Deemed domiciliaries and protected settlements: No relief for offshore income gains

05 November 2018

When the 15 year deemed domicile rule was announced in 2015, the Government promised that income and gains on overseas assets held in a trust established before a settlor became deemed domiciled would not be subject to an immediate tax charge.

Instead, tax would only be paid when a benefit was received from a trust.

For the most part, the Government has delivered on this promise. However, due to a defect in the implementing legislation, profits on the disposal of offshore funds which do not have reporting status (known as offshore income gains) are not protected where the settlor is deemed to be domiciled in the UK as a result of being UK resident for at least 15 out of the previous 20 years.

Strenuous efforts have been made by various professional bodies such as STEP, ICAEW, CIOT and the Law Society to persuade the Government to correct this error. However, HMRC have recently made it known that the Government has decided not to take any action, issuing the following comment:

“A decision has been made not to amend the current legislation to include income arising in offshore non-reporting funds in the foreign trust exemptions at this time.
The current demands placed on parliamentary resource make it difficult for the government to justify returning to the legislation at this time to add to the generous package of protections which the government has already legislated for in the extensive reform of the non-dom rules last year.
Going forward, HMRC will continue to monitor this situation and engage with stakeholders.”

The effect of this is that a deemed domiciled settlor of a protected trust will face an immediate tax charge on any offshore income gains made by the trust or any company owned by the trust, if the settlor or the settlor’s spouse is a beneficiary of the trust. In some circumstances, there could be a tax charge even if the settlor and the settlor’s spouse are not beneficiaries (for example, if they have made loans to the structure or have previously received benefits from the structure).

This is very disappointing for those deemed domiciled settlors who are affected. In a recent survey which was carried out in order to support the representations to the Government, it was estimated that approximately 40 per cent of trusts established by deemed domiciliaries hold non-reporting status offshore funds. The defect in the legislation is clearly unintentional and any change to avoid the consequences that flow from the defect should have been uncontroversial.

Those structures affected now need to review their investment policy and consider whether any action should be taken to mitigate future tax charges. Gains realised since 5 April 2017 will need to be reviewed for the purposes of a settlor’s tax return.

Although it has not been discussed with HMRC, the same issue is likely to arise in relation to profits under the accrued income scheme as the wording of the legislation is similar. The accrued income scheme applies where a security is sold together with the benefit of any interest which has accrued since the last interest payment date. In those circumstances, a part of the sale proceeds equal to the amount of the accrued interest is treated as income and is therefore subject to income tax. As with offshore income gains, these accrued income profits will be taxed on the deemed domiciled settlor even if they arise in a trust structure which otherwise benefits from the trust protections.

Given that the amounts involved are generally relatively small, this is more likely to give rise to a need to monitor and report any accrued income profits rather than justifying a change to the investment policy or structure of the trust.

If you would like to discuss any specific situation, please get in touch with your usual Macfarlanes contact.