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Inherited wisdom

Despite changes to the taxation of non-domiciliaries in the 2008 Budget, excluded property trusts remain useful planning tools for non-domiciled people who are concerned about the potential impact of UK inheritance tax on their estate.

In this respect, it is important to note that the changes in the 2008 Budget only apply to income tax and capital gains tax. There has been no change to the basic IHT rules. This means that:

  • If a person is domiciled or deemed domiciled in the UK, he is potentially subject to UK IHT on his worldwide assets.

  • If he is non-UK domiciled, he is only subject to UK IHT on assets situated in the UK.

    Both these situations are subject to any double taxation relief that applies.

    The problem with planning to mitigate IHT for people with foreign links is that a person’s domicile can change. In particular, under the concept of deemed domicile – which only applies for IHT purposes – a person who is UK resident for 17 out of the last 20 tax years or has been domiciled in the UK for the last three years will be deemed to be UK domiciled for IHT purposes.

    However, it is worth noting that this deemed domicile will not override the actual domicile of some foreigners, most notably those domiciled in France, Italy, India and Pakistan.

    Deemed domicile means that a foreign person who has a legal domicile outside the UK can find that they have a deemed domicile for UK IHT purposes once they have been UK tax resident for 17 years. In such circumstances, the excluded property trust can provide protection against all their assets then being subject to UK IHT.

    It is worth noting that the new tests in connection with tax residence could indirectly have an impact on whether the person is deemed domiciled.

    An excluded property trust would normally be in the form of a discretionary trust. Provided it is established while the settlor is non-UK domiciled and it only holds excluded property, it will be outside the scope of IHT. For these purposes, excluded property covers all property situated overseas, including offshore investment bonds and offshore collectives as well as UK gilts, author-ised unit trusts and Oeics.

    One of the perceived benefits of such trusts has been the fact that the settlor could be included as a discretionary beneficiary of the trust without giving rise to a gift with reservation of benefit. This is on the basis that the excluded property provisions in section 48(3) IHT Act 1984 override the gift with reservation rules in section 102(3) Finance Act 1986.

    HM Revenue & Customs has long accepted this principle. As far back as 1986, it was confirmed in correspondence with the Law Society.

    This was further confirmed in the Capital Taxes Office advanced instruction manual at paragraph D8 but the text was changed in October 2001, indicating that the Revenue was reconsidering its position. Unfortunately, the current IHT manual has been rewritten and contains two conflicting statements.

    First, it states: “Foreign property settled by a settlor with foreign domicile remains excluded property if the reservation of benefit continues up to the settlor’s death, even though the domicile may have changed between those dates.”

    The manual then goes on to give an example of the application of this statement as follows: “The donor, who is domiciled in Australia, puts foreign property into a discretionary trust under which he is a potential beneficiary. He dies five years later domiciled in the UK and without having released the reservation. The property is subject to a reservation of benefit and is therefore deemed to be part of the donor’s death estate.”

    This example totally contradicts the first statement. As a result of this conflict, Technical Connection wrote to the Revenue and it has confirmed to us as follows: “In the meantime, I can confirm that our view remains as set out in the rest of IHTM 14396. In other words, we do take the view that foreign property settled by a non-domiciled settlor remains excluded property where the reservation continues up to the death, even where the settlor has acquired a UK domicile in the interim.”

    This is most comforting and would appear to confirm that if the settlor’s interest terminates on death, no gift with reservation of benefit would arise, irrespective of his domicile at the date of death. So this effectively confirms what we all thought was always the case.

    But this is not the end of the complexities. The manual then considers the tax position if the settlor’s interest in the trust is terminated during his lifetime, for example, he is excluded as a beneficiary.

    Here, the Revenue seems to draw a distinction as to the tax implications that will arise in the event of the settlor’s interest terminating during lifetime according to whether he is UK domiciled or nonUK domiciled at that time.

    The manual states: “However, had the donor attained UK domicile after the gift and then released the reservation during his lifetime, it is arguable that the release would have been a Pet chargeable on his death within seven years” (under section 102(4) IHT Act 1984).

    This infers that provided the settlor remains non-UK domiciled at the time that his interest ceases, then there will be no IHT charge at that time. However, in those cases where the settlor has attained a UK domicile since establishing the trust, the implications of this Revenue view are that a deemed potentially-exempt transfer arises. This will presumably be the case not only if the settlor is formally excluded from the trust but also if he loses his interest in other ways, say, if capital distributions are made to other beneficiaries, such as children, or property is appointed to a separate trust from which the settlor cannot benefit.

    Clearly, if the Revenue view is correct and a settlor is UK domiciled at the time his interest ceases, it would mean that to avoid IHT he would need to survive his deemed gift by seven years.

    The question then arises as to the value of the Pet for IHT purposes. This requires an analysis of sections 3(1) and 3(2) IHT Act 1984.

    Section 3(1) defines transfer of value and a PET is a transfer of value. Section 3(2) states that for the purposes of sub-section (1), no account shall be taken of the value of excluded property which ceases to form part of a person’s estate as a result of a disposition.

    If the property is not a part of the settlor’s estate in the first place under section 102(4), it is difficult to see how section 3(2) can apply to it. On the basis of section 3(2) then, if it is accepted that the settled property is excluded property, the value transferred by the deemed Pet would presumably be nil.

    On the other hand, one could perhaps argue that as there is a deemed Pet and transfer of value, this overrides section 3(2). The relevant deemed Pet provision is section 102(4) Finance Act 1986 which does not deem the property to be part of the settlor’s estate or treat it as property to which he is beneficially entitled. Section 102(4) simply deems the settlor to have made a Pet which is a disposition and a transfer of value. However, if this is the case, why should there be any difference in tax outcome for a situation where the settlor is still non-UK domiciled?

    The position is obviously unsatisfactory for two reasons. First, it is not certain that the Revenue is right that there will be a deemed Pet when the settlor is excluded as a beneficiary while UK domiciled. Second, it is not immediately apparent why, if the Revenue is correct, there should be any difference in tax outcome based on whether the settlor is UK domiciled or non-UK domiciled at that time.

    In the meantime, settlors who have become UK domiciled since establishing an excluded property trust are best advised to avoid a cessation of their “inoffensive” reservation of benefit during their lifetime.

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