UK Implications of US Revocable Trusts Part 2
25 June 2024
In our previous article on US revocable trusts, which was published in Tax Journal here, we discussed the use of US revocable trusts and the Inheritance Tax (IHT) risks that might arise if a revocable trust is or becomes an IHT settlement under English law.
Our clients, however, often find that the UK Income Tax (ICT) and Capital Gains Tax (CGT) implications of their revocable trusts are more of a concern.
In the US, revocable trusts will be categorised as Grantor Trusts and are transparent for US federal income tax purposes, so that the settlor (grantor) is taxed as though he or she personally owned the trust assets, income, and gains.
CGT/ICT settlements vs IHT settlements
Our previous article discussed the requirements for the existence of a trust under English law, and the important distinction between a transparent bare trust and an opaque settlement which would be subject to a special IHT regime. That article considered the features of US revocable trusts that may cause them to be treated as bare trusts from a UK perspective.
It is common even for professional advisors to simply ask whether a US trust is a bare trust or a settlement. However, the question must be asked separately for each UK tax. The definition of a ‘settlement’ under UK tax law is different for IHT and for of ICT/CGT. For CGT/ICT purposes, all trust property is settled property unless it is a ‘bare trust’. That is unless:
a. it is held by a person as nominee for another person;
b. it is held by a person as trustee for another person who is absolutely entitled to the property as against the trustee; or
c. it is held by a person as trustee for another person who would be absolutely entitled to the property as against the trustee if that other person were not an infant or otherwise lacking legal capacity.
It is quite possible for a US revocable trust to be a bare trust for ICT and CGT purposes but a settlement for IHT. This inconsistency may work in the taxpayer’s favour as, in theory at least, it is possible to hold assets outside the scope of IHT in an excluded property settlement, whilst maintaining simple transparent bare trust treatment for CGT/ICT.
Current CGT/ICT consequences of a settlement
The current (i.e. pre-6 April 2025) CGT/ICT regime applying to offshore settlements is complex and cannot be comprehensively condensed into only a few paragraphs. US revocable trusts will always be settlor-interested, and advisors must therefore consider the ICT ‘Transfer of Assets Abroad Code’ and ‘Settlements Code’, as well as equivalent CGT rules found in s.86-87 Taxation of Chargeable Gains Act 1992.
A US settlor of a US revocable trust will personally report and pay US federal tax on the trust’s income and gains. If the trust is an ICT/CGT settlement and has a UK nexus it will additionally be exposed to ICT and CGT:
- If the trustees are UK resident, they will be subject to ICT and CGT on worldwide trust income and gains. It is easy to accidentally import a trust if the settlor is the sole trustee and becomes UK resident.
- If the trustees are offshore, but the settlor is UK resident, the settlor will be chargeable to ICT and CGT on worldwide trust income and gains as they arise, though may claim the remittance basis (if eligible) to prevent an immediate tax charge on foreign income/gains. The protected settlement rules may prevent a charge on foreign income and gains so long as the settlor is not actually UK domiciled or a formerly domiciled resident (born in the UK with a UK domicile of origin), and so long as the trust is not tainted by adding value after the settlor becomes deemed domiciled in the UK. However, the remittance basis and protected settlement rules often cause double-tax difficulties due to foreign tax credit mismatches (see below).
- If the settlor or another UK resident beneficiary receives a benefit from the trust, this benefit will be matched against all undistributed trust income and gains carried forward since the trust became a settlement. Matched income and gains are taxable on the beneficiary unless already charged to the settlor/trustees under the above provisions. This charge may be mitigated through the ‘motive defence’ (see below) or by claiming the remittance basis.
- In many cases a US revocable trust will be a bare trust during the settlor’s lifetime and will only become a settlement following the death of the settlor. Indeed, often the trust may have no UK nexus at all during the settlor’s lifetime, but the trust instrument will provide that, after the death of the settlor, the trust becomes irrevocable and continues for the benefit of next-generation beneficiaries who may be UK resident and/or domiciled. For this reason, the ICT and CGT liabilities of the next-generation beneficiaries (under the third limb above) are often the most relevant. Beware that, although the UK nexus may only have arisen following the death of the settlor, the trust may have been a settlement before this time and pre-death trust income and gains may be matched against post-death distributions to a UK resident beneficiary.
Motive defence
Helpfully, the beneficiary ICT charge (limb 3 above) does not apply if it can be demonstrated that avoidance of a tax liability was not a motivation in creating the settlement. Since many US revocable trusts are not set up for the purposes of avoiding tax liabilities but are usually intended simply to minimise US probate difficulties, this may assist in preventing an ICT charge.
Unfortunately, the equivalent CGT rules are not as generous and, unless the gains are arising to an underlying company held within the trust rather than to the trustees, the motive defence will not be available to prevent trust gains being matched to capital benefits received by a UK resident settlor/beneficiary.
CGT/ICT consequences of a settlement post-6 April 2025
Although there are still some uncertainties surrounding the rules which will apply from 6 April 2025, it is clear that the concepts of tax domicile, protected settlements and remittance basis will be abolished.
The abolition of the protected settlement rules means that UK-resident settlors of non-resident trusts may face significant UK tax liabilities on the worldwide income and gains arising from such trusts if they remain resident from 6 April 2025, regardless of whether the settlor remits those funds to the UK or receives any benefit from them. This may, however, be advantageous in avoiding any timing mismatches in the payment of US and UK tax, improving the tax credit position.
Double tax and foreign tax credits
The income and gains of US revocable trusts are often taxable in the US, either in the hands of the US settlor (under the grantor trust rules) or in the hands of the trustees (typically after the death of the settlor). There is, therefore, an obvious risk of a double tax charge on the same income and gains in the US and UK respectively.
The question of which country has primary taxing rights, and whether US or UK tax suffered will be available as a tax credit to offset the other, is a complex one. Where a US citizen is UK resident (both under UK law and for treaty purposes) the UK will have primary taxing rights except for:
- US source dividends up to the 15% US tax allowed under the Treaty.
- Income and gains derived from US real estate.
- Income and gains effectively connected with US trade or business.
For other income and gains, where a US-citizen UK-resident settlor is liable to ICT/CGT on an arising basis under the Transferor Charge rules above, and the settlor is chargeable in the US on the same income and gains in the same year, the US will accept a foreign tax credit. Conversely, if the trustees are US residents and it is them who are chargeable in the US (not the settlor), the UK will in principle allow a foreign tax credit against the settlor’s Transferor Charge.
The question is made more difficult where there is a mismatch in the identity of the taxpayer, or a mismatch in the timing of the tax event:
- An identity mismatch typically arises where the USA taxes the grantor directly, whereas the UK taxes the trustees and/or the recipient of benefits from the trust. The ‘Exchange of Notes’ in the US/UK Double Tax Treaty confirms that tax paid by a UK resident beneficiary is treated as having been paid by the grantor for the purpose of obtaining a foreign tax credit in the USA. However, this does not apply where it is the trustees who are chargeable in the US (for example, after the death of the settlor).
- A timing mismatch will arise where, for example, the US taxes income and gains as they arise, but the UK tax charge arises in a later calendar year, either when the income/gains are remitted to the UK by the settlor or when a benefit is received by a UK resident beneficiary. The UK has no strict time limit for allowing a credit for US tax paid. However, the US applies a strict rule that a credit will only be available if foreign tax is paid in the same calendar year as the income or gain arises, or in some cases, in the following year. For this reason, it is often advisable to make regular distributions of trust income and capital distributions of trust gains in the same calendar year they arise. As noted above, the abolition of the protected settlement regime and the remittance basis is likely to largely remove this timing mismatch issue.
IHT post 6 April 2025
Although the focus of this article is on ICT and CGT, our previous article, focussing on the IHT position of US revocable trusts, was published before the proposed changes to the tax rules for non-doms were announced in the Spring Budget earlier this year. See our recent article Non-Dom reforms – the opportunities and risks for US clients for the latest updates on IHT issues for US trusts.
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The content of this article is for general information only. It is not, and should not be taken as, legal advice. If you require any further information in relation to this article please contact the author in the first instance. Law covered as at June 2024.