In our previous briefing we mentioned excluded property trusts (or EPTs) in the context of non-doms. So, what are they?
Factors to consider when making an EPT
If an individual has a foreign domicile (a non-dom) and is not deemed to be UK domiciled as a consequence of being UK resident for over 15 tax years out of 20, his or her non-UK assets are outside the scope of inheritance tax (IHT). (We will use the phrase “becoming domiciled in the UK” and cognate phrases to include becoming UK domiciled under the general law or becoming deemed domiciled for tax purposes as a result of being UK resident for over 15 tax years.) On becoming domiciled in the UK, the non-UK assets come within the scope of IHT. Before that point – and assuming the requisite wealth is available – it is open to that individual to make an EPT to avoid the IHT consequences of becoming UK domiciled.
Understanding the basics
A trust is not a company and no one “owns the trust”. Broadly, it is an arrangement whereby you (the settlor) part with the ownership of specific assets (which become the trust fund) by transferring them to a third party (the trustee) who is bound to hold them for the benefit of others (the beneficiaries, which can include the settlor). This is usually documented in a trust deed which defines the beneficiaries and the nature of their interest in the trust fund as well as defining the duties of the trustees within the framework of a wider trust law.
The trustees become the legal owners of the assets making up the trust fund but they do not own them for their own benefit: if the trustee is a company, the trust assets do not form part of its balance sheet and are not available to the creditors of the trust company. The trust deed typically gives the trustee wide powers for the investment of the trust fund.
Trusts vary considerably but many are discretionary: there is a class of beneficiaries and it is up to the trustees to choose who among them to benefit and by how much and how frequently, whether with income or capital, whether by way of a loan or permitting a beneficiary to occupy a property or have custody of a physical object, such as a work of art. On the face of the trust deed, the trustee can pick and choose who is to benefit and in what way but in practice the settlor will have written a letter of wishes to the trustee indicating which beneficiaries should benefit and how. Very often, the letter of wishes makes the settlor in effect the principal beneficiary during his or her lifetime.
As these arrangements usually involve a professional, corporate trustee, it is advisable for the trust deed to carve out certain powers such as powers of veto on the distribution of capital or the power to change the trustees. The person exercising these carved out powers could be the settlor or a third party, usually called the protector.
What makes a trust an excluded property trust and what is the significance?
So much for the basics but what makes a trust an excluded property trust and what is the significance?
A trust will be an EPT provided the settlor was neither domiciled nor deemed to be domiciled in the UK at the time of making the trust and the trust fund comprises non-UK assets at all relevant times, that is, on making the trust, on the occasion when capital is distributed from the trust, on the 10-yearly anniversaries of the trust and on the death of the settlor. All of these are occasions when IHT could be charged at 20 per cent (inception), 0 per cent to 6 per cent (distributions), 6 per cent (every 10 years), and 40 per cent (death). However, IHT is not charged because the settlor was not UK domiciled when the trust was made and the trust assets were not situated in the UK on those occasions – and that’s it. It is not actually necessary for the trustee to be resident outside the UK for the trust to be an EPT but the trustee will usually be resident in a non-taxing jurisdiction because of other taxes.
In contrast, if the individual is UK domiciled, the above IHT charges usually preclude him or her from making a trust and instead those assets will be within the scope of IHT and exposed to tax at 40 per cent on death.
It’s worth noting that there is no requirement for the settlor to be domiciled outside the UK after making the trust, so even if he or she acquires a domicile in the UK at a later point, as long as the trust assets are situated outside the UK, they remain outside the scope of IHT indefinitely.
It is possible to make a UK asset a non-UK asset by holding the UK asset through a non-UK company and effectively ring-fencing the underlying UK asset from IHT. This also used to be the case with UK residential property but this is generally no longer the case since April 2017 as the shares in a non-UK company holding UK residential property are effectively treated as UK assets and exposed to the IHT charges mentioned above. (As it was, since April 2013, these arrangements were becoming unattractive because of the annual tax on enveloped dwellings, called ‘ATED – to distinguish it from our beloved taxes.) The use of holding companies presents other tax issues but that is the subject of a future briefing.
Of course, IHT mitigation is not the sole reason for placing assets in trust. We have mentioned other taxes but there are also succession issues. The trust provides a mechanism for wealth to pass down the generations without the need for a will (in England, a public document following death) or probate and perhaps to overcome restrictions in foreign succession law. They also provide protection against third party claims (depending on the nature of the claims) and facilitate the more orderly management of wealth under one roof.
If you require further information about anything covered in this briefing, please contact Nick Dunnell or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, April 2022