Robert Clifford investigates how a raft of proposals announced by the Chancellor will affect the operation of offshore trusts. Robert Clifford is a partner at Theodore Goddard in Jersey.
One certainty about the Chancellor, Gordon Brown's first full Budget was that it would do no favours for the offshore islands.
As expected, offshore trusts attracted particular attention. But the net effect of the changes does not appear to be unduly disadvantageous, although there is no doubt that the islands will lose some business as a consequence of the Budget proposals.
There is, perhaps, an argument that the radical changes to capital gains tax may, in the long term, have more of an effect on the business of the offshore islands than the changes specifically introduced in relation to offshore trusts.
The abolition of the indexation allowance and the introduction of tapering relief applicable to individuals, trustees and personal representatives, resulting in an effective rate of tax as low as 10 per cent for business assets, may prove to be a disincentive to investors to move offshore.
It is thought likely, however, that non-domiciled individuals, in particular, will continue to consider very carefully the flexibility which remains available through offshore structures in relation to inward investment into the UK.
The direct action taken by the Chancellor in relation to offshore trusts falls into two main categories: the extension of the rules for trusts created before 19 March 1991 and the extension of the charge on beneficiaries.
The main proposal to extend the rules for trusts created before March 1991 brings into line the treatment of trusts set up by UK domiciled and resident settlors before that date with those set up subsequently.
At present the settlor of a trust established after 19 March 1991 is charged to tax in respect of gains made by the trust if the settlor, the settlor's spouse, their children or the companies they control can benefit from the trust.
These offshore trusts are therefore effectively transparent, being treated for capital gains tax purposes as though the trust fund continues to belong to the settlor.
These rules did not apply to trusts created before 19 March 1991 unless, broadly, funds were added to the trust. The Chancellor's proposed changes will extend the rules to trusts established before 19 March 1991, regardless of whether property is added.
The new rules will take effect from 5 April 1999 with special rules applying in the intervening period.
These changes appear to be driven by political expediency rather than a genuine need for fiscal reform. They have a significant retrospective element and give rise to considerable potential problems.
Before the changes, gains made in offshore trusts established before 19 March 1991 could be deferred but they attracted tax at rates of up to 64 per cent in the hands of recipient beneficiaries in the UK.
If the Chancellor's proposals are implemented, many settlors who established trusts years ago, excluding themselves and their spouses from any future benefit, may find themselves liable to capital gains tax in respect of gains made by trustees they cannot control and who have no other connection with the UK. Although such settlors will have a statutory right of recovery in respect of tax paid, such rights may well be unenforcable against their children's trustees in another jurisdiction.
A great deal of thought will need to be given to the future of these trusts, with possibilities being the appointment of new UK resident trustees or changes to the class of beneficiaries.
An alternative may be for non-resident trustees to remain in office until such time as gains are likely to be made. At that point the trustees could decide whether to appoint new UK resident trustees (who would be liable to tax at the current rate of 34 per cent), or to remain outside the UK where the liability to tax on the settlor may be either more or less depending on the settlor's residence status and marginal rate at that time. Any such decisions will be for the trustees rather than the settlors.
The other main change is the extension of the charge on beneficiaries. Under existing rules capital payments made by trustees of trusts established by non-UK domiciled beneficiaries were not liable to tax on receipt by beneficiaries in the UK, whatever their tax status. The example of Paymaster General Geoffrey Robinson springs readily to mind.
Perhaps unsurprisingly the changes proposed by the Chancellor have the effect of charging UK domiciled and resident beneficiaries of such trusts to tax in respect of gains realised and capital payments made on or after 17 March 1998.
In the case of UK domiciled and resident or ordinarily resident beneficiaries receiving capital payments, it is possible that future planning techniques may centre on reducing their liability to tax by making distributions to other non-domiciled family members or by reducing the value of the benefit conferred, for example, by making loans rather than outright payments.
The proposed changes leave intact the inheritance tax benefits of offshore trusts available to settlors domiciled outside the UK. Where offshore trusts are established by such non-domiciled settlors with a purpose other than that of avoiding liability to UK taxation, income arising in the trust continues to be able to be paid to UK beneficiaries without liability to tax.
It would appear also that capital payments will still be able to be made to beneficiaries resident but not domiciled in the UK without liability to capital gains tax.
There were a number of other specific changes in relation to offshore trusts, including:
the changes announced on 6 March 1998 to remove the exemption from gains realised on the disposal of a beneficiary's interest in an offshore trust where new UK resident trustees had been appointed. This exemption had formed the basis of a capital gains tax avoidance scheme;
the retention of pre-1991 tax rules for grandchildren; and
an extension of the information provisions.
Other changes which will have an effect on the offshore islands include:
Taxation of life insurance policy holders. Under existing rules a gain in respect of a policy written in trust was assessed on the settlor. If, however, the settlor had died or become non-resident when the gain was realised, liability to UK taxation could be avoided. With effect from 6 April 1998 liability to tax will fall on UK resident trustees, if there are any. In the absence of such trustees the tax liability may fall on the UK beneficiaries.
Taxation of personal portfolio bonds. These are broadly policies where the benefits are linked to assets personal to the policy holder. The benefit of such policies was the ability to defer a tax charge for many years or to escape tax by being non-UK resident on maturity of the policy. Under the Budget proposals there will be an additional tax charge on the deemed “gain” equal to 15 per cent of the sum of the total premiums paid up to the end of each “policy year” and the total of deemed “gains” from previous years. The additional annual tax charge will not be imposed before 6 April 1999. For a 40 per cent taxpayer the effective annual rate of tax will be 6 per cent of the total premiums paid which may be significant over the period of the policy.
Temporary non-residence. Where individuals leave the UK on or after 17 March 1998, capital gains realised on assets owned at the date of departure during a period of non-UK tax residence will remain chargeable unless the individual becomes not resident and not ordinarily resident for a period of at least five complete tax years. It is intended that particular rules will be introduced for assets owned by offshore trusts and companies. It is likely that future planning may well focus on the terms of appropriate double tax treaties which will continue to be observed. The Budget, however, announced a review of double tax treaties generally.
foreign earning deduction. Prior to the Budget it was possible for a UK resident to obtain a complete deduction from employment carried out wholly or partly abroad during a qualifying period of 365 days or more. The Inland Revenue's belief that the provision gave an unfair advantage to a few has resulted in its abolition with immediate effect.
Stamp duty. With regard to stamp duty on transfers of property (other than shares) the rates are to increase to 2 per cent for transfers between £250,000 and £500,000 and 3 per cent for properties in excess of £500,000. The obvious consequence is the increased cost of investment.
What may yet prove to be the most significant aspect of the Budget for the offshore islands was the announcement of a consultative document with regard to a general anti-avoidance rule.
The purpose of any such statutory rule would be to deter or counteract transactions designed to avoid tax in a way that conflicts with the intention of Parliament. The possibility of such a rule will no doubt promote heated.
For those interested in the subject, the recent report by the Tax Law Review Committee of the Institute for Fiscal Studies makes essential reading.
see page 29 for details of the Isle of Man Budget.