What is a Trust

A trust is a legal relationship where a person gives property to a person or group of persons to manage for the benefit of others.  They are often used for asset protection purposes as well as tax planning.  There are different types of trusts which are each taxed differently.

Key Definitions

Settlor:                person providing the assets

Trustees:             legal owners of the assets

Beneficiaries:     persons the assets are held for the benefit of

Protector:           sometimes appointed to oversee or supervise the trustees

Types of Trust

Trusts come in many forms.  The main types of trust are:

Discretionary:                                  trustees have discretion over distribution of income and capital

Interest in possession (“IIP”):     beneficiaries have a fixed entitlement to income but trustees may have discretion over distribution of capital

Vulnerable persons:                      these can be either IIP or discretionary trusts and are special purpose trusts for vulnerable persons such as minor children and disabled people

The focus of this article will be on discretionary and IIP trusts.

Income and Capital

Balances of income and capital of a trust are typically kept separate to determine how much to distribute.  For discretionary trusts there is usually a power to accumulate income to capital.

Duties and Powers of Trustees

The role of trustee is a fiduciary one and carries much responsibility.  They are responsible for managing the trust assets, ensuring the purpose of the trust is met in accordance with the settlor’s wishes and ensuring the interests of all beneficiaries are looked after in an impartial and balanced manner.

In order to carry out their duties, trustees are usually given wide-ranging powers.  These will include, but not limited to, powers of advancement, investment, dealing with land, borrowing and lending and delegation.

Benefits of Using Trusts

Trusts have a number of benefits.  The key benefits are:

Asset Protection

Trusts can be used to control and protect family assets, especially against bankruptcy, divorce and elderly care costs.  They can be used to control funds paid to beneficiaries to avoid assets being diminished, particularly with younger beneficiaries who may not yet be financially mature.

Succession Planning

Trusts offer flexibility which can assist with succession planning.  This is particularly useful where it is not yet clear to the settlor who should benefit and so a discretionary trust in particular can be used to give flexibility to defer this decision while allowing for the changing needs of the beneficiaries.

Tax

The attraction of trusts for tax planning has diminished somewhat in recent years.  Nevertheless, they do still have a role in tax planning including for inheritance tax (“IHT”) planning, where the trust assets usually sit outside the beneficiaries’ estates, and to benefit from provisions for non-UK trusts created by non-domiciled settlors.

Trust Residence

Rules for Determining Trustee Residence

The residence of a trust is central to its UK tax position since the tax treatment of a UK trust differs significantly from that of a non-UK trust.

For trust residence purposes, the trustees are treated as a single body.  Technically it is the trustees as a body who are the taxable person rather than the trust but for simplicity we will refer to trusts rather than trustees.

For income tax and capital gains tax (“CGT”) a trust will be UK resident if:

• All trustees are UK resident; or

• There are a mixture of UK and non-UK resident trustees and the settlor was either UK resident or UK domiciled / deemed domiciled when the trust was created.

Otherwise the trust will be non-UK resident.

For simplicity in ensuring a non-UK trust remains so, it will usually have a single non-UK corporate trustee often based in the Channel Islands.  This provides the advantage of certainty over trust residence.

Where a non-UK trust does have at least one individual trustee, the residence position of individual trustees must be kept under constant review to avoid inadvertent UK trust residence.

Residence of Individual Trustees

For individual trustees, their residence is determined in accordance with the UK statutory residence test.  This is a test based on days spent in the UK and connections to the UK such as having accommodation or full-time work in the UK.

It is possible under the UK statutory residence test for an individual to have a tax year split into residence and non-residence periods.  An individual trustee having a split year could cause issues with trust residence unless they were only a trustee during the non-resident part of a split year.

Residence of Corporate Trustees

For corporate trustees, their residence is determined in accordance with company residence rules.  Company residence is usually the place of incorporation or where the central management and control is i.e. where corporate and strategic decision making takes place rather than day-to-day management.

It is important, particularly for a non-UK corporate trustee, that the core activities of acting as a trustee are kept outside of the UK.  This means ensuring the strategic decision making takes place outside of the UK.  This is to avoid becoming UK resident through carrying out trustee business through a fixed place of business in the UK.

Impact of Residence on UK Taxation of Trusts

As will be seen below, trust residence will have an impact on the extent to which income and capital gains are taxable in the UK for the trust itself, the settlor and the beneficiaries.  However, residence is not particularly important for IHT purposes though it does have a bearing in some fairly benign situations such as foreign currency bank accounts.

Tax on the Lifetime Creation of a Trust

The relevant taxes on the lifetime creation of a trust are CGT and IHT.  Any taxes on the creation of a trust on death are wrapped up within taxes on estates rather on the transfers to a trust.

CGT

For CGT, the transfer of an asset to a trust is a market value disposal by the settlor with a gain or loss arising depending on the capital gains base cost.  For details on the calculation of gains and losses please go the CGT page here.  Any gain will be subject to tax at the settlor’s appropriate marginal rate, which will be up to 28% depending on their level of income and the type of asset transferred.

Capital gains hold-over relief can be claimed to defer any gain arising on a transfer to a UK resident, but not settlor-interested, trust if the transfer is a chargeable event for IHT.  For details on hold-over relief please go the CGT page here and for more details on the definition of settlor-interested please go to this section here.  Chargeable events for IHT are covered in the next section.

IHT

With the exception of transfers into qualifying trusts for vulnerable persons (e.g. disabled persons) or charitable trusts, lifetime transfers to trusts are chargeable lifetime transfers.  The lifetime rate of tax is 20% if the IHT is paid by the trust or 25% if paid by the settlor.  For details on chargeable lifetime transfers please go to the IHT page here.

Transfers to qualifying trusts for vulnerable persons are PETs while transfers to qualifying charitable trusts are exempt transfers.  For details on PETs and the charity exemption please go to the IHT page here.

Ongoing UK Income Tax (UK Trusts)

Settlor-Interested Trusts

A key consideration for UK income tax on a UK trust is whether it is settlor-interested.

Definition of Settlor-Interested

For income tax, a settlor is broadly treated as having an interest in a trust if trust assets are or may become payable to, or applicable for the benefit of, the settlor or his spouse / civil partner.  For clarity on the position, trust deeds often explicitly include or exclude the settlor and their spouse / civil partner.

Assessment of Income on Trusts

Income received by a settlor-interested UK trust is initially taxable on the trust at up to 45% depending on the type of trust and income source.  As noted above, trusts can either be on a discretionary or IIP basis and the initial rate of income tax for each type is:

Discretionary:       up to 45% depending on the income source

IIP:                           up to 20% depending on the income source

The income assessable can include income from underlying non-UK companies where broadly there was a UK tax avoidance motive in setting up the trust structure. However, having such companies in a UK trust structure is extremely unusual.  For more details on these anti-avoidance provisions, please go to the transfer of assets abroad anti-avoidance section here.

Assessment of Income on Settlor

As well as being assessed on the trust, the income is also taxable on the settlor at up to 45% depending on the income source (though non-resident settlors will only be taxable to the extent of UK income). 

To avoid double taxation the settlor gets credit for the income tax paid by the trust.  In addition, if the settlor is required to pay additional tax on trust income then the additional liability can be recovered from trust.  Conversely if the settlor receives a tax refund this must be paid over to the trust.

A settlor can also be assessable on trust income where their minor child can benefit.  This is not a general assessment on them but only where their child receives a distribution from the trust.

Distributions to Beneficiaries

If distributions are made to a beneficiary other than the settlor, this is assessable on the beneficiary but a tax credit is given at the beneficiary’s marginal rate of tax.

Beneficiary-Taxed Trusts

Assessment of Income on Trusts

As for settlor-interested UK trusts, income received is initially taxable on the trust at up to 45% depending on the type of trust and income source.

The income assessable can include income from underlying non-UK companies where broadly there was a UK tax avoidance motive in setting up the trust structure. However, having such companies in a UK trust structure is extremely unusual.  For more details on these anti-avoidance provisions, please go to the transfer of assets abroad anti-avoidance section here.

There is a difference for discretionary trusts, however.  The income tax paid by these trusts is broadly accumulated in a tax pool and used to finance tax credits on distributions to beneficiaries as described below.  However, where the tax credits on distributions exceed the tax pool the difference becomes an additional tax liability of the trust which they are required to pay over to HMRC.

For IIP trusts it is possible for the income to be mandated to the beneficiary.  Where this is the case, the income is not assessed on the trust at all but instead simply assessed directly on the beneficiaries as described below.

Beneficiary Position for Discretionary Trusts

A beneficiary of a discretionary UK trust is taxed in the UK according to income distributions received, with the situs of the income being UK.  Distributions received are grossed up at a tax rate of 45%.

The beneficiary is taxed on the grossed-up distribution at up to 45% depending on their income levels, with a 45% tax credit given for the UK tax paid by the trust.  If the beneficiary’s marginal rate of tax is less than this, they can claim a repayment.

As noted above, there can be occasions where a settlor is assessable on discretionary distributions of trust income received by their minor children.

Beneficiary Position for IIP Trusts

A beneficiary of an IIP trust is taxed in the UK according to their share of trust income for each tax year with the situs of the income being based on the underlying sources.

A UK resident beneficiary is taxed on all sources at up to 45% depending on the underlying sources and income levels.

If the beneficiary is non-UK resident they are only taxable in the UK at up to 45% on UK income sources.

For both UK and non-UK resident beneficiaries a credit is given for the UK tax paid by trust (unless the trust has not been taxed due to the income being mandated to the beneficiaries).

As with discretionary trusts, a settlor will be assessable on trust income distributions attributed to their minor children.

UK Resident but Non-Domiciled Beneficiaries – Remittance Basis

A beneficiary tax charge for a UK resident but non-UK domiciled beneficiary of an IIP trust is subject to a remittance basis claim.  This can be for the underlying non-UK sources where the distribution is not remitted to the UK.  For details on the remittance basis please go to the domicile page here.

Ongoing Income Tax (Non-UK Trusts)

Settlor-Interested Non-UK Resident Trusts

As for a UK trust, a key consideration for UK income tax on a non-UK trust is whether it is settlor-interested (please go to the section here on UK trusts for the definition of settlor-interested for UK income tax).

Assessment of Income on Trusts and Settlors

The UK income tax position for a non-UK settlor-interested trusts is the same as for a UK settlor-interested trust with three key exceptions:

1. Non-UK income is not initially assessed on the trust;
2. There is more likelihood that the anti-avoidance provisions from having an underlying non-UK company will apply; and
3. There are protections from settlor-interested provisions in connections with ‘protected foreign source income’

For more details, please go to the section here on UK trusts, the section here on the anti-avoidance provisions affecting non-UK underlying companies and the section here for the trust protections.

Trust Protections

The settlor-interested rules are ‘switched off’ for certain trusts created by non-UK domicilairies if the non-UK income is ‘protected foreign source income’.  Where this is the case the income is only assessable on the settlor when it is distributed to them or in certain situations where distributions are made to a spouse or minor child who are not immediately assessable to UK tax on the distribution.

Several conditions apply for income to be protected foreign source income, mainly focused on the settlor’s domicile.  They must have been non-UK domiciled and not deemed domiciled when the trust was created and not have become UK domiciled or a ‘formerly domiciled resident’ (broadly born in the UK with a UK domicile at birth and has returned to the UK).

Also crucial is that the trust must not become ‘tainted’ so care is needed to avoid this.  Tainting occurs when the settlor provides property or income for the purposes of the trust at a time when they are UK domiciled or deemed domiciled.  This includes property provided directly or indirectly.  Tainting occurs from the first tax year in which property is provided.  An obvious example of tainting is where further assets are added by the settlor.  Less obvious examples of tainting include settlor loans where the interest charged is less than HMRC’s official interest rate. 

A settlor tax charge is subject to a remittance basis claim where the distribution is not remitted to the UK.  For details on the remittance basis please go to the domicile page here.

A protected trust will be particularly useful where a settlor can no longer claim the remittance basis and trust distributions can be restricted to being made only when required.  They can also allow avoiding the need to pay the remittance basis charge where the settlor’s only non-UK income is protected trust distributions brought to the UK.

As well as income distributions, it is possible for distributions which are capital in nature to be matched to protected foreign source income where broadly there was a UK tax avoidance motive in setting up the trust.  For more details on these anti-avoidance provisions, please go to the transfer of assets abroad anti-avoidance section here.

Beneficiary-Taxed Non-UK Trusts

Trust Position on UK Income

UK income received by a beneficiary-taxed non-UK trust is initially taxable on the trust at a rate depending on the type of trust and income source (please go to the section here for more details on rates).

Trust Position on Non-UK Income

Unlike UK income, non-UK income received by a beneficiary-taxed non-UK trust is not taxable on the trust.

Beneficiary Position Generally

How a beneficiary of a beneficiary-taxed non-UK trust is taxed depends on the type of trust and their residence.

Beneficiary position for discretionary trusts

A beneficiary of a discretionary non-UK trust is taxed in the UK according to income distributions received, with the situs of the income being non-UK.

A UK resident beneficiary is taxed at up to 45% depending on their income levels, with credit given for the UK tax paid by the trust (provided the trust is fully UK tax compliant).  As well as income distributions, it is possible for payments which are capital in nature to be matched to foreign source income where broadly there was a UK tax avoidance motive in setting up the trust.  Capital payments for this purpose include notional payments such as low or interest-free loans or low or rent-free use of assets.  For more details on these anti-avoidance provisions, please go to the transfer of assets abroad anti-avoidance section here.

If the beneficiary is non-UK resident they are not taxable in the UK on income distributions received but may be able to claim repayment of any UK income tax paid by the trust.

As noted above, there can be occasions where a settlor is assessable on discretionary distributions of trust income received by their minor children including on all distributions relating to UK source income.

Beneficiary position for IIP trusts

A beneficiary of an IIP trust is taxed in the UK according to their share of trust income for each tax year with the situs of the income being based on the underlying sources.  The income assessed on them can include income from underlying non-UK companies where broadly there was a UK tax avoidance motive in setting up the trust structure. For more details on these anti-avoidance provisions, please go to the transfer of assets abroad anti-avoidance section here.

A UK resident beneficiary is taxed on all sources at up to 45% depending on the underlying sources and income levels.

If the beneficiary is non-UK resident they are only taxable in the UK at up to 45% on UK income sources.

For both non-UK and UK resident beneficiaries a credit is given for any UK tax paid by the trust.

As with discretionary trusts, a settlor will be assessable on UK trust income attributed to their minor children and possibly non-UK income.

UK Resident but Non-Domiciled Beneficiaries – Remittance Basis

A beneficiary tax charge for a UK resident but non-UK domiciled beneficiary is subject to a remittance basis claim for where the distribution is not remitted to the UK.  This could be for the entire distribution in the case of a discretionary trust or the underlying non-UK sources in the case of a life interest trust.  For details on the remittance basis please go to the domicile page here.

Transfer of Assets Abroad Anti-Avoidance Provisions

As noted above, non-UK income assessed on a settlor can include income from underlying non-UK companies where broadly there was a UK tax avoidance motive in setting up the trust structure.  These are known as the known as the transfer of assets abroad anti-avoidance provisions.

These provisions can also mean that payments received which are capital in nature are matched to foreign source income including that received by an underlying company.  Capital payments for this purpose include notional payments such as low or interest-free loans or low or rent-free use of assets.

Ongoing CGT (UK Trusts)

Liability of Trusts – Rates and Allowances

There are no settlor-interested CGT provisions for UK trusts so disposals are assessable on the trusts themselves.  The settlor or beneficiaries are not liable to CGT in respect of UK trust gains.  For details on the calculation of gains and losses please go the CGT page here.

The following CGT rates apply to UK trusts:

Residential property interests:      28%

All other assets:                                20%

In the unlikely event that a UK trust owns any underlying non-UK companies, trust gains can include gains from these companies where broadly there was a UK CGT or corporation tax avoidance motive in using non-UK companies.

Asset Distributions

Disposals include asset distributions to beneficiaries but CGT hold-over relief can be claimed where the beneficiary is UK resident and the distribution is a chargeable event for IHT.  For details on CGT hold-over relief please go the CGT page here and for chargeable events for IHT please go to the IHT page here.

Qualifying IIPS – Termination of IIP and Tax-Free Uplift on Death of Beneficiary

Certain IIP trusts are known as qualifying IIP trusts.  These include pre-22 March 2006 IIPs and some IIPs created since, particularly those created on death.  The termination of the beneficiary interest is a chargeable event for CGT purposes with all trust assets deemed to be sold and reacquired by the trust at market value, with a gain or loss arising as a result.

However, where the occasion of charge is the death of the beneficiary gains or losses resulting from the deemed disposal are ignored.  Instead, there is a CGT-free uplift of all assets to market value.

Ongoing CGT (Non-UK Trusts)

Settlor-Interested Non-UK Trusts

Unlike for a UK trust, a key consideration for UK CGT on a non-UK trust is whether it is settlor-interested

Definition of Settlor-Interested

There is a wider, more complex, definition of settlor-interested for CGT purposes than for income tax.  As for income tax it includes where the settlor or spouse /civil partner can benefit but also includes potential or separated spouses, children, grandchildren and companies controlled by any of these individuals.  However, for a trust to be settlor-interested for a particular tax year a defined person must be able to benefit and the settlor must be both UK resident and UK domiciled.

Liability of Trust – Limited to UK Property Interests

A non-UK trust is not liable to CGT except for gains on UK property interests where the rate of tax will depend on whether or not the property is residential:

Residential property interests:                              28% CGT with capital gains rebasing for interests held at April 2015

Commercial / indirect property interests:          20% CGT with capital gains rebasing for interests held at April 2019

Assessment of Gains on Settlor

Instead the default position is that non-UK property gains of a settlor-interested trust are assessable on the settlor at up to 28% depending on the type of gain.  This includes gains from underlying non-UK companies where broadly there was a UK capital gains tax or corporation tax avoidance motive in setting up the trust.

The settlor can, however, recover any CGT they pay from the trust.

Trust capital losses, however, can only be set against settlor-interested trust gains of the same or future tax year.  They cannot be set against the settlor’s personal gains.

Trust Protections for Non-Domiciled Settlors

For the domicile requirement of the settlor-interested provisions, there are protections to ignore deemed domiciles.  These mirror the income tax protections outlined above for foreign income, including tainting of the trust (please go to the relevant section here for more details).  If the protections are met, the trust is not settlor-interested for CGT.

Beneficiary-Taxed Non-UK Trusts

Assessment of Trust

As for settlor-interested non-UK trusts, those that are beneficiary-taxed are not liable to CGT except that the trusts are assessable on gains from UK property interests (see the section here on settlor-interested trusts for more details).

Assessment of Beneficiaries

Gains which are not assessed as UK property gains, including pre-April 2015 / 2019 gains due to rebasing, are available for assessment on UK resident beneficiaries.  They are assessed by stockpiling them for matching to capital payments received by the beneficiaries unless the payment is matched to foreign source income under income tax anti-avoidance provisions.  Capital payments include notional capital payments.  For more details on the income tax anti-avoidance provisions, please go to the transfer of assets abroad anti-avoidance section here.

Gains are not matched to capital payments made to non-UK resident beneficiaries except in the tax year a trust ceases.

Where capital payments are made to more than one beneficiary in a tax year, gains are matched to beneficiaries in proportion to payments received.

Capital payments not matched to gains in a particular tax year are carried forward for matching in future tax years.  Similarly, unmatched gains are carried forward.

Trust capital losses, however, can only be relieved within the trust by setting them against beneficiary-taxed trust gains of the same or future tax year.  They cannot be set against the beneficiary’s personal gains or any settlor-interested gains.  In addition, a beneficiary’s personal capital losses cannot be set against matched trust gains.

Gains Assessed on Others

While gains of beneficiary-taxed non-UK trusts are principally taxed on the beneficiaries, there are some instances where they can be taxed on someone else.

A UK resident settlor is treated as receiving capital payments, with gains matched accordingly, where the payment is to a spouse / civil partner (including those living together as such) or their minor children.  The residence of the recipient spouse etc. is irrelevant while tax legislation gives the settlor entitlement to recover any tax they pay from their spouse etc.

Capital payments made to a non-UK resident beneficiary can be treated as received by someone other than the recipient beneficiary where an onward gift of it is ultimately made to a UK resident person.  This will be the settlor if the onward recipient is a spouse etc. though tax legislation again gives them entitlement to recover any tax they pay from their spouse etc.

Remittance Basis for UK Resident but Non-Domiciled Individuals

The remittance basis can be claimed by UK resident but non-UK domiciled individuals for non-UK gains matched to capital payments (except where a UK resident settlor is treated as receiving direct capital payments made to their spouse etc.).  For details on the remittance basis please go to the domicile page here.

Other matters for UK Resident but Non-Domiciled Beneficiaries

Prior to 2008/09, UK resident but non-domiciled beneficiaries were not assessed at all to non-UK trust gains attributed to capital payments received by them.  When this was changed from 2008/09 two transitional reliefs were introduced:

1. An exemption for pre-6 April 2008 gains and capital payments; and
2. Rebasing of assets held on 6 April 2008 and standing at a gain.  This is to restrict the tax payable to the post-April 2008 growth.  An irrevocable election covering all relevant assets is required to be made by the trust and must be made by 31 January after the first tax year in which a capital payment is received by a UK resident beneficiary

Rates of Tax and Supplementary Change

The rate of tax on matched gains is up to 20% depending on the beneficiary’s level of income.   In addition, a surcharge of up to 60% applies if a gain is not matched to a capital payment made in the same or following tax year.  The surcharge depends on the time between the matched gain arising and capital payment being made and can increase the effective rate to 32%.

Qualifying IIPS – Ending of IIP and Tax-Free Uplift on Death of Beneficiary

As for UK trusts, the termination of a beneficiary’s interest in a qualifying IIP trust is a chargeable event for CGT purposes but with a CGT-free uplift in value where the occasion is the death of the beneficiary.  For more details on this please go to the UK Trusts CGT section here.

Ongoing IHT (All Trusts)

General Exposure to IHT

There are no specific IHT rules based on the residence of trusts – they apply equally to UK and non-UK trusts.

The scope of IHT is primarily based on domicile and situs of assets as follows:

UK domiciles:                 Worldwide assets

Non-UK domiciles:       UK assets only (non-UK assets are regarded as ‘Excluded Property’)

Importance of Settlor’s Domicile

When assets first became comprised in the trust

For trusts, it is the domicile of the settlor when assets first became comprised in the trust that is relevant.  The residence of the trust is not important for IHT. 

If the settlor was UK domiciled (or deemed domiciled) when the assets first became comprised in the settlement, a trust’s worldwide assets are within the scope of IHT.  Conversely, if the settlor was non-UK domiciled IHT is limited to UK assets with any non-UK assets being referred to as ‘Excluded Property’.  For more details on excluded property please go to the IHT page here.

Trusts set up by non-UK domiciles are often referred to as ‘Excluded Property Trusts’.  This is because they typically only hold non-UK situs assets (i.e. excluded property) to keep the trust outside the scope of IHT.  If UK assets are to be held these are normally shielded from IHT by holding them in underlying non-UK companies (though since 2017 this is not effective for UK residential property interests, including loans and collateral).

The non-UK domicile status of the trust continues even if the settlor’s domicile subsequently changes, subject to one exception.  Trusts whose settlor is a ‘formerly domiciled resident’ are subject to IHT on their worldwide assets regardless of the settlor’s previous domicile.  A ‘formerly domiciled resident’ is someone who is UK born, has a UK domicile of origin and is UK resident for the tax year and at least one of the two preceding tax years.

For more details on domicile please go to the domicile page here.

Assets subsequently added to the trust and transfers between trusts

Where funds are subsequently added to a trust, the settlor’s domicile position is revisited.  It is, though, possible to keep the original and added funds separate for excluded property purposes.

The settlor’s domicile position is also revisited where there is a transfer between settlements.  If they are UK domiciled at that time, the transferee settlement does not qualify.

Situs of assets for IHT purposes

The situs of assets for IHT purposes is based on common law principles.  The situs of some of the more common types of assets are given below:

Registered shares and securities:       where the register is held

Land and property:                                 where the land is located

Bank accounts:                                        where the branch is located

Simple debts:                                           where the borrower resides

Specialty debts:                                       where the deed is held (unless the debt is secured solely on UK property)

Gift with Reservation of Benefit

Where the settlor of a trust is also a beneficiary, gift with reservation of benefit provisions apply which effectively mean trust assets remain within the settlor’s estate for IHT purposes.  However, excluded property rules take priority over gift with reservation rules.  Therefore, property which qualifies as excluded property is not subject to the gift with reservation provisions.

Relevant Property Regime

With the exception of qualifying IIP trusts, trusts are subject to an IHT relevant property regime to the extent of assets within the charge to IHT (based on the settlor’s domicile status as set out above).  This broadly subjects trusts to IHT each 10 year anniversary with proportionate charges where capital leaves the trust between 10 year anniversaries.  It is the situs at the point of the relevant charge that is important for determining whether assets are excluded property or not (though there is an exception of a two-year overhang for proceeds from the disposal of UK residential property interests).

For more details on the relevant property regime please go to the IHT page here.

Qualifying IIP Trusts

The assets of qualifying IIP trusts (including pre-22 March 2006 IIPs and some later IIPs) form part of the IIP beneficiary’s estate for IHT purposes.  For more details on IHT for individuals please go to the IHT page here.

Administration

Trust Registration Service

The first administration task trusts will often face is whether they need to be registered on the UK’s Trust Registration Service (“TRS”).  This might be long before it encounters a tax consequence in the UK and could be required as early as 90 days after creation.

The requirement to register since 1 September 2022 is as follows (prior to this date only taxable trusts had a requirement):

1. All taxable trusts (broadly those with a UK tax liability)

• All non-taxable UK express trusts created on or after 6 October 2020 (that is, those created deliberately by the settlor)

• The following non-taxable non-UK trusts:

• those which acquire an interest in UK land on or after 6 October 2020; and

• those with at least one UK resident trustee and who enter into a new business relationship with a UK relevant person (financial institutions, accountants, solicitors etc.) on or after 6 October 2020.

There are some exclusions though bare trusts are not excluded unless to hold a child’s bank account.  The exclusions include, but are not limited to, charitable trusts, disabled persons trusts and co-ownership trusts.

The current registration time limit for taxable trusts is registration within 90 days of becoming liable to pay UK tax.  Relevant non-taxable trusts must register within 90 days of the later of creation or meeting the requirements for a non-taxable trust.

Changes to a trust’s registration details must be notified within 90 days.  Notification is also required if a trust changes from being non-taxable to taxable.

Annual Trust and Estate Tax Returns

The requirement for a trust to submit an annual UK tax return depends on whether it has taxable income or capital gains to report.  For a non-UK trust this will typically be only if it has UK source income to report.

The deadline for submitting a return is 31 January following the tax year.

There is also an annual capital gains form for non-UK trusts to track capital gains and capital payments, but this is not mandatory.

CGT Reporting for UK Property Disposals

In addition to annual tax returns, trusts also have a requirement to complete UK property disposal returns to report disposals of directly and indirectly held UK land and property.  As for annual returns, the requirement varies depending on whether it is a UK or non-UK trust:

UK trust:                 Directly held UK residential property but only if there is a tax liability

Non-UK trust:       All directly and indirectly held UK land and property

Returns must be submitted, and any tax due paid, within 60 days of completion.  For trusts required to submit an annual tax return, a summary of property gains and tax paid is also included on the annual return.

Reporting of Trust Income by the Settlor

The settlor will have reporting obligations for a trust where it is settlor-interested.  The extent will depend on the residence of the trust, residence and domicile of the settlor, type of trust and, if a non-UK discretionary trust, whether the trust is protected.  For more details on the income tax treatment of settlor-interested trusts please go to this section here.

Trusts, particularly UK trusts, may issue the settlor with an R185 to assist with reporting and tax credits available (though for a non-UK trust this will be limited to UK source income).

Reporting of Trust Income by Beneficiaries

Similar to settlor reporting, reporting for beneficiaries will depend on the residence of the trust, residence and domicile of the beneficiary and type of trust.  The type of trust is particularly important since this dictates the source being reported.  For IIP trusts it is the underlying sources which are important whereas for discretionary trusts the source is the trust itself.  For more details on the income tax treatment for beneficiaries of non-UK trusts please go to this section here.

Again, UK trusts in particular may issue beneficiaries with an R185 to assist with reporting and tax credits available.

Reporting of Capital Gains by Settlors and Beneficiaries

For UK trusts there are no capital gains reporting requirements for the settlor or the beneficiaries.  The position is different for non-UK trusts.

For non-UK trusts, a UK resident settlor of a settlor-interested trust and UK resident beneficiaries receiving capital distributions or benefits matched to trust capital gains are required to report the gains on their tax return.  For more details on the CGT treatment of non-UK trusts please go to this section here.

Inheritance Tax Reporting for Trusts

The settlor may need to report the transfer of assets to a trust where the trust is in the relevant property regime.  This will usually only apply in the following circumstances:

Where only cash is held:                          If the value transferred exceeds the IHT nil rate band

Where any other assets are held:          If the value transferred exceeds 80% of the IHT nil rate band

Where there is a reporting requirement, returns are generally due 12 months after the month of the event while any tax is generally due six months after.

IHT reporting for trusts is limited to those within the relevant property regime that have a chargeable event.  Where there is a reporting requirement, returns and any tax are due six months after the month of the event.  For more details on IHT relevant property regime for trusts please go to this section here.

US Tax Considerations

Trust Residence

The US taxation of trusts depends very much on whether the trust is considered to be a US trust or a foreign trust.  A trust is a US trust if it meets both the “Court Test” and the “Control Test”.

The Court Test is met if a court in the US is able to exercise primary supervision over the administration of the trust.  Within the bounds of this overarching concept are some key points which will determine the authority of a US court:

• Where the trust document specifies that a court in the US has the authority to exercise primary jurisdiction over the trust, this will result in the Court Test being met.  It should be noted that the opposite is not always the case where a trust document specifies a court outside the US.
• If the trust is registered with a US court, it will be deemed to have met the Court Test.
• In the case of a trust created by a will subject to probate outside the US, the Court Test will be met if the trustees have been qualified as trustees of the trust by a US court.
• Where the trustees or beneficiaries of an inter-vivos trust take actions resulting in the administration of the trust falling within the primary jurisdiction of a US court, the Court Test will be met.

The Control Test is met if one or more US persons have the authority to control all of the substantial decisions of the trust.  In this respect, the term “substantial decisions” will generally include (but is not limited to) the following:

• Decisions on whether to make distributions of income and/or capital to beneficiaries.
• The quantum of any such distributions made.
• The extent to which distributions are made to particular beneficiaries.
• Whether to add, remove, or replace trustees.
• Decisions relating to the appropriate investment of trust assets.
• Whether to take legal action on behalf of the trust.
• Whether the trust should be wound up.

Any trust that does not meet both of these tests is considered a foreign trust.

US Trusts

There are a variety of different types of US trust, but most generally fall within the definition of “grantor trust”, “simple trust”, or “complex trust”.

Grantor Trusts

A grantor trust is a trust in which the grantor (the US equivalent to the settlor) has retained certain powers over the trust.  Such powers include:  retaining a reversionary interest in the trust principal or income; a power of disposition over the trust assets or income; the ability to borrow from the trust without the need for interest or security; or the power to revoke the trust.

As a result of the ability of the grantor to exercise extensive powers over a grantor trust, such trusts are not considered to be separate taxable entities for US income tax purposes.  In other words, the grantor is considered to have retained ownership of the trust assets as far as the income tax effects of those assets are concerned.

Simple Trusts

A simple trust is a trust is a trust which is required to distribute its income to the trust beneficiaries on an annual basis, cannot make distributions of trust principal, and cannot make distributions to charities. 

As far as income taxes are concerned, the income and gains less deductible expenses of the trust are calculated at the trust level.  The income after expenses is then allocated to the beneficiaries.  Except in very specific circumstances, capital gains of a trust are not included in income distributable to the beneficiaries (known as “distributable net income” or “DNI”).  In the case of a simple trust, this typically means that the trust is liable for tax on capital gains, and the beneficiaries are liable for tax on their share of the income.

Complex Trusts

By contrast, a complex trust is not required to distribute its income annually but may retain or distribute income or principal in accordance with the rules set out in the trust document.

As far as income taxes are concerned, the income and gains of a trust are calculated at the trust level, with a deduction available for income distributed to the beneficiaries.  Except in very specific circumstances, capital gains of a trust are not included in income distributable to the beneficiaries.  With complex trusts, the extent to which income is taxable at the trust level will depend on the extent to which the trust has made distributions to it beneficiaries.

Foreign Trusts

Foreign trusts generally fall into one of two categories:  foreign grantor trusts; or foreign nongrantor trusts.

Grantor Trusts

Generally, a foreign trust will be foreign grantor trust if the grantor is a US person and the trust benefits or could benefit one or more US persons, or if the grantor is not a US person and retains certain powers over the trust.  A foreign trust which is not a foreign grantor trust will be considered a foreign nongrantor trust.  These rules are designed to make it very difficult for a non US person to create a foreign grantor trust for the benefit of a US person.

For income tax purposes, a foreign grantor trust is generally treated in a similar manner to a US grantor trust (i.e. the grantor is deemed to have retained ownership of the trust assets such that any income and gains are reported on his/her individual tax return).

Nongrantor Trusts

It is the taxation of foreign nongrantor trusts where things can get a little complicated.  The trust itself is only subject to US income tax to the extent that it realises certain income from sources.  This in itself is relatively straightforward and almost identical to the taxation of a nonresident alien individual.

• a. Distributions

Where foreign nongrantor trusts become problematic is where they make distributions to US residents or US citizens.  In general, where a foreign nongrantor trust makes a distribution to a beneficiary, that distribution is first considered to be made out of DNI (which, in the case of foreign trusts, does include capital gains).  Once the DNI of the trust is exhausted, any remaining distribution amount is deemed to be paid out of prior years’ undistributed income (known as “Undistributed Net Income”, or “UNI”).  Only once both DNI and UNI are exhausted is trust capital deemed to have been distributed.

The computation of DNI and UNI of a foreign Nongrantor trust can be done using either the “default method” or the “actual method” depending on the information provided by the trust.

If the beneficiary is provided with a Foreign Nongrantor Trust Beneficiary Statement, the beneficiary can choose which method to apply.  However, once the default method is adopted, is must be used for all future tax years (except for the year in which the trust is wound up). 

If the trust does not provide a Foreign Nongrantor Trust Beneficiary Statement, the beneficiary must use the default method.

• b. Deemed Distributions

Assets do not necessarily need to move from a foreign trust to a US beneficiary for a distribution to have been considered made.

Any uncompensated use of trust property by a US beneficiary of a foreign trust is considered to be a distribution by the trust to that beneficiary.  The amount of the distribution is determined by reference to the fair market value of the use of the property.

Additionally, loans from a foreign trust to a US person will also be deemed to be a distribution to that US person.  However, this can be mitigated in cases where the loan meets the requirements to be considered a Qualified Obligation.

i. The Default Method

The default method operates to treat any distribution in excess of 125% of the average distributions over the previous three years as if it were a distribution of UNI.  The remainder is deemed to be a distribution of DNI.

The default method is mandatory in cases where the trust does not provide the beneficiary with a “Foreign Nongrantor Trust Beneficiary Statement” detailing the nature of the income and gains distributed.  In certain circumstances, it may be beneficial even where such a statement is provided.

It is important to note that, if a beneficiary chooses the default method for one year, they must continue to use it for all further tax years.  The only exception to this rule is the tax year in which the trust is wound up.

ii. The Actual Method

The actual method requires the trust to look at the actual DNI of the trust for the year and to allocate it to each beneficiary on a pro-rata basis in accordance with their distributions.  The DNI allocated to the beneficiaries retains its original nature (e.g. interest income is passed to the beneficiaries as interest income, qualified dividends are passed to the beneficiaries as qualified dividends, etc.).

Where the distributions exceed DNI, the trust is required to allocate any UNI to the beneficiaries on the same pro-rata basis.

• c. The “Throwback Tax”

The taxation of any UNI considered to have been distributed to a US citizen or US resident is extremely complex. 

Firstly, UNI does not retain the nature of the original source of income, meaning that beneficial tax rates for long term capital gains and qualified dividends are not relevant.  Instead, the full amount of any UNI distributed is taxable as ordinary income in the hands of the beneficiary. 

Secondly, the beneficiaries tax rate is determined as if the distribution had been received over three of the previous five years (disregarding the year with the highest marginal tax rate, and the year with the lowest marginal tax rate). 

Finally, interest on the resulting tax is calculated by reference to the number of years that income has accumulated in the trust.  The intended effect of the interest charge is to nullify any perceived benefit form deferring tax by delaying distributions to beneficiaries.

This is commonly known as the “Throwback Tax”.

The 65-Day Election

As noted above, the DNI calculations typically involve trust income for the tax year in question.  This can pose practical issues where trustees and beneficiaries are attempting to manage their exposure to income taxes, and particularly to the Throwback Tax, as the trust will not necessarily know its total income for the year in time to make an appropriate distribution by year end.

To ease this difficulty, it is possible for a trust to elect to treat any distribution made during the first 65 days of the year as if that distribution were made on 31 December of the preceding year.

Attribution Issues for Foreign Trust Beneficiaries

Many of the income tax provisions noted above that are related to foreign trusts were enacted with the intent that they should operate to nullify the potential for tax avoidance or tax deferral using foreign trust structures. 

In a similar vein, provisions exist to prevent tax avoidance and tax deferral where a foreign trust holds an interest in certain other types of entity, notably Passive Foreign Investment Companies (“PFICs”) and Controlled Foreign Corporations (“CFCs”).  These provisions can act to attribute PFIC and CFC income to the beneficiaries of a foreign nongrantor trust even in cases where no distribution is made to the beneficiaries during the year.

The operation of the attribution rules is relatively clear cut in the case of interest in possession type trusts where there is no ambiguity as to the beneficiaries entitled to the income.  In the case of discretionary trusts however, a facts and circumstances assessment is required to determine the extent to which income should be attributed to particular beneficiaries.

Distributions in Specie

In contrast with the UK tax position, where a trust makes a distribution of an asset rather than of cash, US tax law does not require the trust to realise gain on a deemed disposal of that asset.  Instead, the beneficiary receives the asset at the trust’s base cost for capital gains purposes.

In the event of a distribution of assets, it is possible for the trustee to elect to realise gain and therefore for the beneficiary to receive the asset at fair market value.  The determination of whether this election is beneficial will depend on the tax position of the trust and the beneficiary receiving the asset.