Trust distribution traps to watch out for

How an offshore trust operates under UK offshore trust taxation rules

Broadly, non-UK income and capital gains (regardless of where the asset disposed of is situated unless there is UK land or property involved) arising within a non-resident trust structure can often roll up without an immediate UK tax charge on the trustees or their underlying non-UK companies. However, the position is not tax-free in every sense. UK-source income and gains on UK property can still fall within the UK tax net at trust or company level.

Where there are UK resident beneficiaries, offshore trustees need to keep track of the trust’s relevant income and stockpiled gains. Broadly, relevant income is accumulated untaxed offshore income that is available to support benefits for beneficiaries, and stockpiled gains are untaxed capital gains accumulated within the structure.

If a UK resident beneficiary receives a capital distribution or a trust benefit, such as an interest-free loan or rent-free occupation of trust property, the value received can be matched to the trust’s relevant income and/or stockpiled gains. That matching exercise can produce an income tax charge, a capital gains tax charge, or both, depending on the facts and the ordering rules.

The matching order

The matching process follows prescribed rules. The summary below is intended as a broad guide for post-5 April 2018 years. Special rules can modify the outcome, particularly where there are non-UK recipients, temporary non-residence issues, close family members of the settlor, or onward gifts.

• Matching to relevant income takes priority. In broad terms, trustees should assume that a capital distribution or trust benefit will be matched to relevant income before stockpiled gains.
• If the whole value received is matched to relevant income, the benefit is taxed as income and is not then treated as a capital payment for capital gains tax purposes.
• If the value received exceeds the available relevant income, the excess can be treated as a capital payment and matched to stockpiled gains.
• Matching to stockpiled gains broadly works by matching first with gains of the same year, then with gains of earlier years taking the latest year first. Unmatched payments can then be carried forward to later years.
• If there are multiple beneficiaries receiving capital distributions or benefits in the same year, the available income and gains are, in broad terms, shared proportionately between them.

Potential distribution traps to watch out for

Receiving distributions and benefits from an offshore trust can give rise to unexpected UK tax consequences for UK resident beneficiaries.

A capital distribution subject to income tax

Trustees make a capital distribution, so the beneficiary expects a capital gains tax outcome. However, if the structure has significant relevant income, the distribution is first matched to that income. The result can be an income tax charge at rates materially higher than the capital gains tax rates the beneficiary expected.

 

A ‘tax-free’ trust benefit that later becomes taxable

Trustees provide a trust benefit when there are no relevant income and no stockpiled gains in the structure. It may appear that the trust benefit is free of tax. However, if income and/or gains arise in later years, the earlier unmatched benefit can become matched and taxed.

A common example is rent-free occupation of trust property. The trust may hold only a residential property for several years, with no income-producing portfolio and no gains are realised. The beneficiary occupies the property rent-free, so an unmatched trust rental benefit builds up. The trustees later sell the property and invest the proceeds in an investment portfolio which generates income and gains. The earlier rental benefit can then become matched and taxed over time.

An interest-free loan

Trustees grant an interest-free loan to a beneficiary. An annual loan benefit then arises for so long as the loan remains outstanding.

Assume the trust holds an investment portfolio, but the trust income is paid away each year to a life tenant so that no relevant income remains available for matching. The unmatched loan benefit can, therefore, build up year on year.

The life tenant later dies. In subsequent years, income starts to accumulate within the structure, and that income is then matched to the unmatched loan benefits from earlier years as well as the continuing benefit on the outstanding loan. At that stage, the beneficiary may already have spent the borrowed funds and may have no ready means of funding the tax liability.

Older gains can make the capital gains tax cost worse

If a capital payment is matched to gains of earlier years, the eventual CGT charge can be increased. In broad terms, the capital gains tax can be uplifted by 10% for each year that such gains remain unmatched and untaxed in the trust, up to a maximum of six years. Trustees and beneficiaries often overlook this point when they look only at the headline capital gains tax rates. In number terms, for a basic rate payer, the 18% CGT rate could be increased to 18% + 18% x 60% (if gains remain unmatched and untaxed for 6 years) = 28.8%; and, for a higher rate payer, the 24% CGT rate could be increased to 38.4%.

The immediate recipient may not always be the final taxpayer

The simple analysis is that the UK resident beneficiary who receives the distribution or benefit bears the tax. That is often the starting point, but it is not always the end of the analysis. Special rules can apply where there are onward gifts, close family members of the settlor, or settlor-interested structures.

Non-UK resident beneficiaries do not participate in the matching exercise

If there are both UK and non-UK tax resident beneficiaries, only the distributions and benefits received by UK resident beneficiaries are matched to relevant income and stockpiled gains. Distributions and benefits received by non-UK resident beneficiaries are broadly disregarded for the matching exercise.

If trust distributions and benefits are made based on the assumption that both UK and non-UK resident beneficiaries will share the relevant income and stockpiled gains in proportion, it could be a big surprise to the UK resident beneficiaries who end up having a much larger portion of matched income and gains than expected.

Relevant income ‘hidden’ in an underlying company

There is a wholly owned offshore company in the offshore trust, which holds a substantial investment portfolio. The trust itself holds an investment property which receives rental income; after-tax rental profits are distributed to the life tenant.

In this typical trust holding structure, it often causes a misunderstanding that there is no relevant income in the trust because all income at trust level is already distributed. However, if the underlying offshore company has not distributed its retained profits to its shareholder, the offshore trust, the retained profits become relevant income.

UK resident beneficiaries, who are of the opinion that they do not have any matched trust income to report on their tax returns, may later realise that they have income tax remain unpaid (with late payment interests accruing on a daily basis); in some cases, the situation may continue for quite a few number of years and could cause a significant cashflow issue to the beneficiaries affected.

Key take-away for trustees and beneficiaries

Before making a capital distribution, granting an interest-free loan, or allowing rent-free occupation, offshore trustees should first review the structure’s relevant income, stockpiled gains, historic unmatched benefits and any company-level income and gains within the structure.

The key point is that the legal form of the payment or benefit does not determine the UK tax result by itself. A payment described as capital, or a benefit that seems tax-free at the time, can still produce a later and sometimes severe UK tax charge.

This article is provided for general information only. It does not constitute tax, legal or other professional advice, and should not be relied on as a substitute for specific advice based on your particular circumstances.