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Malcolm Finney considers the impact of the Finance Act 2008 Capital Gains Tax changes affecting non-resident trusts. 

Background

The Finance Act 2008 has changed quite significantly the capital gains tax treatment of offshore resident trusts primarily with respect to the non-UK domiciled but UK resident individual, although the changes also impact upon the UK domiciled and UK resident individual.

Neither UK nor non-UK source capital gains of non-UK resident trusts are subject to capital gains tax on the part of the trustees. In principle it is therefore advantageous for a UK resident settlor to utilise an offshore trust in order to avoid capital gains tax charges whether on UK or non-UK situs assets.

However, anti-avoidance provisions may apply to preclude this advantage from applying.

Settlor interested rules

TCGA 1992 Section 86 (charge on settlor)

TCGA 1992 Section 86 is the relevant section here. The section has not been changed by FA 2008.

Where section 86 applies (inter alia, if the settlor, spouse or children are potential beneficiaries) the capital gains of the trust are apportioned to the UK domiciled (but not non-UK domiciled) and UK resident settlor who is then subject to capital gains tax thereon.

One of the implications of the restriction of section 86 to UK domiciled settlors only, is that the non-UK resident trust offers the non-UK domiciled settlor an effective tax planning vehicle with respect to investments in non-UK (or indeed UK) situs capital growth assets. In this case, neither the trust nor the settlor is exposed to any capital gains tax charge on trust asset disposals (subject to below).

TCGA 1992 Section 87 (charge on beneficiaries)

TCGA 1992 Section 87 applies where a beneficiary receives a “capital payment” or some other form of “benefit” from the non-UK resident trust. However, it can only apply if section 86 (see above) does not apply. Thus, section 87 will always apply if the settlor is non-UK domiciled but will not apply where the settlor is UK domiciled (unless in the latter case the trust is not settlor interested).

FA 2008 has had a significant impact on section 87.

Before FA 2008, non-UK domiciled beneficiaries were not “caught” by the section whereas, post FA 2008, such individuals are brought within the ambit of the section.

Thus, before FA 2008 neither sections 86 nor 87 applied to the non-UK domiciled individual. As a consequence, a significant tax planning opportunity arose for such individuals resident in the UK. Where the non-UK resident trust made capital gains it could effect payments to the non-UK domiciled but UK resident beneficiaries in the UK without any capital gains tax charge arising either under section 86 or 87. This represented a major “loop-hole” for the non-UK domiciled individual.

Since FA 2008 however, whilst the non-UK domiciled individual is still not within the ambit of section 86, section 87 now applies to such an individual.

Although now within the ambit of section 87 the remittance basis still applies to the non-UK domiciled but UK resident individual in receipt of a capital payment or some other form of benefit. This requires the appointment of trust monies in respect of trust capital gains to be made outside the UK. Similarly, any other form of benefit needs to be provided to the beneficiary outside the UK.

It should be noted, however, that any trust gains arising on UK situs assets are to be regarded as if they were gains arising on non-UK situs assets if the beneficiary concerned is non-UK domiciled and claims the remittance basis. Thus, all section 87 trust capital gains are in principle eligible for remittance basis treatment (assuming the individual beneficiary is non-UK domiciled). A non-UK domiciled individual beneficiary who does not, however, claim the remittance basis will be taxed on the arising basis under section 87 in the same manner as a UK domiciled beneficiary.

A “capital payment” to a beneficiary is defined as any payment by the trust which is not subject to income tax on the part of the beneficiary and includes a transfer of assets or some other form of benefit which is conferred on the beneficiary.

FA 2008 has, however, fundamentally altered the allocation process applying under section 87 to capital payments made to beneficiaries on or after 6th April 2008.

Before FA 2008 the allocation was carried out on a so-called FIFO (i.e. “first in first out”) basis. Post-FA 2008, the allocation is to be carried out on a LIFO (“last in first out”) basis. The new LIFO basis applies whether the settlor of the non-UK resident trust is UK or non-UK domiciled.

Under TCGA 1992 s 87, the capital gains of the trust are apportioned to beneficiaries who receive capital payments from the trust. If in a tax year the trust makes capital gains and makes capital payments to beneficiaries in that tax year, then the capital gains are apportioned to the beneficiaries up to the amount of the capital payments. The beneficiary is then liable to capital gains tax on the apportioned capital gains. If the capital gains of the trust for a given tax year exceed the capital payments of that tax year, then the excess may be carried back to the prior tax year and apportioned to capital payments made in that tax year which have not previously been matched and so on. In the event that a surplus of capital gains still remains in the trust then such capital gains will be available to match against future capital payments made by the trust.

The trust may, however, make capital payments to beneficiaries prior to the trust having made any capital gains. In such cases any capital gains made by the trust at a later date are then, at that time, apportioned to the capital payments thus precipitating the capital gains tax charge at that time.

Thus, under the new rules, post FA 2008, later capital payments will now be matched with later trust gains (pre-FA 2008 capital payments were matched with the first available trust capital gains). This new basis is to apply whether the beneficiaries receiving the capital payments are UK or non-UK domiciled and the new LIFO rule applies when matching any trust gains to capital payments where such payments are made on or after 6th April 2008.

Transitional provisions

No capital gains tax charge will arise on a non-UK domiciled beneficiary where a capital payment received before 6th April 2008 is matched with capital gains of the tax year 2008/09 or later. Similarly, no capital gains tax charge will arise on a non-UK domiciled beneficiary where a capital payment received in or after 2008/09 is matched with capital gains of 2007/08 or any earlier tax year.

In addition, the trustees (not settlor or beneficiaries) of the non-UK resident trust (whether the settlor was UK domiciled or not) have an option under FA 2008 to “rebase” the trust assets to their market value as at 6th April 2008. The effect under such rebasing is that trust capital gains accruing but not realised prior to 6th April 2008 will not be chargeable on the part of the non-UK domiciled beneficiary (whether the remittance basis claim has been made or not) if matched to capital payments made on or after 6th April 2008. Under the LIFO basis of matching the post-5th April 2008 element of any trust gain will be matched prior to the pre-6th April 2008 element in respect of capital payments made on or after 6th April 2008.

The election is irrevocable and applies to all trust assets. It must be made on or before the 31st January following the first tax year in which a capital payment is made to a UK resident beneficiary irrespective of the beneficiary’s domicile status.

Pre FA 2008, where a capital payment was either in whole or in part matched to the section 87 capital gains pool a possible supplementary charge applied, thus increasing the capital gains tax charge on the beneficiary.  In view of the reduction in the capital gains tax rate under FA 2008 to a flat 18% (compared to a marginal rate of 40% pre FA 2008) the minimum and maximum supplementary charges are, post 6th April 2008, 3.6% and 10.8% (compared to 8% and 24% respectively pre FA 2008).

“Washing out”

“Washing out” continues to be available as a capital gains tax mitigation technique post FA 2008. Under this technique capital payments are made to non-UK domiciled individuals (whether UK resident or not) or to non-UK resident UK domiciled individuals so that the respective capital gains available for matching are reduced without at the same time precipitating a capital gains tax charge on such beneficiaries. Capital payments may then be made without at that time precipitating any tax charge (due to a lack of “matchable” capital gains within the trust).

Conclusions

The pre FA-2008 tax position with respect to non-UK resident trusts and non-UK domiciled but UK resident trusts is now, post FA 2008, less favourable; albeit the section 87 charge is, post FA 2008, restricted to 28.8% compared to the pre-FA 2008 charge of 64%.

Nevertheless such trusts are still of value for capital gains and income tax subject to careful planning.

FA 2008 (and indeed FA 2006) did not impact on the excluded property treatment of the non-UK resident trust for the non-UK domiciled individual and arguably for this benefit alone, the non-UK resident trust still reigns supreme.

The above article is based on the author’s new book “Wealth Management Planning: The UK Tax Principles” published by Wiley & Sons and is available  here.