When an offshore trust owns an underlying offshore company, funds are often extracted by the company paying a dividend to the trustees, followed by an income distribution from the trustees to a beneficiary. In broad terms, that is the orthodox income route. It points towards an income tax analysis for the beneficiary, rather than straight to the capital gains matching code.
Difficulties tend to arise where the company does not distribute to the trustees first. Instead, the company may pay cash directly to a beneficiary, waive a debt, or allow a beneficiary to use property rent-free. In practice, a direct cash payment by the company is sometimes described in the accounts as a ‘capital distribution’, although that label is not the legal test for UK tax.
The key technical point is that section 96 TCGA 1992 is not a characterisation test. It does not say that every payment by an underlying company is capital. Rather, it is only engaged where there is already a ‘capital payment’ from an offshore company wholly owned by trustees. The real gateway is section 97, which asks whether the payment is excluded because it is income, deemed income, or part of an arm’s-length transaction.
| Route | Typical legal step | Usual UK tax starting point |
| Dividend to trustees, then trust distribution | Company pays dividend to trustee-shareholder; trustees distribute trust income | An income tax distribution, which gives rise to an income tax charge. |
| Direct cash payment to beneficiary | Company pays cash to beneficiary directly | Character must be tested first. It is not automatically a capital distribution, even if trustees or company accounts label it as such. |
| Interest-free loan to beneficiary | Company advances funds on non-commercial terms | A loan benefit, which could be matched to trust accumulated income (and causes an income tax charge) or to realised capital gains (and causes a CGT charge). |
| Rent-free occupation / use of assets | Company makes land or other property available without commercial charge | A rental benefit, which could be matched to trust accumulated income (and causes an income tax charge) or to realised capital gains (and causes a CGT charge). |
The usual route is still the dividend route
Where the underlying company has distributable reserves, the normal commercial route for extracting funds is for the company to declare a dividend to its shareholder, namely the trustees. If the trustees then make an income distribution to a UK-resident beneficiary, the beneficiary is usually in income-tax territory rather than the capital gains matching regime.
That point matters because trustees and beneficiaries sometimes start with section 96 and work backwards. In most cases the better discipline is the reverse: start by identifying what legal step was actually taken. If the company has declared a dividend, and the trustees have then distributed trust income, the analysis usually starts as an income analysis.
If profits stay inside the company, they do not necessarily disappear for UK tax purposes
If the company receives income and does not distribute it, that income can still matter. Under the benefits code, ‘relevant income’ broadly means income of a person abroad which can be used directly or indirectly to provide a benefit to the individual. HMRC expressly recognises that, where a trust owns an underlying foreign company, the income of both the trust and the company may need to be considered.
This is important because trustees sometimes assume that, if no dividend has been paid up to the trust, there is no income problem. That is too simple. For benefits-charge purposes, income within the underlying company can still be relevant income if it can be used, directly or indirectly, to fund a benefit for the beneficiary. Once income has become relevant income of a tax year, it does not stop being relevant merely because it is later capitalised or left sitting in the structure.
A direct company payment to the beneficiary is not automatically capital
A direct cash payment by the underlying company to a UK-resident beneficiary can point in more than one direction. It may be income in nature. It may be a deemed income receipt under an anti-avoidance code. Or it may be a capital payment. The answer does not turn simply on the fact that the payment came from a company rather than from the trustees.
The label used in the company accounts is also not conclusive. Calling something a ‘capital distribution’ does not make it capital for UK tax if, on a proper legal analysis, it is really an income-type extraction or another receipt that is chargeable to income tax.
That is the reconciliation between the usual dividend route and section 96. There are two separate questions. First, what is the character of the payment – income or capital? Second, if it is capital, from whom is it treated as having been received? Section 96 only answers the second question. It is a source rule, not a character test.
A step-by-step route through the income and capital analysis
A more reliable way to approach a direct company cash payment is to work through the questions in sequence.
First, identify the legal step that has actually been taken under the company’s governing law. For a foreign company, that will usually mean the law of the place where the company is incorporated or registered, together with its constitutional documents and the relevant resolutions. That first review helps show whether, as a matter of company law, the payment is properly to be treated as income or capital in nature. It may be tempting to start with section 96, but that is the wrong order. Section 96 is not engaged unless and until there is already a capital payment.
Second, once the legal character of the step has been established, apply the relevant UK tax provisions to those facts. UK tax does not simply follow the label used in company accounts. Foreign company law and trust law establish what has legally been done, and UK tax law then decides how that step is taxed in the United Kingdom.
Only after those stages does the capital route come fully into view. If the direct payment is not chargeable to income tax, is not treated as income for these purposes, and is not made under an arm’s-length transaction, it may fall within the section 97 definition of a capital payment. If that gateway is met, section 96 can then deem the payment to have been received from the trustees for the purposes of section 87. If the payment is instead charged to income tax, section 97 excludes it from capital-payment status and section 96 never starts to operate.
The practical discipline is therefore: character first, source second. First decide what the company has legally done and how UK tax classifies that step. Only then ask whether section 96 is engaged.
Why loans and rent-free occupation often sit differently
Loans and in-kind benefits are different. Section 97 is not limited to outright cash payments. It extends to benefits, and section 97(4) values a capital payment made by way of loan or other non-cash benefit by reference to the value of the benefit conferred.
That is why an interest-free or low-interest loan to a beneficiary is a classic example of a possible capital payment. The same applies where a beneficiary occupies property rent free or at an undervalue. Since 6 April 2017, the legislation has included specific valuation rules for loans and for making land available. So, in this area, Parliament has positively legislated for non-cash value extraction to be analysed under the capital-payment machinery.
Even here, however, the analysis is not mechanical. A loan on commercial terms, or occupation at a commercial rent, should not be a capital payment. And if a separate income rule applies, the income rule can displace capital-payment treatment. The correct approach is, therefore, still sequential: first ask whether the benefit is already taxed as income or is genuinely arm’s length; if not, then the capital-payment code is in view.
Final observations
For trustees and beneficiaries, the most useful discipline is to separate the issues into three questions. First, what legal step has actually been taken? Second, is the receipt income, deemed income, or a capital payment? Third, if it is indeed capital in nature, is it matched to accumulated income or realised gains?
That discipline usually avoids the main trap in this area: assuming that a direct cash payment can be made to look ‘capital’ just because it is paid by an underlying company and described that way in the accounts. In many structures the orthodox dividend route remains the right analytical starting point. The answer depends on character first, not source first.
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.
