Transfers between trusts: a potential triple whammy
There are many good reasons why trustees might transfer assets from one trust to another of the family’s trusts. They might want to separate the diverging interests of different family members. They might want to lend or give money to a ‘dry trust’ which, for example, holds residential property used by the family, to pay for the running costs.
But however good the reasons for trustees moving assets between trusts, since the passing of the Finance Act 2020 (on 22 July 2020), they do so at their peril.
Take Henri, a UK resident non-domiciliary who set up Henri’s trust No 1 for the benefit of himself and his family.
Henri has become deemed domiciled in the UK. He divorced his first wife and now has a second family. He would like to set aside funds for the new children, but he does not want their interests to be mingled with those of his first family.
Henri asks the trustees of the No 1 Trust to appoint funds onto a new settlement for the benefit of the children of his second wife. He is a beneficiary of the new trust.
This seems sensible so the trustees carry out Henri’s wishes.
For trust purposes, Henri will be the Settlor of both the No 1 Trust and the new trust. Henri was not domiciled or deemed to be domiciled in the UK when he established the No 1 Trust, so the assets will be ‘excluded property’ outside the scope of UK inheritance tax. As Henri is now deemed domiciled, Finance Act 2020 (FA2020) has the effect that any funds transferred to the new trust will not be excluded property. The assets in the new trust will be ‘relevant property’ subject to inheritance tax at the maximum rate of 6% at ten year anniversaries and if assets are appointed out of the trust.
From 22 July 2020, the date of Royal Assent to FA2020, funds transferred from an excluded property trust to another trust will remain excluded property only if the settlor of the transferor trust is not UK domiciled and not deemed domiciled in the UK at the time of the transfer.
If the transfer is made after the settlor has died, the new trust will have excluded property status, even if the settlor was deemed domiciled at his death. But if the settlor’s death triggers the transfer, his domicile must be tested at that point.
The second problem created by FA2020 is that, as the assets transferred to a second trust lose excluded property status, a settlor who is a beneficiary of the transferee trust will have a ‘reservation of benefit’ in taxable property.
On the settlor’s death, whether or not he is domiciled or deemed domiciled in the UK at the time, the trust assets will be subject to a 40% tax charge. The spouse exemption is not available.
Planning tip: if a settlor in this situation loses his deemed domiciled status, the trustees should think about distributing the assets to him so that he can start all over again. Such planning may of course be inhibited by the tax system in the new country of residence.
And it gets even worse. Assume that Henri set up a second excluded property trust, the No 2 trust, while he was neither domiciled nor deemed domiciled in the UK. He is a beneficiary of the No 2 Trust. Before 22 July 2020, Trust No 1 transferred assets to Trust No 2 at a time when Henri was deemed UK domiciled for inheritance tax. Under the old law this did not affect the excluded property status of the trust. The assets in the No 2 Trust remain excluded property for trust inheritance tax charging purposes as the transfer was before Royal Assent to FA2020. However, further changes to the general definition of excluded property mean that as Henri was deemed domiciled at the time of the pre 2020 transfer, he will be treated, on his death after July 2020, as having a reservation of benefit in relevant property and the transferred assets will be subject to inheritance tax at 40%.
As if that was not enough, a transfer from one trust to another, on or after 6 April 2017, at a time when the settlor is deemed domiciled would ‘taint’ the recipient trust and the settlor would be taxable on all the trust income and gains on the arising basis.
A particular issue arises in the case of US trusts. Many such trusts state that, in the event of the settlor’s death and / or on other occasions, assets are to be transferred to a ‘separate trust’, often for the settlor’s spouse or children. If those transfers are to genuinely separate trusts in UK terms (and they often will be) the transfer could trigger the FA2020 provisions, resulting in the successor trusts holding relevant property subject to inheritance tax ten year and exit charges.
Clearly, sensible planning will be subject to unwelcome restrictions in the future and trustees will need to think long and hard-and take advice-before dealing with the trusts they look after.