United Kingdom

2. Taxation

a. Tax system

i. General concepts of tax liability

Income tax (IT) is charged in accordance with various IT acts, principally the Income Tax(Earnings and Pensions) Act 2003 (ITEPA), the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) and the Income Tax Act 2007 (ITA). Capital gains tax (CGT) is charged on gains realised from disposals (and deemed disposals, such as when a beneficiary becomes absolutely entitled as against a trustee) of assets computed in accordance with the Taxation of Chargeable Gains Act 1992 (TCGA). Inheritance tax (IHT) is charged in accordance with the Inheritance Tax Act 1984 (IHTA). Annual finance acts amend existing legislation and introduce new provisions.

ii. Trust tax rates

2009/2010 Interest in Possession (IIP) Trust Discretionary Trust and Accumulation & Maintenance (A&M) Trust*
Dividends 10% satisfied by notional tax credit 32.5%
Other income 20% 40%
CGT 18% 18%

* Subject to the standard rate band: first GBP1,000 taxed at 10 per cent/20 per cent, as appropriate. The band is shared between all the trusts created by the same settlor to a minimum of GBP200 (see d. 2 below).

* as noted above, the top rates of income tax will be increased to 50 per cent for those individuals with taxable income above GBP150,000 and for discretionary or accumulation and maintenance (A&M) trusts (in place of the 40 per cent rate shown), with effect for the year commencing 6 April 2010. The dividend rate will increase in such cases to 42.5 per cent.

iii. Tax evasion and avoidance

Tax evasion is illegal and carries severe penalties. Historically there has been a clear distinction between tax evasion and legitimate tax avoidance, but this distinction has become blurred, with avoidance increasingly being targeted and wide-ranging anti-avoidance legislation being introduced.

If a settlor (or spouse/civil partner) retains an interest in settled property, the income is taxed on the trustees, at the trust special rate of 40 per cent (32.5 per cent for dividends) but it is deemed to be the settlor’s income. The settlor, by HMRC concession, is given an equivalent tax credit on the income deemed to be the settlor’s, as are beneficiaries to whom such income is actually paid.

Distributions of income from trusts for minor unmarried children are taxable to the settlor. For CGT purposes a trust is ‘settlor interested’ if its beneficiaries include a minor unmarried child of the settlor. Gifts of assets into such settlements are not eligible for holdover relief or tax deferral.

Rules requiring disclosure of tax avoidance schemes now cover IT, CGT, corporation taxes, national insurance, VAT and Stamp Duty Land Tax (SDLT). Promoters must make disclosure within five days of the date when a relevant scheme becomes available for implementation.

iv. Taxable periods and filing requirements

The year of assessment for IT and CGT is 6 April to 5 April. Every person (including a trustee) who is liable for IT or CGT must give notice to HMRC by 5 October.

Trustees are required to file a return of income and capital gains. Returns completed manually must be filed by 31 October and electronic returns by 31 January after the end of the year of assessment (or within three months if returns are issued later).

HMRC may make an enquiry into any return within 12 months of the filing date or later if the return is submitted late. If HMRC can show ‘discovery’ (i.e. inadequate disclosure), they have an extended time limit of five years.

Trustees are required to preserve records until the end of the enquiry period, or, if they are carrying on business as trustees, for five years.

b. International

i. Residents with foreign investments/transactions

Taxation of individuals depends on their residence and domicile. A UK resident/ordinarily resident (R/OR) individual, domiciled in the UK, is taxable on worldwide income as it arises and on worldwide capital gains. FA2008 introduces significant changes to the taxation of a foreign-domiciled resident in the UK. From 6 April 2008 such individuals are taxable on worldwide income and gains as they arise unless they elect to be taxed on a remittance basis. If a foreign domiciled individual has been present in the UK for more than seven out of the past ten years there will be a minimum tax charge of GBP30,000pa if the remittance basis is claimed. Furthermore, the individual will be denied the personal allowance for income tax and the annual exemption for capital gains tax. If a foreign-domiciled resident has less than GBP2,000pa offshore income they will be assessed on the remittance basis without election. Definitions of remittances to the UK are included in FA2008.

ii. Expatriates

The basic test of UK residence is 183 days in any tax year; FA2008 defines a day in the UK as being present at midnight (subject to limited exceptions for transit passengers).

Visitors spending fewer than 183 days in the UK may also be resident if they make regular visits with all circumstances taken into account when assessing the weight to be ascribed to the quality of such visits. While, generally, a person is regarded as resident when visits exceed, on average, 91 days per tax year, a lesser number of days’ presence may still lead HMRC to view residence as being assumed if other factors evidence a settled connection with the UK. This particularly applies for an individual previously ordinarily resident in the UK who seeks to expatriate. Visitors may be resident from the year of arrival, if they intend making such regular visits; otherwise, they are resident from the tax year in which they so decide or, at the latest, from the fifth year after establishing such a pattern of visits.

Someone coming to the UK for employment is treated as resident from the day of arrival to the day of departure, if coming to work for at least two years. If a person intends to stay for three years or more, that person would be regarded as ordinarily resident.

An employee is taxable on worldwide employment income, unless the duties are performed wholly outside the UK for a non-resident employer, in which case a foreign domiciled employee may be taxed on the remittance basis. Those not ordinarily resident may qualify for earnings attributable to foreign duties to be taxable only on remittance – though to do so will result in the loss of personal allowances and exemptions as described above.

iii. Non-residents

Under HMRC practice, an individual leaving the UK to work full-time abroad is treated as not resident and not ordinarily resident from the day after departure until the day before return, provided that the absence from the UK and employment abroad both last for at least a whole tax year. Visits to the UK should total less than 183 days and average (taken over a maximum period of four years) less than 91 days a tax year, but there is the need to look at all factors in assessing the quality of UK visits.

Where gains are realised during a period of temporary absence (less than five tax years) from assets held at the departure, TCGA 1992 contains anti-avoidance provisions that charge CGT in the year of return.

Under FA2008, remittances during a period of absence of less than five tax years may be taxed on a returning individual who has claimed the remittance basis.

Unless double taxation agreements provide otherwise, non-resident foreign workers are subject to UK tax on any income received by way of remuneration for the performance of UK duties, unless purely ‘incidental’ to their overseas duties.

Non-residents are, in general, entitled to the personal tax allowance only if UK nationals, Commonwealth citizens, or European Economic Area (EEA) nationals.

Non-residents are liable for tax on UK source income, with certain exemptions. Their liability will be the lower of tax assessed in the usual way on total UK income and tax at normal rates on non-excluded UK income received (e.g. rental income). Interest and dividends are excluded income.

Non-residents/ordinary residents are not liable for CGT, unless gains are derived from assets used in a UK trade or derived from short-term land transactions.

iv. Tax treaties

Where double tax agreements have not been put in place, the UK gives unilateral relief for foreign withholding tax.

c. Pre-owned assets tax (POAT)

POAT applies IT on the benefit enjoyed when a person has continuing use of an asset they either owned or for which they provided the funds to purchase. POAT may be avoided if an election is made to opt into the ‘gifts with reservation of benefits’ (GROB) provisions, with the result that this property will be aggregated with the taxpayer’s estate on death for IHT purposes. Time limits apply.

d. Taxation of trusts

i. IT

1) IIP trust

The trustee is liable to 20 per cent tax on all income other than dividends. Dividends carry a 10 per cent tax credit and the trustees have no further liability on such income. Certain items, which are capital for trust purposes but deemed income for tax, are taxed at 40 per cent, regardless of the type of trust. All trustees are taxable at 32.5 per cent on the deemed income element of payments made by a company on the redemption, repayment or purchase of its own shares or of rights to acquire such shares.

Although general trust expenses are not deductible in computing trustees’ liability, they are deductible when calculating income taxable in the hands of a life tenant.

2) Discretionary trust

Trustees have a standard rate band. This is set at a maximum of GBP1,000, but this is divided between all trusts created by the same settlor subject to a GBP200 minimum. Income within this band is charged to IT at 10 per cent or 20 per cent (as appropriate). The IT rate on income in excess of the standard rate band is 40 per cent (32.5 per cent for dividend income). Trustees are required, however, to account for tax at 40 per cent on distributions of income to beneficiaries (who are then entitled to a corresponding tax credit) with the consequence that where tax has been charged at a lower rate, additional further liability may arise.

ii. CGT

Trustees are chargeable to CGT at the tax rate of 18 per cent. Trustees are entitled to an annual exemption – GBP5,050 for 2009/10 (but reduced where there are related settlements). For CGT purposes, trustees are deemed to dispose of trust property and reacquire it at market value when assets are transferred to a beneficiary. Holdover relief may be available. The trustees may be able to claim entrepreneurs’ relief, reducing the tax rate to 10 per cent.

iii. IHT

Trusts created since 22 March 2006 will, in general, be subject to the unified regime that previously applied to discretionary trusts. Broadly, rather than being aggregated with a life tenant’s free estate, property held in trust is now taxed every ten years and on distribution. There are exceptions for trusts for qualifying disabled beneficiaries and for certain categories of trusts created on death: trusts for bereaved minors (TBMs), 18 to 25 trusts and immediate post-death interest trusts (IPDIs). IIP trusts created before 22 March 2006 continue to be taxed under the old rules during the lifetime of beneficiaries who were alive on 21 March 2006, or where conditions were met to establish a transitional serial interest (TSI).

A&M settlements have been taxed as discretionary trusts since 6 April 2008, unless the terms provide for absolute vesting by the age of 25 years. In such cases there will be no IHT charge if assets are taken absolutely at 18 years. If vesting is delayed, IHT charge will be imposed in relation to the additional period from 18 years until vesting.

TBMs and 18 to 25 trusts can arise only by will on the death of a parent (including a step-parent or other individual who has had parental responsibility), under intestacy provisions in favour of issue, or under the Criminal Injuries Compensation Scheme. Provided the beneficiary becomes absolutely entitled to the assets at age 18 years, IHT and CGT rules work in the same way for both trusts. There is no IHT when assets leave the trust, and CGT holdover relief can be claimed. Assets of the trust are not treated as part of the beneficiary’s estate should the beneficiary die under the age of 18 years, with no base cost uplift (unless an IIP subsisted). In an 18 to 25 trust, when the age of 18 years has passed and assets have not vested, there will be no CGT base cost uplift if the beneficiary dies before taking an absolute interest. There will be an IHT charge (maximum rate of 4.2 per cent) on exit (on which event, CGT holdover relief will be available).

iv. Inter vivos settlements

Generally, lifetime transfers into trust are chargeable at the lifetime IHT rate of 20 per cent, subject to increase should the donor die within five years. There are exceptions for gifts to trusts for qualifying disabled beneficiaries and for gifts into a TBM on termination of a prior IPDI (most typically in favour of a surviving spouse). In such cases, the gift is a potentially exempt transfer with no IHT liability, provided the donor survives for seven years.

Transfers of chargeable assets to any type of trust attract CGT. The settlor is deemed to have disposed of, and the trust to have acquired, the assets at market value. Holdover relief is generally available, provided the trust is not settlor interested.

v. Trust modernisation

FA2005 introduced special provisions for trusts for vulnerable beneficiaries (narrowly defined). FA2006 aligns the definitions of ‘settlor’ and ‘settled property’ for most income and capital gains purposes. It also provides that a trustee may make an irrevocable election for sub-funds to be segregated for tax purposes.

vi. Non-resident trusts and foreign investment entities

A trust will be resident in the UK if the settlor is resident, ordinarily resident or domiciled in the UK at the relevant time, and at least one of the trustees is resident in the UK. For a testamentary trust, the relevant time is the date of the settlor’s death; for an inter vivos trust, it is the date when the settlor is treated as making a settlement. There is no longer privileged treatment of UK professional trustees, as there was previously for CGT.

A non-resident trustee is treated as resident in the UK whenever acting as trustee in the course of a business carried on in the UK through a branch, agency or permanent establishment. This additional test is a cause of considerable concern to non-resident trustees with UK affiliates or agents and HMRC guidance is still awaited. Overseas trustees may need to take advice on the scope of these provisions. Further information is available on the STEP website.

Non-resident discretionary/accumulation trusts are subject to tax on UK source income at 40 per cent (32.5 per cent on dividends). The income of a non-resident life interest trust is taxed as that of the life tenant, and is dependent upon the life tenant’s UK tax status.

Income of an offshore trust is assessable as the settlor’s if the settlor or settlor’s spouse/civil partner can benefit from the trust, and is resident in the UK. Undistributed income of an offshore trust may otherwise be attributed to capital distributions made or benefits provided to a beneficiary who is resident and ordinarily resident in the UK.

Trustees of non-resident trusts are not themselves liable for CGT. Capital gains in offshore trusts are attributable to the settlor, if resident/ordinarily resident and domiciled in the UK, and if any of the settlor, spouse/civil partner or children and grandchildren are interested. A settlor who is non-resident or claims the remittance basis is not liable to CGT on gains as they arise, even if gains are made in the UK. If not assessable on the settlor, gains realised by foreign trustees are attributable to capital advances or benefits conferred on other beneficiaries. FA2008 introduces significant and complex changes for offshore trusts with beneficiaries of foreign domicile or who claim the remittance basis. Gains realised after 5 April 2008 will be taxable attributable to capital payments remitted to the UK by such beneficiaries, except to the extent that such gains relate to the period before 6 April 2008, provided that the trustees have elected (within two years of the first such payment) for assets to be held in trust – or in an underlying close company – to be rebased at 5 April 2008.

Beneficiaries to whom taxable gains are attributed under these provisions will be subject to supplementary charges (bringing the maximum capital gains tax rate to 28.8 per cent) if more than a year has elapsed between the realisation of the trust gain and its attribution.

Further complex provisions apply to gains realised from offshore funds which have not secured ‘distributor’ or ‘approval’ status. Such gains are taxed as income.

Property owned by a non-domiciled individual and situated outside the UK is excluded property for IHT purposes. This principle also applies to trusts; if the settlor was not UK domiciled at the time of the settlement, foreign property held within the trust is excluded, except where an initial IIP was given to the settlor or settlor’s spouse/civil partner before 22 March 2006 (or the trust is a post 22 March 2006 IPDI or trust for qualifying disabled beneficiaries). In such cases, excluded property status is lost if the last to hold the interest of the settlor (or spouse/civil partner) is domiciled or deemed domiciled in the UK when the interest terminates.

e. Taxation of gifts, transfers, estates and at death

There are no annual wealth taxes in the UK. IHT is charged on capital transfers. The value of the capital transfer is calculated by reference to the diminution in value of the transferor’s estate. A gift where the transferor retains a benefit is not an effective transfer of value for IHT purposes.

Capital transfers, on death and inter vivos, between UK domiciled spouses/civil partners, qualifying charities and political parties are exempt from IHT. Additionally, for lifetime giving, exemptions allow an individual to make gifts of up to GBP3,000 each year free of IHT, together with small gifts of up to GBP250 to individuals, and certain gifts in connection with marriage. Regular gifts out of income have no impact for IHT. Business property relief or agricultural property relief may be available.

Absolute lifetime gifts to individuals are ‘potentially exempt transfers’ (PETs). Provided the donor survives for seven years, there is no IHT. There may be CGT chargeable on the disposal of a chargeable asset. In certain circumstances, the CGT can be deferred until the donee disposes of the asset.

On death, the free estate and any interests in settled property not within the relevant property regime are aggregated with transfers in the seven years (PETs and all chargeable transfers) before death to ascertain IHT payable. IHT on the lifetime gifts is recalculated (using the nil-rate band in place at the time of death – currently GBP325,000) at the death rate of 40 per cent. Where the donor has survived by more than three years, there is a tapered relief on the amount of tax payable. Any lifetime tax paid is deducted from the tax due on death. The value of the free estate and settled property (less any IHT reliefs available) in excess of the unused nil-rate band is subject to IHT at 40 per cent.

FA2008 introduced the transferable unused nil-rate band for spouses. On the death of the second spouse after 9 December 2007 the unused percentage of the nil-rate band on the death of the first spouse, as applied to the nil-rate band at the time of the second death can be added to the available nil-rate band of the second spouse to die.

Donees of lifetime gifts in the previous seven years are liable for any additional IHT due. Personal representatives are responsible for IHT on the free estate, although the will may specify that a gift bear its own tax. Trustees are liable for the tax on the settled estate. There is a tax-free uplift to market value of all assets in the estate for CGT purposes.

Personal representatives are liable for IT during the period of administration (10 per cent on dividend income – covered by the tax credit, and 20 per cent on other income). If personal representatives are required to sell assets to administer the estate, they will be liable for CGT at 18 per cent on gains exceeding the annual exemption, equivalent to the personal exemption (currently GBP10,100) for the year of death and two subsequent years.

f. Other taxes

If a trade or business is carried on by a trust, the trustees must register the trade/business for value added tax (VAT) if the trade/business revenue exceeds GBP68,000.

Stamp Duty is a tax on documents, not a tax on transactions. The rate of duty on shares or securities is 0.5 per cent. Gifts for no consideration, including gifts into or out of trust, are generally exempt from Stamp Duty.

Stamp Duty Land Tax (SDLT) is a tax on transfers of interests in land and buildings in the UK. There are different rates of SDLT for residential real property and non-residential or mixed real property. Gifts for no consideration are generally exempt, except for a transfer of an interest in land to a company.

In addition to central government taxation, local authorities impose property taxes. The rates are set by the local billing authority and vary from year to year.

© 2012 Society of Trust & Estate Practitioners