Trustees should review inter-trust loans before 6 April 2018 to ensure that trusts are not accidentally tainted with potentially disastrous tax results for UK resident settlors
Finance Act 2017 (FA17) introduced the new concept of "protected settlements" to non-UK resident trusts, whereby the UK resident settlor is not automatically liable for tax on trust gains and foreign income in the absence of distributions. This enables protected settlements to be used for tax-free accumulation of gains and foreign income or, at least, enables the settlor or beneficiaries to regulate their effective rate of tax by reference to their spending. (The trust will not be protected if the settlor is either domiciled in the UK under general law or has become deemed domiciled by virtue of being a returning non-dom).
Ensuring the trust remains a protected settlement is particularly important once the settlor has become deemed domiciled in the UK as a result of being UK resident for more than 15 out of 20 tax years. FA17 sets out certain criteria for a trust to be protected, including that the trust should not be "tainted" (by the provision of property or income for the purposes of the trust) once the settlor has become deemed domiciled. If the trust becomes tainted, it is tainted for good, resulting in the settlor being liable for tax on trust gains and foreign income on the arising basis. This briefing focuses on just one form of tainting as it is likely to be overlooked by trustees, namely inter-trust loans.
Tainting by inter-trust loans
Where there is a loan from one non-resident trust to another and the settlor is the settlor of both trusts or the settlor of one and a beneficiary of the other, then those loans need to be on arm's length terms to avoid tainting. What constitutes "arm's length" is not defined except in relation to interest, which has to be paid (it would seem) each tax year:
- FA17 specifies that in the case of a loan to trustees, interest must be at the official rate or more; and in the case of a loan by the trustees, interest must be at no more than the official rate.
- In the case of inter-trust loans, these requirements mean that the only rate of interest that can be charged is the official rate. If the rate is above the official rate, the creditor trust will be tainted but, if it's below the official rate, then the borrowing trust will be tainted.
We understand that, in this context, HMRC regards loans to or from closely held companies underlying trusts as being the same as loans to or from trustees. So these will also need to be on arm's length terms and interest at the official rate will also need to be paid.
End of UK tax year planning
Trustees and settlors will need to consider the following scenarios:
- Where the settlor became deemed domiciled on 6 April 2017, there is a year's grace period during which inter-trust loans need to be put on arm's length terms for the year to 5 April 2018 and the interest must actually be paid by then. In addition, interest must be paid in each successive tax year to avoid tainting.
- Where the settlor is going to be deemed domiciled on 6 April 2018, inter-trust loans will need to be on arm's length terms from that date, with interest being paid for that tax year and successive tax years.
- Where there are settlors falling into either category, the parties to the loans will have until 5 April 2018 to put their house in order.
- In any tax year when the settlor is in the 15th tax year of being resident in the UK, as part of planning for him or her becoming deemed domiciled in the 16th tax year, the trustees should review all inter-trust loans (including loans involving underlying companies) and, where necessary, place them on arm's length terms.
A few observations
- The official rate is currently 2.5%. In many cases, this rate of interest will be manageable but it is at a historic low and, over time, is likely to increase once the base rate starts going back to its norm.
- Payment of interest by one trust (or underlying company) will generate income in the structure which, in due course, is likely to come into charge when matched with distributions.
- Often loans are made from one structure to another because of a lack of liquidity in the debtor structure, so it is likely that the debtor does not have the means to pay interest. In that event, other means will be needed to avoid tainting, such as restructuring the loans, where the circumstances allow.
Given the significance of tainting, it is essential to seek advice in good time as any remedial action may take time to implement and FA17 allows no leeway for delay or error.
If you require further information on anything covered in this briefing please contact Nick Dunnell or your usual contact at the firm on 020 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, January 2018