Trustees and the need for reviews

A recent case illustrates the importance of regular trust reviews.

Trustees must take the time to review the trusts they administer to take into account changes in circumstances that have arisen since the trusts were first established so as to ensure there are no new potential tax issues. Likely changes include, for example, the investments made by the trust, and beneficiaries’ residences. A case I recently acted on provides an excellent example of why reviews are so important.

I was instructed by non-UK resident Bermudan trustees of a number of trusts established in the 1950s for the benefit of US resident beneficiaries. Over many years, the trustees invested directly in UK situs investments. Having cleared off potential UK inheritance tax issues, attention turned to potential income tax issues when it transpired that some of the original family’s descendants had become resident in the United Kingdom. It was therefore important to consider whether the UK source income was now subject to UK tax.

Section 811 of the UK Income Tax Act (ITA) 2007 limits the income tax liability of a non-resident individual or trustee in respect of UK source income to any sums deducted, or treated as deducted, from disregarded income.

Section 812 ITA 2007, however, states that the exemption under Section 811 is not available if one of the trust’s beneficiaries is “an individual who is UK resident or a UK resident company”. A person is a beneficiary of the trust if “an actual or potential beneficiary of the trust” and meets one of two conditions.

• “Condition A is that the person is, will, or may become entitled under the trust to receive some or all of any income under the trust.”
• “Condition B is that some, or all, of any income under the trust may be paid to or used for the benefit of the person in the exercise of a discretion conferred by the trust.”

The references to income include a reference to any capital insofar as it represents accumulated income. If Section 812 were to apply in this case, all UK source income of the trustees would be subject to UK income tax in the hands of the trustees.

Under the terms of the trusts under consideration, as matters currently stood there was only one principal beneficiary now entitled to the income: a US resident, who took the majority of the income each year and paid US tax on it. Crucially, his UK resident family members would only be able to take an income from the trusts in the event of his death.

It transpired that some of the original family’s descendants had become resident in the UK.

We were instructed by the trustees to advise whether existing and future UK resident family members, who had never received income from the trusts and who would not receive income from the trusts until the principal beneficiary died, could trigger Section 812, which would give rise to UK income tax liabilities for the trustees of over £1.5 million. In addition, I was asked to consider whether a tax credit for tax paid in the US by the principal beneficiary could offset the trustees’ liability.

Because of the potential liability for interest and penalties if a liability for UK tax arose, the trustees made a nil disclosure to Her Majesty’s Revenue and Customs (HMRC) and the worldwide disclosure facility. HMRC advised that they would investigate the claim for a nil disclosure and, for over three years, I argued with HMRC on the application of Section 812.

HMRC contended that the wording of Section 812 was sufficiently wide that, notwithstanding the fact that the UK resident family members had not received, and might never receive, any income from the trusts if they died before the US principal beneficiary, the trustees were liable to UK tax on the UK source income. HMRC noted the reference in Section 812 to “an actual or potential beneficiary of the trust” who “is, or will or may become, entitled under the trust to receive some or all of any income under the trust.”

All UK source income of the trustees would be subject to UK income tax.

I first argued that, because Section 812 applied by reference to a “tax year”, and as no UK resident family member had received income in the tax years under investigation (the majority of the income being paid to the principal beneficiary), Section 812 did not apply.

I also argued that Section 812 could not apply, as it could not presently be ascertained if the UK resident family members would ever be beneficiaries of the trusts, as this would be dependent on them being alive at the date of the principal beneficiary’s death.

HMRC rejected these arguments because of the broad wording contained in Section 812, and continued to assert that the trustees were subject to UK tax as a result.

In order to reach a negotiated settlement with HMRC, I proposed a compromise under which the trustees would agree to pay UK tax on a proportion of income not distributed to the principal beneficiary during the tax years in question. This was rejected by HMRC, noting that Section 812 was an all or nothing section where there could be no scope for compromise.

HMRC advised that they had considered the meaning of the words “potential beneficiary”, which is not defined in any part of ITA07. They indicated that they found it hard to consider any other terminology that could apply to the UK resident family members other than “potential beneficiaries”.

I disagreed, referring HMRC’s to its own glossary to the Trusts, Settlements and Estates Manual, which defines a beneficiary as “the person for whose benefit property is held”. I then went on to introduce the concept of a “contingent beneficiary”, referencing HMRC’s International Manual, which defines a “contingent interest” as follows: “A beneficiary has an interest in the trust dependent on something happening (the ‘contingency’).”

In line with these definitions, I argued that the wording of Section 812 should be construed as follows:

• An “actual” beneficiary is one who has an immediate entitlement to income, for example a life tenant of an interest in possession trust.
• A “potential” beneficiary is one who has an entitlement to income if the trustees exercise their discretion to make an income distribution in the beneficiary’s favour, for example a beneficiary who is a member of the immediate discretionary class.

I then argued that the UK resident family members had no right to the present income of the trusts as they were neither life tenants nor members of the immediate discretionary class. I asserted that they only have a potential right to income if they are alive on the death of the principal beneficiary, and so are “contingent” beneficiaries. With this, I had given HMRC a way out under the strict wording of Section 812.

HMRC accepted my argument and the nil disclosure, which also rendered moot the issue of whether or not there would be a tax credit for tax paid in the United States. The moral of the story is: “never give up!”

Finally, to ensure this issue never arose again, I recommended the trustees interpose underlying companies.