Practical points on granting a loan to a UK resident beneficiary

Granting a loan to a trust beneficiary is part and parcel of what offshore trustees deal with on a daily basis. Where the borrowing beneficiary is UK tax resident, there is often much more to consider than simply putting loan terms into writing.

How an offshore trust operates under UK offshore trust taxation rules

First of all, it would be helpful to briefly set out how an offshore trust operates under UK offshore trust taxation rules.

Broadly, non-UK income and realised capital gains arising within a non-resident trust structure can often roll up without an immediate UK tax charge at trustee level. However, that does not mean the position is 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 income that may support benefits for beneficiaries, and stockpiled gains are realised untaxed capital gains accumulated within the structure.

If a UK resident beneficiary receives a capital distribution or a trust benefit, typically an interest-free loan or rent-free occupation of trust property, UK tax can arise under the income and/or capital gains matching rules. A trust loan should, therefore, never be looked at in isolation.

A loan structured as a simple debt

If a loan is structured as a simple debt, the situs of the loan is where the borrower resides. If the borrowing beneficiary is UK resident, the offshore trustees hold a UK-situs asset.

This, in turn, can bring the debt within the UK IHT net. If the trust is within the relevant property regime, the loan may then affect principal (10-yearly) and exit charge calculations for as long as it remains outstanding.

A specialty debt secured on a UK asset

A loan to a beneficiary is sometimes structured as a specialty debt, which is a debt created by deed or instrument under seal. An unsecured specialty debt is usually situated where the debt instrument is kept.

However, if a specialty debt is secured on UK land or other tangible UK property, the debt can instead be treated as UK-situs property. That, again, can bring the principal and exit charges into view.

An unsecured debt but used on a UK residential property

This is a common trap that offshore trustees often fall into. A debt can be brought within the IHT regime if the borrowed funds are used by a beneficiary on the acquisition, maintenance or capital enhancement of a UK residential property.

It is, therefore, essential that trustees ask, before granting a loan, what the borrowed funds will actually be used for.

The IHT 2-year tail

If there is already an outstanding loan that has been used by a borrowing beneficiary on a UK residential property, trustees and beneficiary may wish to repay the loan before the next 10^th anniversary of the trust settlement date in order to avoid or reduce the IHT exposure.

If so, timing matters. A repayment made within the 2-year period before the 10-year chargeable event may be ignored for these purposes, so that the charge can still be calculated by reference to the loan value before a loan repayment.

If, however, the UK residential property itself has been sold and the debt is then repaid, the position can be different. That is why trustees should be very careful before assuming that a simple repayment solves the problem.

Should a loan be interest bearing?

Trustees have a fiduciary duty to consider the interests of all beneficiaries. They may, therefore, feel obliged to charge interest on a loan granted to one beneficiary so that other beneficiaries do not lose out on the interest foregone.

An interest-bearing loan to a UK resident beneficiary can create a few UK tax issues. First, withholding tax may need to be considered if the interest is UK-source yearly interest paid to non-UK resident trustees.

The interest received is UK-source income in trustees’ hands. This may draw the trustees into the UK self-assessment regime and create an annual trust return filing obligation, with the related tax compliance reporting cost that goes with it.

So, charging interest may solve one concern but create another. Trustees should therefore be careful not to assume that an interest-bearing loan is automatically the cleaner answer.

The Schedule 4B TCGA 1992 trap

If offshore trustees grant a loan whilst there is outstanding borrowing at trust level, the anti-avoidance Schedule 4B rules may need to be considered.

If those rules apply, the result can be severe. Very broadly, trustees may be treated as making a deemed disposal at market value of trust assets, with the resulting gains then feeding into the stockpiled gains regime and potentially causing an unexpected tax charge on a UK resident beneficiary.

What if a loan is interest-free?

How about offshore trustees granting a loan which is interest-free and unsecured, where there is no outstanding borrowing at trust level and the loan is not used by the borrowing beneficiary on a UK residential property?

The borrowing beneficiary is treated as having received a trust loan benefit, which is measured using HMRC’s official rate of interest, currently 3.75%. Using a £1 million loan as an illustration, the annual loan benefit would be £37,500. That may not look like a large amount at the start, but it can build up quickly.

If the trust is a ‘dry’ trust, generating little income and realising few gains each year, there may be nothing for the annual loan benefit to match with. The unmatched benefit is then carried forward. If the trust later realises a significant gain, for example on the sale of a property, the accumulated unmatched benefit could then trigger a significant tax liability for the beneficiary.

A loan remains outstanding forever

It is often seen in a trust’s annual accounts that a loan receivable from a beneficiary remains outstanding for years.

If there was no real intention for the loan to be repaid when it was granted, or if it was already clear from the outset that the borrowing beneficiary would have no realistic means of repayment, HMRC may seek to argue that the position is a capital distribution in substance rather than a genuine loan.

Again, in many such cases, the borrowing beneficiary may already have spent the funds long before any challenge is raised. That can create a serious cashflow problem if an unexpected tax bill then follows.

Waive a loan and exclude a beneficiary immediately after

Trustees may be tempted to waive a loan at a time when there is no relevant income and no stockpiled gains in the trust, and then exclude the beneficiary immediately afterwards. At first sight, that may appear to remove the matching and the associated tax problem for the beneficiary.

Later trust income should generally not be available to match if the beneficiary has already been excluded and can no longer benefit. The position on later stockpiled gains is less clear. There is a risk that a capital distribution made, i.e. in this case, the loan waived, while the person was still a beneficiary may still be matched to gains realised later.

There does not appear to be clear HMRC guidance or a decided case directly on this point. Trustees and beneficiaries should, therefore, be careful before assuming that a loan waiver followed by exclusion makes the problem disappear.

Key takeaway for trustees and beneficiaries

A trust loan is rarely ‘just a loan’ for UK tax purposes.

A loan that looks straightforward in trust accounts can create IHT issues, annual loan benefit issues, matching issues and, in some cases, anti-avoidance issues. Trustees and beneficiaries should understand the risks before a loan is granted, not after.

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.