Understanding excluded property trusts

Rachael Griffin goes through the benefits of using excluded property trusts

When advising clients on offshore matters, understanding the domicile rules is essential. With on-going refinement of both the residency and domicile rules, advisers have been forced to review many clients’ positions. These changes presented several planning opportunities, and advisers may want to remind themselves of the rules.

One of the key areas that can be explored in relation to domicile is around the use of offshore bonds. For non-UK domiciles, the use of offshore bonds has ongoing appeal, specifically in conjunction with an excluded property trust.

In simple terms, an excluded property trust enables a non-UK domicile to place property into a trust where it will be free from any future UK inheritance tax charges, when that individual becomes either deemed domicile or domicile in the UK at a later date. An excluded property trust is generally a discretionary trust. It provides a needed amount of flexibility regarding the choice of beneficiaries and most importantly the settlor is able to benefit without the ‘gift with reservation’ rules applying.

Definition of excluded property

The definition of excluded property – a term used within the IHT legislation referring to assets which are exempt from that legislation – covers a range of differing types of property. It includes property that is situated outside the UK and owned by an individual who is also domiciled elsewhere. In addition, certain types of settled property also fall within the excluded property definition.

In order to fit the definition of excluded property and therefore to benefit from the excluded property rules, the property must fulfil certain criteria. Initially, the settlor must not be considered domicile or deemed domicile in the UK. If the settlor is either domicile or deemed domicile they will be subject to the IHT rules under UK tax laws. However, where an excluded property trust has been used and subsequently the settlor becomes domicile or deemed domicile, any such settled property will remain free from IHT.

Also, as the settlor is non-UK domicile at the time the gift into trust is made, then no IHT reporting or IHT is due at that time. As the property is considered excluded property, exit charges and periodic changes are not applicable.

The second condition requires that the assets of the settlor must be situated outside the UK – they must be ‘non UK situs’ assets. Clearly, an offshore bond would be suitable to meet these criteria and as an additional benefit of an offshore bond is that as it produces no income, trustees would not need to complete a self assessment return.

Example

Consider, for example, Spanish film director Pedro who was born, lived and worked in Spain. After becoming a household name in Spain, he is offered a job working with a production company in London and moves to the UK. While in the UK, Pedro meets Margaret, a UK domicile and after a whirlwind courtship they decide to get married. Pedro has cash within his Spanish bank account with a value of approximately £1 million.

Despite becoming engaged and working in the UK, Pedro has not determined in which country he will reside for the long-term future. Taking out an offshore bond using the money from his bank account and placing this within an excluded property trust will enable Pedro to retain some flexibility around the taxation of his assets. An offshore bond will enable Pedro to retain his assets, and should he become UK domiciled in the future, the property that was placed within the excluded property trust will not be subject to UK IHT.

Eventually Pedro marries Margaret and they decide to make their home in the UK. After a number of years, Pedro is regarded as a UK domicile however, the bond within the excluded property trust (even though he is able to benefit) would not be subject to IHT.

On retirement, Pedro and Margaret decide to buy a property in the Lake District and decide to use the assets within the excluded property trust to fund this purchase. To do this, Pedro is faced with two options: he can either take the proceeds out of the trust as a beneficiary, or the trustees can purchase the property – at this point the trust will lose its status as an excluded property trust (on the assumption that the trust is still in existence), as the asset of the trust is now situated within the UK.

Advisers working in this area should pay special attention to the ongoing changes around the rules of domicile and residency to ensure that clients have the best plans in place.  Being caught out by an unexpected tax charge may cause problems for clients and advisers so thorough planning and an understanding of the rules both in the UK and abroad is essential.

Rachael Griffin is head of product law and tax at  Skandia International