Shore things?

Are offshore trusts dead? It might seem so as high tax jurisdictions enact ever-more sophisticated anti-avoidance tax legislation and a blanket of bureaucratic money laundering compliance spreads across the globe, increasing administration costs. In fact, the reality is rather different and reports of the death of the international trust industry are perhaps exaggerated. Indeed, a renaissance may be ahead.

Trusts have been used (in the late 20th century at least) to reduce, avoid or defer tax liabilities. In the UK context, the Finance Act 1980 legislation provided a green light to UK-resident and UK-domiciled individuals to use foreign trusts to defer capital gains tax on investment portfolios and property. By the late 1980s, when the use of Jersey trusts had become commonplace cocktail party chatter, the Government had to act to curtail the use of foreign trusts to safeguard the Exchequer. The doors closed to new trusts in 1991 and the grandfathered treatment of pre-1991 trusts was removed in 1998. This, combined with a general reduction in capital gains tax rates on business assets, reduced significantly the use of tax haven trusts by UK families.

The Treasury may be planning to adopt a similar approach to the favourable rules which apply to UK-resident, non-domiciled persons and which have been a mainstay of the British Isles’ offshore trust industry since the mid-1990s. With newspapers writing about billionaire Labour Party donors enjoying the benefits of London without making meaningful tax contributions, the Government announced a review of the residence and domicile rules in late 2002. Since then there has been just one consultation paper indicating that modernisation was necessary and tax benefits for foreigners should be circumscribed.

It is this latter aspect that is keeping the draft legislation drawn up by HM Revenue & Customs under wraps. If handled incorrectly, this issue could lead to significant capital flight, the withdrawal of foreign financial institutions and, indeed, the withdrawal of whole industries (for example shipping and bloodstock) from the UK, and it could even destabilise our beloved residential property market, which props up the UK economy. If the Finance Act 2005 is anything to go by (abolishing the ability of non-UK domiciliaries to shelter gains on UK companies using bearer shares), the plan is to start making annual incremental legislative changes to the non-UK domiciliary tax regime and the benefits conferred by foreign trusts. Perhaps 2006 will see the rules on the taxation of capital gains of trusts extended to non- UK-domiciled persons as well as UK domiciliaries. Such an approach could be justified on the basis that it merely brings the treatment of capital gains into line with the treatment of income.

If the tax-driven uses of offshore trusts continue to be circumscribed, why do I believe there is a bright future? Because of a renewed interest in asset protection planning as entrepreneurs begin to wake up to the fact that divorce laws can decimate their wealth. The so-called 50-50 rule established by the House of Lords in the case of White v White has been manifesting itself in the last 12 months in ever-more bizarre ways, in particular:

  • In Miller, the Court of Appeal gave the wife £5m after a short marriage (equating to £5,000 per night).
  • In Rowlands, the wife attacked her father-in-law’s £100m-plus fortune.

As high-net-worth individuals realise that not only their own marriage breakdowns, but those of their offspring, represent a far greater threat to their wealth than any tax liability, so carefully crafted and administered offshore trusts combined with family protocols (“if you want to participate in my wealth you have to abide by my rules”) and prenuptial agreements will become the norm to protect inherited wealth. The Bahamas has stolen a march on its competitors by passing legislation that prohibits a Bahamas court enforcing a foreign matrimonial judgment, but of course it will be necessary for the assets as well as the trust to be based in the Bahamas.

The other major dynamic of the international trust industry in the 21st century is the ever-increasing voluntary and enforced movement of individuals around the globe. Whatever the reason, be it education, work, retirement to the sun, or to escape political and economic instability or ethnic repression, cross-border movement is the greatest opportunity to restructure wealth in a way that is both tax-efficient and to protect assets from the reach of capricious governmental bodies or vexatious litigants. Moving oneself (or one’s children) to the US or the UK, for example, is likely to involve the creation, dismantling or restructuring of trusts to minimise or to take account of the tax rules in the new host jurisdiction. Pre-immigration ‘drop-off trusts’ may confer benefits (differing in size and scope) in the US, the UK, Canada and France, to name just four high tax jurisdictions.

In a purely UK context, those UK-domiciled families which retained their trusts from the 1980s (as opposed to repatriating them to the UK) are beginning to see benefits, as UK trusts are now taxed at 40 per cent rates. With the growth of absolute return asset allocation strategies involving the use of hedge funds (always offshore, non-distributor funds) the return from these assets are taxed as income and not capital gains. In a trust where the settlor is either excluded from benefit or dead, the maximum tax liability on distribution is 40 per cent, and this can be deferred indefinitely without the supplementary charge which applies to capital gains. Where the original settlor has died, even capital gains can be deferred indefinitely, albeit subject to the six-year supplementary charge.

Trusts are the modern incarnation of ‘uses’, a device designed to protect the landed estates of medieval landowners who went on crusades in the 12th century. As we enter the 21st century, perhaps the original purpose of trusts, that of asset protection, will reassert itself over the purely tax-driven planning of recent decades.

Andrew Penney is head of international tax and trust at Speechly Bircham