US/UK estate tax planning has never been more fraught with traps for the unwary. The radical changes introduced in the UK Finance Act 2006 (FA 2006) to the inheritance tax treatment of trusts may have a serious impact on UK domiciliaries who, either because they are resident in the US or have US assets, undertake a common form of US tax planning known as the ‘Living Trust’. A Living Trust is a trust created during a person’s lifetime, usually to avoid having to apply for probate in the US or for US estate planning purposes. US nationals can also be caught out if they either hold UK assets, or have lived for many years in the UK.

The difficulties for a UK domiciliary arise if they are either resident in the US or are a US national as they will fall within both the UK inheritance tax and the US estate tax regimes (the UK taxes on the basis of domicile and the USA on the basis of nationality)

Often people in this position (and even their US advisors) are not aware of the FA 2006 changes to the inheritance tax treatment of trusts. These changes make it almost impossible to set up substantial lifetime trusts without incurring an immediate charge to inheritance tax. Living Trusts are heavily marketed in the US as a sensible planning option, one marketing slogan calling it ‘the fail-proof way to pass along your estate to your heirs’. This ignores the effect of such planning from the UK perspective, which can be disastrous for the UK domiciliary.

The double tax treaty between the two countries will not prevent a charge to UK tax arising in these circumstances

The broad effect of the UK FA 2006 changes is to impose an immediate 20 per cent charge to UK inheritance tax on the creation of lifetime trusts (with a few exceptions), with periodic charges to UK inheritance tax every ten years and exit charges whenever assets leave the trust. The double tax treaty between the two countries will not prevent a charge to UK tax arising in these circumstances and there could be penalties imposed by the UK Revenue if the Living Trust is not reported to them.

It is quite possible that a UK domiciliary believes he has lost his UK domicile, simply by virtue of becoming resident in the US for an extended period. However a domicile of origin in one of the jurisdictions of the UK is not easily shed, and such a claim to have become non-UK domiciled could be challenged by the UK Revenue.

Not all Living Trusts will be caught. Only those created (or amended) after 22 March 2006, the date when many of the FA 2006 changes came into effect, are at risk. Much will depend on how the Living Trust document is worded and each case depends on its facts. The wording of any proposed Living Trust (or even an amendment to an existing Living Trust) needs a ‘health check’ by a UK lawyer with expertise in UK inheritance tax and trusts, to avoid creating a ‘settlement’ that will fall within the UK inheritance tax regime.

It is advisable for any US national who may become UK domiciled to consider estate tax planning well in advance

Different considerations will apply to US nationals who do not appear to have any strong UK ties. The implications of FA 2006 are still relevant to them broadly if either or both of the following situations apply:

• if they hold assets situated in the UK; or
• if they become domiciled in one of the three jurisdictions that make up the UK, namely England and Wales, Scotland or Northern Ireland (for simplicity we are referring to ‘UK domicile’ rather than domicile in one of these three jurisdictions, as the inheritance tax regime is the same in each).

It is important to be aware that the concept of ‘domicile’ has a particular meaning in English law, which is not the same as mere residence. Broadly, it is possible that a US national could acquire a UK domicile by virtue of:

• Having a father with a UK domicile
• Being resident in the UK (even for a relatively short period) and forming an intention to permanently remain here; or
• Falling within the so-called ‘deemed domicile’ statutory rules under section 267 Inheritance Tax Act 1984, by virtue of having lived in the UK for 17 out of the last 20 UK tax years (and an individual can be caught under these rules after only 15 years and a few days, depending on the date of arrival in relation to the UK tax year).

The following examples illustrate some of the implications for US nationals.

Joe is a US national and a US resident who purchased a UK property ten years ago for his son to live in, when he came to study in London. The property is still in Joe’s sole name and is now worth approximately GBP1 million. Joe creates a Living Trust in 2009 over his worldwide property, which is unfortunately worded in such a way as to be caught by the UK settlement rules. There is an immediate charge to UK inheritance tax on the value of the London property. This is at zero per cent on the first GBP325,000 (the so-called ‘nil rate band’), with the balance taxed at 20 per cent, giving rise to a tax charge of GBP135,000. There are also charges (at a maximum of 6 per cent) every ten years on the value of the London flat and, if the flat is sold, when any funds are paid out. If Joe dies within seven years of creating the Living Trust, there will be a further 20 per cent charge on his death.

Tom is a US national who has lived in the UK for 18 years, so fulfils the deemed domicile criteria. Most of his assets are in the USA, and, on a recent visit to the USA in 2009, Tom set up a Living Trust to cover his worldwide estate, including his UK assets. Though the Living Trust is transparent for US purposes, it is worded in such a way as to fall within the UK settlement rules. Because Tom is deemed domiciled in the UK, this gives rise to an immediate charge to inheritance tax, at zero per cent on the first GBP325,000 and at 20 per cent on the balance of his worldwide estate (as the UK taxes on the basis of domicile).

Similar considerations would apply if Tom had been in the UK for a shorter period, but had formed an intention to remain here for the rest of his life and so became domiciled here for UK purposes.

It is therefore advisable for any US national who may become UK domiciled to consider estate tax planning well in advance. In fact it can be helpful for US nationals who may become UK domiciled at a later date to have created a settlement over their non-UK assets, which will qualify as ‘excluded property’, and thus remain outside the UK inheritance tax regime even if they then become UK domiciled.

All this means that the seemingly harmless step of placing your estate into a Living Trust is not to be entered into lightly by US nationals with UK aspects to their estates (or vice versa) without taking the appropriate advice.