Tue Oct 1
There has been a lot of speculation, especially as we have a new Government in the UK, about the benefits or otherwise of a wealth tax. A wealth tax being a tax, annual or otherwise, on the net wealth of a person. The UK already has such a tax for trusts.
Our view is that for a wealth tax to be effective then it should be either (i) a global initiative otherwise the ultra-wealthy will always have a place to move to, or (ii) restricted to immoveable property in its own jurisdiction.
The UK’s current wealth tax
The UK’s estate duty on the estates of the deceased was replaced in 1975 by capital transfer tax (CTT) which introduced a regime for trusts settled by UK domiciled individuals. This introduced a regime which survives in inheritance tax (IHT) which levies a 6% charge to inheritance tax on the net asset value of the trust on each ten-year anniversary of the trust’s commencement. Trusts to which this regime applies are known as “relevant property trusts”.
Currently, there is a beneficial IHT regime for trusts settled by non UK domiciled individuals called excluded property trusts, but the Government has already announced that these will be abolished. Tax residence of the settlor only plays a part in deeming an individual to be domiciled for IHT purposes if they had been resident in the UK for 17 (now 15) out of the previous 20 years. Both the current and the last UK Governments were keen to remove domicile from the UK tax regime.
The UK Government has already announced that the beneficial IHT regime for trusts settled by UK resident but non-UK domiciled individuals (RNDs) will end so how will that work and what should be done now?
What is the likely change?
It is likely that any trust, wherever established or tax resident, will become relevant a property trust on 6th April 2025.
At present, trusts settled by RNDs only become relevant property trusts if property is added to a trust after the settlor has become UK domiciled or deemed domiciled. We understand that there is intense lobbying for this to remain the case, otherwise wealth generated historically when the settlor had no nexus to the UK would come into the scope of UK taxation, which would be a huge deterrent to new arrivals to the UK and those in the UK thinking of leaving. Note that, unlike for income tax and capital gains tax, whether the settlor can benefit from the trust or not, is irrelevant for IHT purposes. Going forward, we should expect a trust to be a relevant property trust once the settlor has been UK tax resident for four years.
An example
Let us consider a trust established before the last set of changes to the deemed domicile rules in April 2017, say a trust established on 31 March 2017.
Its first ten-year anniversary will be on 31 March 2027. The ten-year charge is calculated by reference to quarterly periods during the ten years in which the trust has been within the charge to IHT. In this case that will be 8 quarters, so the IHT will be 6% multiplied by NAV of the trust’s assets multiplied by 8/40ths. If the trust has a NAV of £10m at the time, the tax due would be £10m x 6% x 8/40 which is £120,000.
So future NAV is a critical component and one way of mitigating a future IHT charge is to reduce the current NAV of the trust by distributing out that NAV (with some reorganisation) to an individual. Ideally that person would be
- An existing or added beneficiary of the trust
- Not UK resident nor UK domiciled
- Expected to live for a good number of years
- Not resident in a country which would tax
- the distribution
- the wealth on that individual’s death
- Able to hold the asset (usually a sterling denominated loan note) indefinitely and
- Someone who can be trusted not to do something silly (although there is a limit to the amount of damage one can cause with an ordinary loan note).
Care should be taken to ensure that there are no arrangements with that individual to resettle the assets on a new trust on similar terms to the existing one as HMRC could argue that the settlor of the original trust could be a settlor of the new trust.
The tricky part is reorganising the trust assets to create the loan note in the first place without triggering any underlying charges, tax or otherwise.
UK income tax and capital gains tax consequences
If done correctly, it should be possible to create clean capital in the hands of the individual, or indeed anyone he may make onward gifts to at some future time. Indications to date are that the Government will continue to respect the concept of clean capital.
Issues with a wealth tax
At a rate of 6% per every ten years, there are worse wealth taxes out there, but wealth taxes have their problems.
The first rule of designing a tax is that the only things you can tax heavily are land and the poor (which these days includes a large part of the middle class), as traditionally they are the only sources of revenue which cannot run away from the government, i.e. leave the country without causing massive disruption to their lives. The second rule is to tax when the taxpayer has cash available, in other words, try and avoid what are known as “dry tax charges”, a tax charge imposed where there is no corresponding cash generative event. A tax system should focus on collecting cash, not bankrupting its taxpayers.
The first rule is why a wealth tax should, ideally be global. If not, capital will move and if capital is invested in land, it will divest.
The usual answer for the taxpayer to the second one is to put away a small amount pa, which could be say 0.4% of NAV per annum (depending upon property values and interest rates). But over a ten-year period that requires discipline and management.
The rate
I have been studying and advising on tax for over 40 years, and the rate has been 6% throughout. But given that the thought of 6% every ten years is enough to scare off some people, then if the Government decides to increase the rate it will probably have the effect of reducing the tax collected rather than increase it (see my last article).
How long can a trust be caught by IHT?
One of the matters to be decided is how long, once a trust is caught by the rules for relevant property trusts, will it stay within the UK IHT net? The period of ten years has been raised and this raises the risk that once trapped in a ten-year long regime, the rate can be increased, perhaps punitively e.g. if at the time of the next ten-year charge the settlor is no longer UK resident, then the tax charge could be at a rate of 40%! Some commentators have also muted introducing an exit tax on capital assets owned by those individuals who cease to be UK resident.
For those of you thinking that one could distribute assets out of the trust before the ten-year event, then under current legislation once the trust is a relevant property trust, distributions of capital attract IHT at a rate being n/40 x value of reduction in the estate of the trust x 6% where n is the number of quarters since the last ten-year charge.
However, the current legislation expressly states that assets leaving the trust within 3 months of the date after the last ten-year event do not attract IHT.
IHT can also be “avoided” if the trust distributes assets to a charity or an employee benefit trust, but of course, the assets are no longer available to the original beneficiaries which cuts across the point of having a trust in the first place.
Could the existing trust transfer its assets to a new trust?
It could, but for UK tax purposes both the IHT and CGT rules regard this as a continuation of the original trust for UK tax purposes. The only way to break the trust is, as mentioned above, to distribute the assets to an individual to hold them unconditionally.
Will we see a lot of trusts being unwound before 6th April 2025?
I suspect that there will be some trusts that are unwound, but trusts will still have a role to play. The first reason for this is asset protection. The second is preserving wealth for future generations especially where those generations are already, or a are likely to be spread over several jurisdictions. An offshore trust remains a safe place to protect a body of assets from creditors and multiple tax authorities.
And as the world and society generally become more international, and also more uncertain, there will remain a need for a place to hold assets. The trick will be to prevent multiple wealth and other taxes eroding that wealth.
