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  • Katherine Bullock

Thinking Big – Offshore Tax 2021 – The perils of tainting

Golden trusts must be watched like a hawk. This isn’t surprising when you consider that they are an extremely valuable asset with exceptional tax benefits. For example, the settlor is not taxed on the gains and foreign source income of such a trust and its underlying entities provided that they are retained within the structure. So long as these trusts do not contain any UK-based property or indirectly held UK residential interests, they should also be excluded from IHT. The settlor may, of course, still be liable to pay income tax on the UK source income arising within a trust structure if they have retained an interest, and on any benefits that they receive from the trust to the extent that such benefits can be matched with the income and gains arising within the trust.

"...benefits can easily be lost if the trust is not handled with care..."

The circumstances in which a golden trust can arise are limited – a non-resident trust must be settled by a non-UK domiciled individual - but not a non-domiciled individual born in the UK with a UK domicile of origin - before the tax year in which the settlor becomes deemed domiciled in the UK under the 15 out of 20 year rule. On top of which, these benefits can easily be lost if the trust is not handled with care. So with all eyes on what may be the most anticipated Budget in many years, it may be easy to overlook the care and maintenance of these protected trusts and the perils of tainting.

Think of protected trusts in many ways as being like a piggy bank; if handled properly assets should grow in value free of tax. But like a piggy bank, once broken, you cannot glue it back together again afterwards – at least not without foresight and a great deal of difficulty.

Sadly, my piggy bank analogy falls short in that while the purpose of a piggy bank is to slowly add value over time, this cannot be done with a protected trust. The basic proposition is that no property or income can be provided either directly or indirectly to the settlement by the settlor, or by the trustees of another settlement of which the settlor is the settlor or a beneficiary, when the settlor is domiciled or deemed domiciled in the UK. Any such addition ‘taints’ the trust. Its special tax properties are lost. And there are many, many ways in which a trust can become tainted - an area of special concern for trustees and settlors on an ongoing basis.

In essence, value cannot be added to the trust. The scope is therefore far wider than what might normally be considered additions of property or income. For example, value might be added by paying the insurance premiums for policies held by the trust or paying for the maintenance of a trust property; value might be added by providing services or by forgoing opportunities. This prohibition must be strictly observed; there is no amount which is too small to destroy the status of the protected trust. Also, note that the protections of a golden trust only apply to those deemed domiciled in the UK. Should the settlor become actually domiciled, this will also taint the trust.

It is not all doom and gloom, however! There are seven exceptions where value added can be disregarded. In particular, these allow certain loans on an ‘arm’s length’ (as defined) basis both by and to the settlor, but the rules must be strictly observed and the penalty for getting it wrong is, of course, that the trust is tainted. The risks involved are high. It is best to plan in advance and include an adjuster clause to allow any addition that may cause a protected settlement to be tainted to be reversed. This is a particularly sensible addition in the case of loans to underlying companies, but careful drafting is required for these to be effective.

In short, the parties making the loan must do so using all the care, all the checks and all the terms which they would normally employ when dealing with an unrelated party, making certain that the loan would make business sense in that context and that it is not giving special preference in any way. Again, failure to do so will taint the protected trust.

So, is there a cure for a tainted trust? One possible, although expensive remedy, may lie in the doctrine of mistake. Amongst other criteria, there must be a distinct mistake which is sufficiently serious that it would be unconscionable for the recipient to retain the property. But does that include the wealthy taxpayer trying to avoid tax?

The best option then is to plan in advance; to proceed with extreme caution and vigilance; and to monitor but not necessarily rely solely on HMRC guidance.

Protected trusts are an exceptionally tax-efficient way of holding foreign assets, and the fact that they are so easily tainted and extremely difficult to recreate means that they should be handled with the utmost care. No action should be taken without careful consideration and preferably expert advice. In practice, this means checklists and tick boxes remain the order of the day.


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