Brendan Harper examines UK Government proposals to scrap the tax breaks enjoyed by non-doms on trusts held offshore
The UK Government has published draft legislation in relation to its proposals to change the tax regime in respect of resident non-domiciled individuals. While this legislation confirmed the changes as originally announced, it also seemed to go a lot further than previously thought, particularly in respect of offshore trusts.
One of the most attractive features of the current regime for non-doms in the UK is that the harsh anti-avoidance provisions applicable to offshore trusts do not apply to those created by non-UK domiciled settlors. These advantages are most pronounced in respect of capital gains tax.
Usually, where an offshore trust has been created by a UK domiciled individual, capital gains created by the trustees will be taxable on the settlor if he, his spouse, children or grandchildren can benefit from the trusts. These are referred to as the settlor charging provisions and are contained in s86 TCGA 1992.
If the settlor and his family cannot benefit, or if the settlor is non-resident, non-domiciled, or dead, then the trust gains will be taxed only when they are matched to capital distributions made to UK resident and domiciled individuals. In addition to this, if capital gains have not been distributed within two years of realisation, the beneficiary is subject to a surcharge upon distribution equal to 10% of the tax payable for each year that the gain has remained in the trust, to a maximum of six years. The effect of this is to increase the maximum CGT to 64% (or to 28.8% when the new 18% CGT rate comes into force). These are known as the beneficiary charging provisions and are contained in s87 TCGA 1992.
To date, s86 has not applied where the settlor is non-UK domiciled and s87 has not applied to trusts where the recipient beneficiary is non-UK domiciled.
This made offshore trusts very attractive for non-domiciled individuals. For example, if a non-dom owned UK assets directly, he would be subject to UK CGT immediately on disposal. If he owned overseas assets directly, then he would be subject to UK CGT on a remittance basis, even if it were only the original capital that was remitted.
If assets were held in an offshore trust, however, then gains could be remitted to the UK completely tax-free, regardless of their source, as long as the settlor and the beneficiary (if different) are non-UK domiciled.
The draft legislation now proposes to end this tax break. In future, capital gains will be subject to s86 (i.e. chargeable on the settlor immediately if he or his family can benefit from the trust). Gains made on UK assets will be chargeable on the settlor immediately, and gains on non-UK assets will be charged on the remittance basis as though the assets were held directly.
The changes in relation to s87 will go even further, however. Where a non-UK domiciled UK resident beneficiary receives a benefit from the trust that can be matched to previous trust gains, the distribution will be taxable immediately, regardless of the source of the gains and regardless of whether they are remitted or not. This seems particularly harsh, as the beneficiary would at least have been chargeable on a remittance basis if non-UK assets were owned directly.
Furthermore, in order to work out whether a distribution to a beneficiary is subject to UK CGT, it would be necessary to track the historic capital gains made by the trust (either to 1998, or 1981, depending on the domicile of the settlor). As CGT was never an issue, it is likely in many cases that trustees have not kept detailed records of capital gains.
In addition to this, the beneficiaries may have been receiving tax-free distributions from the trust for many years. Due to the way that s87 operates, these would be classed as excess capital payments that can be charged to CGT if, at a later date, the trustees make capital gains. This was never an issue for non-domiciled beneficiaries until now, and it may be necessary for beneficiaries to track all payments they have received from trusts.
Both of these measures result in retrospective taxation. Thankfully, HMRC issued a press release on 12 February 2008 that confirmed the legislation would be amended before publication of the Finance Bill so that there will be no retrospection, and the new rules will not apply to gains that have been realised or accrued prior to the changes coming into effect.
However, the note does not confirm that beneficiaries receiving s87 gains will be able to claim the remittance basis in respect of non-UK assets. These changes will therefore still make offshore trusts unattractive for non-domiciled individuals in the future.
Trustees of existing trusts would be well advised to seek advice now about their future strategy in order to mitigate the effect of these changes.
- Brendan Harper is technical services manager at Friends Provident International.
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