(Un)Settling Scores: HMRC Reforms Excluded Property Rules Following Barclays Wealth Trustees

Current Rules

The current Finance Bill contains some important changes concerning Inheritance Tax ('IHT') and its application to excluded property trusts, largely prompted by the Court of Appeal's decision in Barclays Wealth Trustees. The significance of this is that, where excluded property is added to a trust, the 20% IHT entry charge which would typically apply is avoided, and (provided the trust remains an excluded property settlement) the ongoing ten yearly IHT charges on trust property do not apply.

The current law defines excluded property in a settlement as property situated outside the UK which became comprised in a settlement where the settlor was domiciled outside of the UK at the time the settlement was made. Property in trust can therefore remain excluded property even after the settlor has become domiciled or deemed domiciled in the UK after settlement. Excluded property status can be maintained where property is transferred from one trust to another, even if settlor has become domiciled or deemed domiciled at the time of transfer.

HMRC has long been contending that a new settlement is made every time property is added to a trust.  Therefore, if a settlor becomes UK domiciled since settling a trust, the property added would comprise a new settlement of assets which are not excluded property. The Court of Appeal disagreed with this assessment in Barclays Wealth, holding that a settlement is made when it is first established. This means that excluded property transferred into another settlement (as happened in the Barclays Wealth case) retained its excluded property status, provided that the settlor of the receiving trust was also non-UK domiciled when the settlement was originally formed.

The logical implication (though not decided by the Court) was that it would be possible to convert non-excluded property to excluded property even after a settlor was domiciled by transferring it to a trust which the settlor had established before being domiciled.

Forthcoming Changes

As a result, the Finance Act 2020 has sought to put HMRC's analysis on a statutory footing by amending the Inheritance Tax Act 1984. It does this in two ways. The first – with retrospective effect – is to change the test for assessing the settlor's domicile to determine excluded property status to the 'time the property became comprised in the settlement' for any tax charges after the Finance Bill comes into force, even if property was added to the settlement before the new Finance Bill was passed.

The outcome is that the new legislation will change the status of property in all trusts if the settlor has become domiciled (or deemed domiciled) within the UK between creating the trust and adding property to it. This will also arguably effect an extension of the gift with reservation of benefit rules to assets transferred to a settlement at a time when the settlor had become UK domiciled, but where the settlement was established at a time when the settlor was non-domiciled.

In practice, this is unlikely to cause problems for most trusts, because most settlors will not have added property to settlements having become UK domiciled or deemed domiciled (not least because of the up-front IHT on the transfer, as well as jeopardising the trust's protected status for income tax and CGT purposes, in the case of settlors who are only deemed domiciled).

However, this relies on the changes catching only the gifts into trust not a much broader range of transactions (including commercial loans) which result in property becoming 'comprised in a settlement' after the settlor has become domiciled within the UK. In addition, HMRC are known to have been more aggressive in challenging taxpayers' domicile position in recent years, rather than waiting for deemed domicile to be acquired, and the new definition may give them another reason to raise this issue.

The other change principally affects transfers between trusts. Under the new rules, excluded property transferred into a new settlement before the new Finance Bill comes into force will remain excluded property provided the settlor of the transferring trust was non-UK domiciled when the transferred property became comprised within the settlement and that the settlor of the receiving settlement was UK non-domiciled when the settlement was created (i.e. in line with the previous rules).

However, for transfers of property between settlements after the new Finance Bill the settlor of the transferee trust and the transferor trust need to be non-UK domiciled at the time of the transfer. Careful consideration of this new rule will be required before any further transfers of excluded property are made within a trust as they could be charged IHT.

These rules will also have effect for the "gift with reservation of benefit" rules and will extend the reservation of benefit rules to catch assets transferred between trusts when the new rules remove excluded property status from the trust assets.

This could have serious consequences for trustees in the future, because the trustees will need to be very mindful of the settlor's domicile (and deemed domicile) status when they are considering transferring assets to another trust.  Failure to assess this correctly could pull the transferor trust into the Inheritance Tax regime, as well as creating reservation of benefit issues for the settlor and lose  "protected" status for income tax and CGT purposes.

Actions for Trustees

The rules are not yet in force – although this is expected imminently – and, for the future, trustees of excluded property trusts should:

• Review their settlor's domicile position carefully: are they confident the settlor was non-domiciled each time they added assets to the trust?
• Consider whether they need to exclude settlors as beneficiaries in order to prevent a gift with reservation of benefit arising or limit the tax exposure in relation to it.
• Take advice before making trust-to-trust transfers once the Finance Bill is in force: this will involve careful consideration of the (deemed) domicile status of the settlor of both the transferor and transferee settlement.
• Not accept additional assets from the settlor after they have become actually or deemed domiciled within the UK (although trustees will already be alert to this risk for other reasons).
• Consider amending the Trust Deed to include wording to protect against accidental additions or transfers.