Protecting your protected trust

The tax benefits of a protected trust can be destroyed if action is taken which ‘taints’ it.

You are not domiciled in the UK but you have just become ‘deemed UK domiciled’ (see boxes below). Before you became deemed domiciled you transferred most of your offshore investments to a ‘protected trust’. The trust assets are now outside the scope of inheritance tax and the income and gains can roll up, free of UK tax, unless and until a UK beneficiary receives a distribution from the trust. Nothing can go wrong. Right? Wrong!

A trust loses protected status if it is ‘tainted’. A tainted trust retains inheritance tax protection, but you, as settlor, will pay tax on all income and gains arising in the trust. 

Tainting involves adding property or value to the trust. Examples include:

• transferring investments to the trustees or to an underlying company;
• paying the insurance premiums on a policy held by the trust; and
• adding cash to a property-owning trust to pay for trust expenses and property running expenses.

There is no disregarded minimum; if you transfer £1 to the trust, the whole settlement is tainted.

It is not only the settlor who can taint a trust. Another trust of which you are also the settlor, or even just a beneficiary, can taint the trust if they add value. If someone else adds assets to your trust, they do not taint your trust but may be treated as creating a new trust of their own.

There are ‘safe harbours’, excluded from the tainting rules, including the following:

• transactions on arm’s length terms. ‘Arm’s length’ has a special meaning for loans;
• a loan by you to the trustees will not taint the trust, provided the rate of interest the trustees pay is at least the ‘official rate’ (currently 2.25%); and
• if you pay interest on a loan by the trustees to you the trust will be tainted if the interest is more than the official rate. 

Trust protections only last as long as you are merely deemed to be UK domiciled. If you actually become UK domiciled, the effect is the same as tainting.

The good(ish) news is that, in either case, the trust reverts to protected status in the event of your death.

The bottom line is; do not enter into any transactions with your trusts without taking advice.