Offshore income gains

30 January 2019

HMRC confirms that offshore income gains do not fall within the protected settlement regime.

When introducing the 15-year deemed domicile rule in 2017, the Government promised that income and gains on overseas assets owned by trusts established before a settlor becomes deemed domiciled in the UK would not be subject to an immediate tax charge and tax would only arise when benefits were received from the trust.

However, as explained in our November 2018 note, there is a defect in the implementation legislation such that offshore income gains (profits on the disposal of offshore funds which do not have reporting status) (OIGs) do not fall within the trust protection rules. HMRC has confirmed that it has no plans to amend the legislation to rectify this.

Following this, a detailed technical analysis was submitted to HMRC arguing that OIGs should be protected in the same way as other income and gains under the protected settlements regime. HMRC has however rejected this analysis and has confirmed that, in its view, the trust protections do not apply to OIGs.

The effect of this is that, based on HMRC’s interpretation of the legislation, OIGs realised by an otherwise protected trust or underlying company will be attributed to the settlor if the settlor or the settlor’s spouse is a beneficiary of the trust unless the settlor is not yet deemed domiciled in the UK and benefits from the remittance basis of taxation.

Where the settlor claims the remittance basis, the OIGs will only be taxed if a UK beneficiary receives a benefit from the trust (and if the beneficiary is non-domiciled, the benefit is remitted to the UK).

Settlors who are not yet deemed domiciled in the UK and do not currently claim the remittance basis (for example, because the majority of their non-UK income and gains is in a protected trust) may wish to consider whether it is worth claiming the remittance basis to protect the OIGs. Alternatively they may wish to request their trustees to avoid such investments.

Deemed domiciled settlors will have an immediate tax liability in respect of OIGs realised by the trust/underlying company (with no right of reimbursement from the trustee). It remains to be seen whether HMRC will accept that OIGs on which tax has been paid can be distributed without any further tax liability in order to enable the settlor to pay the tax.

As a consequence, trustees (particularly trustees of trusts with deemed domiciled settlors) may wish to consider their investment guidelines and avoid investment in offshore non-reporting funds (and therefore OIGs).

Where trusts have realised OIGs in the 2017/18 tax year or later and these have not been included in tax returns, settlors will need to consider whether to amend their tax returns to include detail of the OIGs and to pay the additional tax.

It should be noted that, although HMRC takes a contrary view, it is arguable that OIGs should be “protected foreign source income” and the trust protections (which apply to trust income and gains) should apply. If taxpayers rely on these arguments and so do not report any OIGs on their tax returns they would be well advised to refer to this in the additional information section (white space) of the tax return.

Given these arguments, it is possible that we will see litigation on this point in the future.

While HMRC has not commented directly on this, there are parallels in the way the OIG legislation works and the accrued income scheme. HMRC is therefore likely to take the view that income taxable under the accrued income scheme is likely to fall outside the trust protections.

The accrued income scheme aims to impose an income tax charge on any element of the proceeds of sale of a security (typically bonds) where the sale price includes accrued but unpaid interest.

To avoid problems under the accrued income scheme, if practical, bonds should be held until redemption or sold on an interest payment date.

Where trusts hold interests in offshore non-reporting funds specific advice should be taken in relation to possible ways of mitigating a deemed domiciled settlor’s tax liability on OIGs although in many cases, short of challenging HMRC’s position, there will be limited options and this class of investment would be best avoided.