In a significant ruling, released on 7 March 2025 (Louwman v HMRC [2025] UKFTT 295 (TC)), the First-Tier Tribunal has dismissed a taxpayer’s appeal against income tax assessments issued by HMRC, on the basis that offshore income gains (OIGs) and accrued income profits (AIPs) do not constitute “protected foreign source income” under the 2017 protected settlements regime. This decision has far-reaching implications for many taxpayers with offshore trusts.

Background

When introducing the 15-year “deemed domicile” rule in 2017 (whereby UK residents are “deemed” to be domiciled in the UK for all tax purposes once they have been UK resident for at least 15 out of the past 20 tax years, and as a result are no longer eligible for the remittance basis of taxation), as a concession aimed at minimising the migratory response to the reforms, the Government promised that foreign income and all capital gains on overseas assets owned by trusts, established before the settlor became deemed domiciled in the UK, would not be subject to an immediate tax charge on the settlor (even after the settlor became deemed domiciled in the UK). Instead, UK tax would only arise when benefits were received from the trust. For the most part, the 2017 legislation achieved this goal by providing (for income purposes) that “protected foreign source income” (PFSI) benefited from this favourable treatment.

However, a defect in the implementation legislation meant that it was unclear whether OIGs (which arise where a person makes a gain on the disposal of offshore funds without reporting status, and are taxed as income) or AIPs (which arise when securities which carry (or have carried) accrued but unpaid interest are transferred, with the AIP portion of the disposal proceeds reflecting the accrued interest taxed as income) fell within the definition of PFSI.

Despite attempts by various professional bodies and advisors to persuade the Government to clarify the position, no action was taken, and HMRC has consistently maintained that the 2017 trust protections do not apply to OIGs or AIPs.

The Tribunal's decision

In this case (the first to be heard on this issue), the taxpayer had established a number of trusts prior to becoming deemed domiciled on 6 April 2018. Following this date, OIGs and AIPs had arisen within the trust structures, in respect of which HMRC assessed the taxpayer to income tax under the transfer of assets abroad regime.

The taxpayer argued that:

• on a purposive construction of the relevant legislation, the OIGs and AIPs fell within the definition of PFSI (the “Construction Argument”); and
   
• should the Construction Argument fail, the relevant provisions do not give effect to Parliament’s intentions and should be rectified to ensure that they do (the “Rectification Argument").

However, the Tribunal rejected both arguments.

In addressing the Construction Argument, it was noted that, for income to qualify as “relevant foreign income” (a pre-requisite for satisfying the definition of PFSI), it must arise from a source outside the UK. However, the Tribunal concluded that, since OIGs and AIPs are deemed (rather than actual) income, they do not have a source in the traditional sense. In this context, the Tribunal noted that both case law and statute recognise that not all items of income have a source, and also rejected the taxpayer’s arguments regarding the specific legislative provisions which bring OIGs and AIPs within the charge to tax. The fact that OIGs and AIPs do not have a source means that, in the absence of any specific provision stating the contrary (such as regulation 19 of the Offshore Funds (Tax) Regulations 2009, which provides that OIGs are to be treated as relevant foreign income where they are deemed to arise to a non-UK domiciliary, and section 670A of the Income Tax Act 2007 which contains an equivalent provision for AIPs), they cannot fall within the definition of relevant foreign income. Since the taxpayer was deemed domiciled in the UK at the relevant time, regulation 19 or section 670A could not apply and so the OIGs and AIPs arising within her trust structures did not constitute relevant foreign income (and, as such, did not fall within the definition of PFSI).

Regarding the Rectification Argument, the Tribunal applied the principles set out in the House of Lords decision in Inco Europe Limited v First Choice Distribution [2000] 1 WLR 586, which permits courts to correct obvious drafting errors in legislation in certain narrowly defined circumstances. However, the Tribunal, “somewhat reluctantly, reached the conclusion that this is not a case where rectification is appropriate”. Although they suspected that “the omission of OIGs and AIPs from the definition of PFSI may well have been inadvertent” and recognised that such omission “operates unfairly for the individuals who have been affected by the change in law”, given the strict nature of the test in Inco, the Tribunal concluded that rectification in this case “would amount to an impermissible usurpation of the legislative function of Parliament”. In reaching this conclusion, the Tribunal took into account the fact that the extra-statutory material published in the run-up to the introduction of the 2017 reforms did not refer specifically to OIGs or AIPs (and that any references to “foreign income” in such material should be read as “relevant foreign income”, which the Tribunal had already established did not include OIGs or AIPs arising to a deemed domiciliary). They also agreed with HMRC that Parliament must have been aware of the scope of the “relevant foreign income” definition, particularly given the existence of specific provisions which treat OIGs and AIPs as relevant foreign income for non-UK domiciliaries only.   Accordingly, there was insufficient certainty that Parliament intended OIGs and AIPs to fall within the definition of PFSI for the Tribunal to find in favour of the Rectification Argument.

Implications and future considerations for taxpayers

This decision has significant implications for deemed domiciled settlors of protected settlements as it means (subject to the outcome of any appeal by the taxpayer) that such individuals will be liable to UK income tax on any OIGs or AIPs which have arisen to the trustees or any underlying company since 6 April 2017, if the settlor or their spouse is a beneficiary of the trust (and, in some circumstances, even if the settlor and their spouse are not beneficiaries, for example, if they have made loans to the structure or have previously received benefits from the structure).  

Going forwards, significant reforms are being made to the taxation of UK resident non-UK domiciliaries with effect from 6 April 2025, including the removal of the 2017 trust protections. The effect of these reforms is that, from 6 April 2025, the default position will be that, as with all other income, OIGs and AIPs arising within non-UK resident trust structures will be attributed to the settlor (assuming they or their spouse are beneficiaries or meet the “capital sum” conditions), unless the settlor is able to claim the benefit of a ”motive” defence or is eligible for a new four-year inpatriate regime.

All of this means that the points of contention in this case (i.e. whether OIGs or AIPs constitute PFSI under the protected settlements regime) will be of largely historic relevance in the near future (although care should be taken by deemed domiciled settlors who are looking to rebase assets held in trust ahead of the 6 April 2025 changes where those assets may include unrealised OIGs and AIPs). Having said that, the decision highlights the vital importance of clarity in legislative drafting. Professional bodies and advisors have pointed out various ambiguities in respect of the reforms being introduced by the Finance Bill which is currently making its way through Parliament (including in relation to the treatment of OIGs under certain aspects of the new regime) and, although the Government has introduced a number of amendments to clarify certain points, there are various issues which remain unclear. It is to be hoped that certainty for taxpayers can be provided within a shorter timeframe than the issues at stake in this case!