Background
The UK inheritance tax treatment of settlements depends on whether the settlor was domiciled or deemed domiciled in the UK at the time the settlement was made.
If the settlor is not UK domiciled or deemed domiciled at the time the settlement is made, ie first created, the settlement is what is known as an excluded property settlement. Non-UK property held in an excluded property settlement is not within the scope of inheritance tax. This remains the case even if the settlor subsequently becomes UK domiciled or deemed domiciled in the UK, or if the settlor is a beneficiary of the excluded property settlement.
It has long been held by HMRC that any additions to a settlement made after the settlor has acquired UK domicile or deemed domicile status will be treated as a new settlement, and cannot be treated as excluded property and most, if not all, practitioners have advised accordingly. However this was never specifically provided for in the legislation, the Inheritance Tax Act 1984 ('IHTA 1984') and following a recent case that went against HMRC, new legislation has been introduced to confirm the position.
Where non-UK property is transferred between trusts, that property retains its excluded property status even if the settlor is UK domiciled or deemed domiciled at the time of the transfer. The only requirement under the current law is that the settlor of both trusts was non-UK domiciled at the time the settlements were first established. As a result, trustees have always been able to move assets between trusts without compromising the excluded property status of the trust property.
Finance Bill 2020 (which has now received the Royal Assent) introduces provisions into IHTA 1984 which confirm that:
property added to an excluded property settlement after the settlor has become UK domiciled or deemed domiciled will not be excluded property for UK inheritance tax purposes; and
property transferred between excluded property settlements after the settlor of the transferring settlement has become UK domiciled or deemed domiciled will not be excluded property for UK inheritance tax purposes.
These changes arise largely in response to the decision in the recent case of Barclays Wealth Trustees (Jersey) Ltd & Michael Dreelan v HMRC [2017]. In that case, HMRC's interpretation of IHTA 1984 was contested successfully, as it was held that, on the precise wording of the legislation, the excluded property status of property transferred between settlements was determined by the settlor’s domicile status at the time the settlement was first created, rather than at the time when the property was transferred.
Changes
The key changes to the inheritance tax treatment of settlements are summarised below.
Additions to a settlement
Where property is added to a settlement, it will only be excluded property if the settlor was non-UK domiciled at the time the property is added to the settlement.
This means that the domicile position of the settlor at the time of the addition is now critical. Property added to a settlement once a settlor has become UK domiciled or deemed domiciled will not be excluded property (although any existing settled property will remain excluded property). Instead the additional property will be subject to inheritance tax under what is known as the relevant property regime which means that there could be inheritance tax charges on the ten-year anniversary of the settlement. If the settlor is a beneficiary of the settlement, the additional property may also be treated as forming part of their estate under the reservation of benefit rules.
This now puts on statutory footing the position HMRC has always adopted. As such, the change in the legislation is not surprising.
In practical terms, this is unlikely to change anything since most advisors have never recommended that settlors who are UK domiciled or deemed domiciled should make additions to existing excluded property settlements.
Language has also been added into the legislation which means that any income accumulated after the settlor becomes UK domiciled or deemed domiciled does not automatically lose excluded property status.
Importantly, and unusually, this change to the legislation will have effect from the time that the settlement was created, so it is retrospective.
Transfers between settlements
Where non-UK property is transferred from one settlement to another, that property will remain excluded property only if the settlor of the transferor settlement is domiciled outside the UK at the time the property is transferred. The transferred property will also remain excluded property if the transferor settlement was an excluded property trust at the time of the settlor's death.
This change is not retrospective, so will only affect transfers made following the enactment of the Finance Act.
However, there is a pitfall to be aware of, which is that where non-UK property is transferred between trusts after the settlor has become UK domiciled or deemed domiciled, and the settlor is a beneficiary of the transferee settlement, the transferred property will not qualify as excluded property. Trust property which is not excluded property is treated as relevant property and is subject to inheritance tax under the UK's relevant property regime. In addition, the property transferred will also be subject to inheritance tax under the reservation of benefit rules, which means that the property will be included in the estate of the settlor on death. This represents a significant change in HMRC's practice.
The inheritance tax rules must also be considered alongside the rules for income tax and capital gains tax for non-UK settlements. Transfers between trusts after the settlor has become domiciled or deemed domiciled in the UK will mean that the transferee settlement cannot be treated as a 'protected' settlement for income and capital gains tax purposes.
The effects of these changes on settlors and trustees of excluded property settlements
As a result of these changes, settlors who have become UK domiciled or deemed domiciled can no longer add property to the settlement which will qualify as excluded property.
Property added will be treated as relevant property. This means that there could be an upfront inheritance tax charge when the property entered the trust, on ten-year anniversaries of the trust, and if capital was distributed from the trust. If the settlor can benefit from the settled property, the settled property could also be treated as forming part of the settlor's estate on death. This would make the property subject to inheritance tax on the settlor's death.
In practical terms, the change to the legislation is unlikely to affect anything since most advisors would not have recommended making additions to a trust following the acquisition of a UK domicile or deemed domicile status. That said, given the retrospective nature of the change, trustees should review any historic gifts and transfers, or any other addition of value, to settlements which may now be caught. If any transactions are caught it will be necessary to consider what corrective measures can and should be taken and what the tax implications of doing so are.
Trustees of settlements where the settlor has acquired UK domicile or deemed domicile status will not be advised to make transfers between the settlor's trusts if the settlor can benefit from those trusts. Transfers where the settlor has acquired a UK domicile or deemed domicile could result in inheritance tax charges under the relevant property regime as well as a charge to inheritance tax on the death of the settlor under the reservation of benefit rules. The transferred property will only remain excluded property if the settlor is already deceased. Transfers may also be possible if the transferred property qualifies for other reliefs from inheritance tax (for example, business property relief).
Further, if the transferee settlement is a protected settlement for income and capital gains tax purposes, the transfer could result in the loss of protected status. Trustees will therefore need to assess the domicile status of the settlor each time assets are transferred between trusts and will need to review the tax profile of the transferee settlement to avoid unintentional tainting of the settled property.
