Important changes were made to the UK's deemed domicile regime in 2017. These complex new rules pose yet another set of challenges for offshore trustees of trusts with UK resident, deemed UK domicile settlors. While most hope to avoid the new tainting regime for so called 'protected settlements', given the ease with which a trust can be tainted, and the potentially calamitous tax consequences of a tainting event, this is an area of high risk for trustees.
The 2017 Changes
The Finance Bill (No.2) 2017 has narrowed the deemed domicile window from 17 to 15 out of 20 tax years of UK residence. From 6 April 2017, non-doms who have been resident in the UK for at least 15 out of the last 20 years will be deemed UK domiciled for all UK tax purposes including IHT, income tax and CGT. This means that if the non-dom is a settlor of a trust, the trust's income and gains are attributed to the settlor on an arising basis (as would be the case with a naturally UK domiciled settlor).
What all this means is that where the UK resident settlor has already become, or is shortly about to become, UK deemed domiciled, the trustees should be extremely cautious, and obtain appropriate tax advice before accepting any kind of contribution from the settlor (which includes the settlor paying a liability directly on behalf of the trustees).
What is a Protected Settlement?
A protected settlement is not defined in terms in the legislation. It exists in the lacuna between trusts that have a different tax treatment applied to them. An offshore trust will have protected status if:
- At the time the trust was established the settlor was not UK domiciled under general law and, if the trust was established after 5 April 2017, the settlor was also not deemed UK domiciled at that time;
- The settlor was not a 'formerly domiciled UK resident' (ie born in the UK with a UK domicile of origin but with a foreign domicile of choice and UK resident for the relevant tax year); and
- The settlor continues to be non-UK domiciled under general law in the relevant tax year.
The Benefits of Protected Settlement Status
Protected trust status is extremely valuable for those able to qualify for it. Broadly, for so long as the trust qualifies for protected status, the settlor will not be taxed on an arising basis on foreign income or capital gains that are retained in the trust (or its underlying entities). Instead settlors will only be taxed on such income and gains as and when benefits are received from the trust.
Preventing the loss of protected settlement status will now be a key consideration for offshore trustees managing trusts whose settlors are UK resident and deemed domiciled due to their long-term residence in the UK.
A protected trust will lose its protected status if the trust becomes tainted.
Tainting can only occur from the start of the tax year in which the UK resident settlor acquires deemed domiciled status under the new 15/20 year rules; however it would be prudent for trustees to closely examine the new rules.
The fund will become tainted if property or income is provided directly or indirectly to the trust by the settlor or by the trustees of another settlement of which the settlor is the settlor or a beneficiary after 5 April 2017 (or the settlement date if later) at a time when the settlor is either UK deemed domiciled or domiciled under general law. Note that any additions of value (as well as of actual property) will be relevant.
The key question when it comes to what it is to 'provide' assets to a trust is whether something has been done which has caused something to be received by the trustees or by an underlying trust owned company, and if so, whether there was a subjective intention that the trust or any of the trust's beneficiaries should benefit from that receipt.
This has the potential to be a hair-trigger. A transfer of assets from a deemed UK domiciled settlor directly to the trustees, accompanied by a bounteous intent (and it is hard to imagine circumstances when it would not be), will be a tainting event unless it falls within one of the exemptions from tainting discussed below (for example to allow for the payment of trust expenses in a "dry-trust" scenario).
There is UK authority (IRC v Leiner (1964) 41 TC 589) to the effect that the payment of interest on a loan between the settlor and the trustees at a market rate of interest was a provision of assets where the settlor's subjective intention was to use the interest payments as a means to cause income to accrue to the trust which was used to benefit his son, the beneficiary. There is also UK authority that a settlor agreeing to guarantee a bank loan taken by the trustees will amount to a provision even though no money actually changes hands (IRC v Wachtel ChD  1 All. ER 296).
Loans between trustees and settlors or between settlors and underlying trust-owned companies are likely to be a source of difficulty under the new rules. The fact of a loan to a trust, leaving debts outstanding when repayments of capital or income could be made (i.e. soft loans left outstanding indefinitely), the payment of interest on a loan to the trustees, or the repayment of principal on a loan, are all potential sources of risk.
For a loan to be exempt from tainting, it must be at arm's-length. What constitutes a loan at arm's length has been defined by statute. Where a loan is made by the trustee the interest on it cannot exceed HMRC's official rate of 2.5% for the loan to be on arms' length terms. For loans made to the trustees by the settlor the interest rate cannot be less than 2.5%.
Readers should also note that the exemptions from tainting expressly apply only to loans made to the trustees. Any loan whatsoever to an underlying trust owned company, (even if was it made to the trustees would qualify at arm's length), would result in tainting.
What Transactions Will Not Taint the Trust?
The following list of statutory exemptions mean that what would otherwise be a tainting transaction can be ignored:
- A transaction, other than a loan, which is at arm's length terms
- A transaction, other than a loan, where there is no intention that benefit should be conferred gratuitously
- The making of a loan to the trustees on arm's length terms
- The payment of interest to the trustees under a loan made by the trustee on arm's length terms
- The repayment of a loan made by the trustees
- Any action taken in pursuance of a liability incurred before 6 April 2017
- Any payment made to the trustees to allow tax liabilities or administration expenses to be met, where the income of the trust is insufficient to cover such costs.
Tainting and Trust Expenses
This exemption is likely to be particularly useful for "dry" trust structures (i.e. those holding only non-income producing assets. However the exemption applies only to tax liabilities and administration expenses of the trust, and not it seems, the tax liabilities and administration expenses of any underlying company.
What Happens if the Trust Becomes Tainted?
The consequences of tainting are draconian because there is no de minimis limit or statutory mechanism in UK law to reverse an inadvertent tainting transaction. Any addition, however small will result in a permanent forfeiture of protected status.
If tainting occurs, assuming the settlor has an interest in the settlement for the purposes of UK tax, the settlor will become liable on an arising basis for all the income and capital gains of the trust.
What Options Exist Where There Has Been Tainting?
The new tainting rules are very complex and there is obvious scope for a Protected Settlement to become inadvertently tainted – either by the addition of funds by the settlor or by the trustee. That carries with it the possibility for claims against trustees or professional advisors for negligence.
A Possible Cure?
Following the UK Supreme Court's decision in the combined appeals of Futter v Futter and Pitt v Holt in 2013 the scope to reverse transfers of property into trust or the exercise of powers by trustees has been restricted, at least under English law.
For trusts affected by these changes, that have Jersey as their proper law, there is scope to rely upon the statutory jurisdiction that exists by virtue of Arts 47D-J Trusts (Jersey) Law 1984 to reverse a transaction that has had the effect of tainting the trust fund.
Art 47E provides the Royal Court with a discretionary power to set aside a transfer or disposition of a property to a trust due to mistake if the following tests are answered in the affirmative (In Re M Trust  JRC 198).
- Was there a mistake on the part of the settlor?
- Would the settlor not have entered into the transaction "but for" the mistake?
- Was the mistake of so serious a character as to render it unjust on the part of the donee to retain the property?
It does not matter whether the mistake was of fact, law, as to the effect or as to the consequences. Accordingly a mistake as to the tax consequences of a trust or a transfer to a trust is a mistake for these purposes (see Re S Trust  JLR 375).
In a case where a settlor has been accustomed to making gifts or loans to a trust and is not made aware of the new rules, it seems likely that the court would find there to have been a mistake. The Jersey court has also indicated that where, as would be the case with tainting, a significant and unexpected tax liability arises, it is more likely than not to conclude the settlor would not have entered into the tainting transaction but for his or her mistake.
Where the tainting does not arise as a result of a transfer of property or provision to a trust by a settlor but arises from the exercise of powers by the trustee in a particular way, for example the exercise of a power to enter into a loan with the settlor, an application can be made under Art 47H, which is a statutory version of what was formerly known as 'the rule in Re Hastings Bass'. Where the tainting arises from the trustee's failure to review an existing arrangement with the settlor that has the effect of tainting the fund, the options are more limited. The statutory jurisdiction to reverse a transaction applies only to the positive exercise of a power. Where the issue is that no power has been exercised when it reasonably should have been (for example to vary the terms of a loan to make it arm's length), there is simply nothing capable of being reversed by the court.
The new tainting rules are highly likely to be a relevant consideration that the trustee is to be expected to have taken into account before the exercise of a power, for example, to make a loan to the settlor.
While the relief under both Articles 47E and 47H is discretionary, the Jersey Court has expressed itself to be more sympathetic to those who use Jersey trusts as legitimate tax and wealth planning vehicles than is currently in vogue in the United Kingdom.
Where a settlor is not yet UK deemed domiciled, trustees should be considering the funding needs of the trust. If additions to the trust need to be made, they should be made before the settlor becomes deemed domiciled and with the benefit of professional tax advice.
Offshore trustees should exercise extreme caution in relation to any transaction between the trust and its settlor or any other trust connected to the settlor where the settlor is deemed UK domiciled or there is any uncertainty about whether the 15/20 year window has closed.
Despite the best efforts of advisers and trustees, it seems very likely that gifts or transactions will occur, in ignorance of the new rules, that will push trusts with deemed UK domiciled settlors into the non-protected settlement regime.
For those Jersey trusts for which it may already be too late to avoid a tainting transaction, professional advice on how the event may be reversed should be sought in short order. Where reversing the tainting event is not possible, the UK's new tainting rules are likely to be a major source of claims against trustees for negligence in the coming years.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.