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A RAILWAY STATION overseas, so I am told, has a prominent sign which reads: 'Beware! To touch these wires is instant death. Anyone found doing so will be prosecuted'. Further up the line a notice says: 'When two trains approach each other at a crossing, they shall both come to a full stop and neither shall start up until the other has gone'!
As the world nowadays is full of dubious announcements and warnings like these, at first I thought that there ought to be a warning on the front sheet of the new trust tax legislation: 'Beware! May cause drowsiness'. No sleeping pills could work as well as reading legislation with, for example, a provision inserting the word 'the' before the word 'trustees' in an existing section and dozens of other changes with equal earth shattering effect. My favourite of all was a new section which says that 'if the deemed person referred to in subsection (1) is not treated for the purposes of income tax as resident and ordinarily resident in the UK, then for the purposes of the Income Tax Act he should be treated as neither resident nor ordinarily resident in the UK'! Translated into simple terms, if a person is non-resident for tax purposes, then he is non-resident for tax purposes. How amazing is that!
Actually my proposed warning would be as inappropriate as the two railway signs. Buried in all the new clauses there are some which really would have major impact and in some cases startling effect.
Settled property
The first of the income tax provisions deals with the meaning of 'settled property' for income tax purposes. Settled property is any property held in trust other than by a person as nominee or bare trustee for another (including a person under the age of 18).
Should anyone be hoping that HMRC have hereby inadvertently killed their arguments in cases such as Arctic Systems, let me make it clear straightaway that the existing definition of settlement in ITTOIA 2005, s 620 — the old 'arrangement' definition — continues for the limited purposes of the settlements anti-avoidance provisions. Confused? You will be! Settled property will mean different things in different places, despite the avowed intent of harmonisation (or, more correctly, harmonisation if it suits HMRC). The new definition is 'unless the context otherwise requires' so existing case law on section 620 is still of full effect. Where the new definition applies is elsewhere in the Taxes Acts, for example the deep discounted security provisions for trustees and the single premium bond provisions relating to trusts.
Who is the settlor?
The next provision sets out in detail who is to be treated as the settlor of a settlement for income tax purposes. The basic provision repeats the wide-ranging test from the settlements anti-avoidance provisions, so that a person is a settlor if he has actually provided, or undertaken to provide, any property directly or indirectly for the purposes of the settlement. One might say: big deal, what difference does that make? The answer is that this is clearly a wider test. For example in ITTOIA 2005, s 465(3) an individual is taxed on single premium bond gains arising in any trust which he created. If a person adds funds to another person's settlement, he might well argue that it was not a settlement which he created and so he is not taxed on life insurance gains within the trust. That argument will now fall away as the new test includes any situation where one provides property for the purposes of a settlement.
Another reason for identifying who is the settlor arises from the introduction of the new £500 basic and lower rate band available to trusts otherwise taxable at the rate applicable to trusts. Clearly someone in very high authority has worked out that this could be used as a method of avoidance; for example if one makes two trusts, instead of one, one can get two £500 basic rate bands and not just one. This large loss to the Exchequer cannot be countenanced and a new provision is to be introduced so that in such a case one will only get £250 for each trust. If, heaven forbid, one were to set up more than five trusts to get over five times the £500 band, the new provision says that all the trusts will get just £100 each at the lower rates. I am sure that this will stop schemes we have all been itching to set up and will produce massive savings for the Exchequer.
In circumstances where funds are transferred from one settlement to another, the person who was the settlor of the first settlement is thereafter considered to be a settlor of the second, except where the transfer is by virtue of an assignment by a beneficiary of the first settlement or, rather curiously, where the transfer occurs on the exercise of a general power of appointment.
Deeds of variation
As is well known, a deed of variation can have different treatment for inheritance tax purposes from that which applies for income tax and capital gains tax. For inheritance tax, the inclusion of a suitable statement within the deed of variation will mean that it is treated as having been made by the testator and not the person who makes the variation. There is no similar provision for income tax, and the capital gains tax position was supposedly decided by the House of Lords in Marshall v Kerr [1994] STC 638, although in fact their Lordships left the position in some disarray.
There is to be a new income tax rule relating to variations. In many cases it will be the same as the existing rule, namely that the person making the variation is the settlor of any trust created under it, but this will certainly not always be the case.
The new rule is that if the person making the variation was absolutely entitled as a legatee under the will, including entitlement but for being an infant, he or she will continue to be a settlor of any trust created by the variation. If, however, the funds affected by the variation would in any event have been comprised in a settlement on the death of the testator (including a settlement under the rules of intestacy), any variation affecting those funds will, for income tax purposes, be treated as having been made by the deceased.
Probably the most common types of trust set up under a will these days are either a two-year discretionary trust or a discretionary trust of the nil rate band; the new income tax rule for variations will be superfluous in relation to these, as normally the discretionary funds can be resettled by the existing trustees as may be desired by the discretionary beneficiaries. The new income tax rule as regards variations into trust will therefore be primarily of benefit where there is an existing life interest trust under the will which is varied by the beneficiaries of it.
Residence of trustees
The existing income tax rule as regards the residence of trustees is in FA 1989, s 110, and it is completely different from the capital gains tax rule. This has enabled trusts to be non-resident for capital gains tax purposes, but resident for income tax purposes, which has suited some avoidance situations.
The test for trustees' residence is now to be harmonised for both taxes along the lines of the existing income tax rule. However, there are to be some new possibilities.
For both income tax and capital gains tax, a trust will be resident in the UK if the settlor was resident, ordinarily resident or domiciled in the UK when it was made and if one of the trustees is a resident here, even if there is a majority of non-resident trustees. The place where the administration is carried on is no longer to be a relevant factor. If, therefore, a resident or domiciled settlor wants to create a non-resident trust, he must not have any UK resident trustees.
The residence of a trust created by a non-resident and non-domiciled settlor is not covered so clearly as it was in FA 1989, s 110. This is where the odd provision I have already mentioned, about a person who is not treated for tax purposes as being resident is not to be treated as being resident, must come into its own, on the basis that if trustees are not within the provisions which make them resident in the UK, then they are automatically treated as being non-resident. So a non-resident and non-domiciled settlor can have a majority of UK trustees and, so long as one of them is non-resident for tax purposes, the trust will also be non-resident. The existing income tax rule was to similar effect.
Election for non-residence
What is new is an election provision for trustees to be treated as being non-resident. This is not quite as exciting as it sounds, as it applies only for settlements made by persons not domiciled, resident or ordinarily resident in the UK and where each trustee of the settlement is acting as trustee in the course of a business carried on by him. If the trustees would otherwise be treated as resident in the UK under the new rules, they may make an election to be treated as being non-resident for tax purposes.
Capital gains: definitions
The income tax definitions of settlor, settled property, and also the provisions relating to transfers between settlements and variations of wills are all repeated verbatim in the new capital gains tax provisions. In practice this should mean no change as regards what is a settlement for CGT purposes, as the new definition refers to 'property held in trust' other than under a bare trust, and that was also the existing definition in TCGA 1992, s 68. And as you might easily guess, harmonisation is not to stretch as far as as ss 86 and 87 where the income tax definition in ITTOIA 2005, s 620 continues to apply. Oh dear, has someone forgotten to take this opportunity to attack offshore employee benefit trusts which are commercial trusts outside s 620?
As regards the meaning of settlor, the old definition in TCGA 1992, s 77 is greatly expanded upon along identical lines to the new provisions for income tax purposes. One clarification is that there is now a cessation rule so that when the settlement no longer contains any property which originated from the settlor concerned, he ceases to be a settlor in relation to that trust. This will be helpful in cases where a person makes an interest-free loan to the trust and thereby becomes a settlor of it under decisions such as that in CIR v Wachtel 46 TC 543. Once the loan is repaid, it will be clear that this person is no longer a settlor in relation to the trust.
Residence of trustees: capital gains
One of the main areas of change in the new rules relates to the residence of trustees for capital gains tax purposes. The income tax rules, as outlined above, are to be introduced for capital gains tax purposes and there is no doubt that there will be many situations where the residence of a particular trust will change for capital gains tax purposes. This can work either way, in that some non-resident trusts will become resident and some resident trusts will become non-resident. However, the commencement date is deferred to 6 April 2007 and so there is an opportunity before then to ensure that the status of the trust continues as at present, by suitable reorganisation of the persons acting as trustees.
Children's trusts
Another major change in the capital gains tax rules relates to parental accumulation and maintenance trusts. These are now to become settlor interested in terms of TCGA 1992, s 77 with effect from 6 April 2006. The test is whether a 'dependent child' of the settlor is a beneficiary or a potential beneficiary, and this means any child under the age of 18 and who is unmarried or without a civil partner. It seems therefore that accumulation and maintenance trusts will be settlor interested even after some children attain the age of 18, so long as there is one child remaining who is a potential beneficiary and who is under that age.
Fortunately this new rule has its limits. Anyone who makes a family trust will not be within s 77 under the new rule, purely because he may have children in the future.
The paranoia within HMRC concerning the use of s 77 to tax gains on the settlor looks wholly anachronistic. Exactly what avoidance is envisaged is very hard to discern, when trustees pay the top rate of tax in any event. For a moment one might have thought that this is HMRC actually being kind in allowing the settlor's lower rates of tax to apply to the settled property if he or she is not a higher rate taxpayer, but this is almost certainly not the case as this extension to the settlor-interested trust rule seems to demonstrate. What must be in mind is the blocking of schemes to get hold over relief into a children's trust; for example it was possible to start with a discretionary trust and convert to accumulation and maintenance trust later, and hold over was then obtained under TCGA 1992, s 260. That will no longer be possible. In practice it was only achievable in smaller trusts anyway, as an inheritance tax charge would arise on funds in excess of £275,000. The excessive enthusiasm of our policy makers to jump on every bit of tax saving which is produced by modest planning still seems to be running at fever pitch, and it is causing untold woe throughout the tax legislation. This was scarcely artificial tax avoidance which I thought was supposed to be the source of all the extra cash required for the Government's spending plans.
It will still be possible to hold over gains on business assets, e.g. shares in unquoted trading companies, to a bare trust for a child under the age of 18, but not any other type of trust even though they would be far more suitable for the job.
There is a last chance before 6 April next to hold over gains into a children's trust. Those wishing to take advantage of this will have to act very quickly. There will be no clawback after 5 April next on the introduction of the new régime.
Sub-fund elections
Ever since 1965, one of the problems with the capital gains tax rules relating to trusts is that they ride roughshod over all the beneficial interests, so that, for example, the first beneficiary to achieve absolute entitlement could take the benefit of all losses brought forward on the notional disposal at that stage or, as another example, the losses in one fund of a trust would be used against gains in a different fund. The received wisdom is that as these are the statutory rules, it is not really permissible to make compensating transfers between funds, although personally I have always felt that there are enough equitable principles in trust situations to justify compensating transfers. Also it was often easy to get the beneficiary providing the compensation to agree, as he would be the one who had just become of age.
New provisions are to be introduced which will enable sub-funds to be recognised for income tax and capital gains tax purposes. Unfortunately the new rules are rather complex and of limited usefulness and in some respects it is hard to see what the policy behind them is driving at. Some of the complications arise from the fact that sub-fund elections can be backdated, although not to take effect before 6 April 2006, but disregarding this facility, the conditions to be satisfied are as follows:
1. The principal settlement itself must not be a sub-fund settlement.
2. The sub-fund must not be the whole of the property comprised in the principal settlement.
3. The sub-fund must not include property jointly owned with the principal settlement (but disregarding the capital gains tax rule treating shareholdings in the same company as a single asset). So fractional shares in a property cannot be held in different sub funds.
4. Any beneficiary under the sub-fund must not be a beneficiary under the principal settlement, except in certain permitted situations, such as entitlement on the death of another beneficiary.
It will be possible to make several sub-fund elections.The requirement for segregation of beneficial interests, so that the same person cannot be a beneficiary under two different sub-funds, may cause problems, but perhaps not as many as may be feared. For example, if there are two life tenants with the funds going to the same beneficiary after their joint lives, it would seem that two sub-funds can still be set up because the remainderman will become entitled to the funds from each sub-fund on the death of a beneficiary, which is one of the let-outs. There must not, however, be any general discretionary power of appointment, although the Trustee Act 1925, s 32 power is permissible.
By far the worst aspect about the sub-fund provisions is that a CGT disposal will arise on setting up the sub-funds; representations against this have not been successful. HMRC consider that there will still be advantages in setting up the sub-funds which will justify any capital gains tax charge but, in the real world, I cannot see that trustees will willingly subject themselves to immediate tax liability which could otherwise be avoided. There is no specific hold-over provision, so only the existing hold-over rules will apply; in this circumstance it is likely to be that for business assets, if at all. Apart from that, the statutory help with streaming losses to the right beneficiaries comes at a price.
All in all, the sub-fund provisions are most likely to be used when new settlements are made so that no capital gains tax cost will then arise.
Generally
The new proposed trust legislation brings in many disadvantages, stops several existing schemes, and offers relatively insignificant advantages to trustees. Once again, the propaganda says that it is tidying up and reforming, but in reality the primary motive must surely be to make further inroads into relatively benign tax planning. I do not think that the rhetoric about stopping artificial tax avoidance is squaring up with what is actually coming out of Somerset House. Perhaps the most suitable warning to go on the front page of the legislation should have been 'Warning: may cause apoplexy'!
Malcolm Gunn is a tax consultant with Squire, Sanders & Dempsey following its merger with the London office of Haarmann Hemmelrath; tel: 020 7382 4862, e-mail: mgunn@ssd.com.
