United States: To Taint Or Not To Taint: US Persons Face A New Question About Their Excluded Property Trusts

US citizens and green card holders are already familiar with worldwide taxation. US persons who have become 'deemed domiciled' in the UK for inheritance tax ('IHT') purposes also must contend with the fact that UK inheritance tax no longer applies solely to their UK situate assets (as is the case for UK non-domiciliaries) but rather to their worldwide estates as well. The rates of US federal estate tax and IHT are currently aligned at 40%; however, historically there has been a marked disparity between the available exemptions in each jurisdiction that many US persons living in the UK have wished to account for in their estate planning.

Excluded property trusts ('EPT's) continue to provide an effective vehicle through which to preserve the US federal estate tax exemption. However, recent changes to the UK deemed domicile rules and the introduction of offshore trust protections, coupled with the fact that the remittance basis charge is no longer available to UK non-domiciliaries after 15 years of UK tax residence, has introduced new complications when using EPTs.

h4. Excluded property trusts

EPTs allow a US person (and any other UK non-domiciliary) to keep non-UK situated assets outside the scope of IHT as long as the EPT is established and fully funded before 6 April of the UK tax year in which he becomes deemed domiciled in the UK. By establishing and funding an EPT before becoming deemed domiciled in the UK, a US person is able to preserve the difference between the US federal estate tax and IHT exemptions, resulting in more assets passing tax-free to the next generation.

The recent changes introduced in the US last December (with the passing of The Tax Cuts and Jobs Act 2017) has made the disparity between the US and UK exemptions even more substantial, making the use of EPTs all the more attractive from an estate planning perspective. US persons now have a US$10 million (indexed to US$11.18 million for 2018) exemption from US federal estate and gift tax whereas the 'nil rate band' in the UK is only £325,000 (ignoring the residence nil rate band which is of limited application in this context).

US persons often establish EPTs that are 'offshore trusts' from a UK tax perspective. These EPTs historically were broadly income tax neutral for settlors who did not claim the remittance basis; the settlor generally continued to be subject to US and UK income tax on any trust income as though the trust did not exist, and offsetting credits were generally available for the tax paid. However, the changes to the remittance rules in the Finance (No. 2) Act 2017 (the 'Act') have added a layer of complexity to these trusts.

h4. Changes to the remittance rules and offshore trust protections

As of 6 April 2017, an individual is deemed UK domiciled for UK income tax and capital gains tax purposes in addition to IHT if he has been UK tax resident for 15 out of the prior 20 years (the '15 year rule'). Once an individual is deemed domiciled in the UK he is no longer eligible to access the remittance basis, which means he can no longer receive distributions from an offshore trust outside the UK and avoid a UK tax liability by paying the remittance basis charge.

Under the new 'protected trust' regime brought in by the Act, a non-UK resident trust established prior to the settlor becoming deemed domiciled under the 15 year rule automatically qualifies as a protected trust. Protected trusts benefit from a UK tax-free roll-up of accumulated non-UK income and all non-distributed gains in the trust unless the trust is 'tainted'. The trust's non-UK assets also will be protected from IHT. Provided no additions are made to the trust once the settlor has become deemed domiciled in the UK, there will be no UK tax until a distribution or benefit is received from the trust.

Non-UK income arising in a protected trust is not treated as belonging to the settlor. Gains accruing to the trustees of a trust under which the settlor is a beneficiary are not taxed in the hands of the settlor even if he is deemed domiciled, provided that the protected trust status is maintained.

If the settlor has acquired actual UK domicile status under UK common law (i.e., that the UK has become his permanent home and he intends to remain here indefinitely), then his EPT would no longer be a protected trust, as that status is only available for trusts established by people who later become deemed domiciled under the 15 year rule.

Continuing to allow the EPT to qualify as a protected trust under the new rules may give rise to unexpected issues for US settlors. For instance, the income and gains currently accumulating in the trust could be subject to an effective 'double tax' when eventually distributed to UK resident beneficiaries. For instance, if an EPT qualifies as a protected trust and the settlor is currently paying US income tax charges as they arise, accumulated income and/or gains which are later distributed to UK resident beneficiaries (to, for example, the settlor's children), there would be a UK tax charge at this point in time, and there would be no offsetting credits available for the US tax already paid by the settlor.

h4. To taint or not to taint?

Practically, the settlor may prefer to 'taint' his EPT so that it no longer qualifies as a protected trust. The result of tainting the EPT is that the income and gains would be subject to UK tax in the settlor's hands on an arising basis, and tax credits would be available for the US tax paid. Tainting the EPT would not alter the IHT benefits that the settlor secured when he established the EPT, i.e., the previously settled assets in the EPT would remain outside of his estate for IHT purposes. That being said, new assets settled will not be 'excluded property'.

The tainting rules, their exemptions and the UK tax implications of tainting are complex, so it is important to consider carefully all of the relevant circumstances when deciding how to taint an EPT. For example, new property settled into trust would constitute 'relevant property' under the relevant property regime ('RPR'). Depending on the value of the property added, the addition could constitute a chargeable transfer, triggering an immediate 20% entry charge to IHT. However, as there is no de minimus value for tainting, it should be possible for the settlor to ensure that any addition falls within his UK annual exemption amount of £3,000. The settlor also must consider how the newly settled property is retained in the EPT (or whether, for example, it is used to pay fees or other costs) for the purpose of calculating periodic and exit charges under the RPR. Finally, it will be important to ensure that the transfer of value to the EPT does not fall within the exemptions to the tainting rules.

With respect to timing, a protected trust is tainted in the year in which the tainting occurs. Once the trust is tainted, it is tainted forever and protected status (giving deferral for UK income and capital gains tax) is irrevocably lost. Tainting the trust does not have a retroactive effect for the income and gains already accumulated. The funds prior to the tainting would be considered protected foreign source income in the relevant year. To the extent that the settlor waits to taint the trust, there will be more accumulation to contend with. It may be worth 'running the numbers' to determine whether it would be preferable to pay the higher UK tax rate in the current year versus accumulating more income and gains which will suffer from the 'mismatch' in the future but which provide potential value in terms of immediate investment opportunity. This may depend on the extent to which reliance on trust assets may be needed in the future by UK resident beneficiaries.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.