article considers the position for a trust which has been and is settlor-interested for income tax, and which holds income which arose before 5th April 2017 which has not been remitted to the settlor.
We are assuming here that the trust has segregated its capital, income and gains so that it can choose the source of the funds to be invested in the UK. We also assume that the income is segregated into pre and post 5th April 2017 accounts.
Trustees can use clean capital to invest in the UK without triggering a tax charge on the settlor. We consider in this article which other funds the trustees can invest in UK assets without a tax charge, and how this investment might be structured.
Treatment of income from UK assets in a protected trust
Under the new protected trust rules, trust income and gains arising after 5th April 2017 would not become chargeable to tax if the trustee invested the money in UK assets directly. This is because the effect of the protected trust rules is that the income and gains of the trust are not treated as being those of the settlor, whether or not they have become deemed domiciled in the UK.
However, if the assets give rise to income at trust level, this is UK source income and taxable, and so normally an overseas underlying company would be used to make UK investments. This ensures that no UK income arises at trust level, when it would be assessable on the settlor. As we explain below, in some circumstances it won’t be beneficial to use an overseas company to ensure UK income tax is not payable, as this will negate the ability to invest historic overseas income in the UK without a taxable remittance.
Transition provisions
There are also transition provisions for pre 5th April 2017 income, which apply where the trust was settled by an individual who
- has been UK resident since the settlement was made
- was non-domiciled and assessable on the remittance basis throughout the period to 5th April 2017, and
- was “interested in” the trust for income tax purposes.
The income also has to have arisen post 5th April 2009. If all of these conditions are met it follows that the income won’t have been subject to UK tax, as the remittance basis would have applied.
The transition provisions allow the pre 6th April 2017 income to be invested in the UK without triggering a tax charge, by defining this as not being a remittance of the income which had arisen under the old rules.
The legislation works by treating the trustees themselves as not a “relevant person” for the purposes of determining whether there has been a remittance to the UK.
Practical issues
One practical issue is that the transition exemption only applies where the trustees remit pre 5th April income to the UK. If the trustees lend or subscribe this money to an overseas underlying company, and that company (a relevant person) invests in the UK, then there will be a tax charge.
The second practical issue is that the transition exemption only applies for the purposes of the income tax settlement legislation, and not for the purposes of the transfer of assets abroad legislation. So, if the trustees have an account comprising only pre 5th April 2017 income, but haven’t split this between income taxable under the settlements legislation and income taxable under the transfers of assets legislation, then this may prevent the income being used because it is not clear what part of it if any falls within the transition provisions.
Possible strategy- use of UK underlying company
One point to consider is whether using a UK underlying company to invest in UK assets would be appropriate. If the trust funds either debt or equity of such an underlying company with pre-5th April 2017 income, in addition to clean capital and post 6th April 2017 income and gains, then this is not a taxable remittance.
The use of an overseas underlying company no longer provides CGT or IHT protection for UK residential property, and if the current proposals are enacted, it will not provide CGT protection for any UK real property. The IHT protection for non-residential property may well be lost in future.
If the UK underlying company invests in UK shares, it may be a low tax vehicle as a result of the Substantial Shareholdings Exemption (where investments in shares are of more than a 10% holding) and the distribution exemption, which means that UK companies don’t suffer corporation tax on dividends from other UK companies. The shares in the UK underlying company are within the scope of UK IHT.
Thus a UK underlying company may be worth considering.
Income arising in that underlying company is not arising to a person abroad so if benefits are provided, this does not create an income tax charge under the transfer of assets abroad. The income in that UK company can be retained and potentially used to make loans to other underlying companies of the same trust, which should not taint the trust and thus can be interest free.
Therefore, if the trustees can identify the pre 5th April 2017 income which is within the transition provisions, this offers more flexibility for investments in the UK than would be available under Business Investment Relief.
Conclusion
The transition provisions were designed to encourage trustees of protected trusts to invest in the UK, but the fact that they don’t cover income assessable under the transfer of assets abroad legislation significantly restricts their usefulness in practice.
For a trust which can be confident in identifying that these provisions apply, it may be worth considering using a UK underlying company rather than an overseas underlying company.
As is often the case with the non-domicile changes in Finance Bill No 2 2017, the practical application is complex and offers many traps.
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