Welcome relief? Mitigating double taxation of beneficiaries

Introduction

US citizens(1) who are UK-resident beneficiaries of US trusts may be taxed twice on the trust's income or capital gains because of the overlapping scope of UK and US taxation. The UK-US Double Taxation Convention (the treaty) may not serve as the desired panacea where there is a mismatch in both the timing of tax liabilities and the taxpayer's identity under the domestic laws of each jurisdiction. This potential liability to double taxation may be an unfair cost of using such trusts to benefit members of transatlantic families. However, as outlined below, there are options for mitigating this exposure so that UK residents may benefit from US trusts without suffering cross-border double taxation.

Double taxation and US domestic trusts

As noted above, a mismatch in the timing of tax payments and the identity of the taxpayer may affect the taxpayer's ability to claim treaty relief and can result in double taxation. The below table sets out the persons chargeable to tax in each jurisdiction on income and gains arising in US domestic trusts that are not UK resident.

In general, there is no time limit for claiming a credit for any US tax liability against UK tax where the United States has primary taxing rights. By contrast, if those rights rest with the United Kingdom, time limits apply in the United States for claiming credit for the UK tax against the US tax liability. If the 'paid' basis of claiming foreign tax credits applies, the UK tax must be paid either during the calendar year in which the income or gain arises or, with additional planning, by the end of the following year in order to claim a foreign tax credit against the US tax liability on that income or gain.In the case of grantor trusts, to the extent that both a grantor (in the United States) and a beneficiary (in the United Kingdom) are taxable on the same income or gain, the "exchange of notes" to the treaty regards the beneficiary's tax liability as being the grantor's liability. In this way, the treaty mitigates the mismatch in the taxpayer's identity, albeit that when determining the grantor's US tax liability, consideration may need to be given to the sourcing of income and gains and the timing of distributions.

Managing exposure to double taxation

A UK-resident US citizen could be taxed twice if they are taxed on the arising basis and receive the distribution, or they are a remittance basis taxpayer and the distribution is remitted to the United Kingdom, after the end of the calendar year following that in which the income or gain arose.

Outlined below are some options for managing such exposure.

Trustees lend to beneficiaries

Loans to UK-resident beneficiaries could be made on interest-free and repayable-on-demand terms. The beneficiary would be treated as receiving a taxable benefit to the extent that the interest paid (if any) was less than interest at Her Majesty's Revenue and Customs' (HMRC's) official rate (2.25% from 6 April 2020).(3) For an additional-rate taxpayer, the maximum effective rate of income tax on the benefit of not having to pay interest on the outstanding loan is currently 1.0125% of the value of the loan per annum.

Give UK beneficiaries right to US trust's income

If the net income of the trust is distributed regularly (eg, each quarter) to beneficiaries who are UK-resident US citizens, any UK income tax paid on the income could be claimed as a foreign tax credit in the United States, provided that the UK tax was paid either in the calendar year in which the income arose or by the end of the subsequent year.(4)

Use capital payments to match US trust's capital gains

Managing a UK-resident beneficiary's exposure to double taxation on a US trust's capital gains is more challenging, largely due to the complex rules that apply to the UK taxation of income and gains arising to non-UK resident trusts. If the trustees can include gains within a trust's DNI for US tax purposes, consideration could be given to making 'capital payments' (ie, distributions and other benefits that are not chargeable to UK income tax) to the beneficiary in the same year that the gains are realised by the US trust. This should align the timing of the tax liability in both jurisdictions, allowing double tax relief to be claimed. However, from a UK perspective, this option is effective only if the US trust has no 'relevant income' (which includes offshore income gains arising on the disposal of non-UK collective investments without UK-reporting status) because benefits are taxable by reference to the trust's relevant income in priority to its realised gains.

However, making annual distributions of a trust's gains reduces its effectiveness as a vehicle for a family's succession plan by removing funds from a trust that may fall outside the scope of UK inheritance tax.

Comment

A UK-resident beneficiary's potential liability to double taxation may be managed in the following ways:

• For short-term funding needs, the beneficiary could borrow from the US trust on interest-free and repayable-on-demand terms.
• The trustees could give the beneficiary an entitlement to the US trust's net income to facilitate the claiming of tax credits in the jurisdiction that does not have primary taxing rights.
• Capital payments equal to the trust's gains realised in a given year could be paid to the beneficiary in the same year, as long as the trust has no accumulated relevant income and the gains can be included within the trust's DNI for US tax purposes.

Whichever method is adopted, it is important to monitor the timing of tax payments in both jurisdictions and the selection of appropriate investments (eg, US mutual funds without UK-reporting status are not suitable).(5)

Endnotes

(1) For simplicity, this article refers to the position for US citizens, but Green Card holders would generally be in the same position.

(2) A UK resident settlor is also taxed only on receipt of a benefit provided that the trust is a protected settlement (which is beyond the scope of this article).

(3) This assumes that the characterisation of the payment as a loan is respected by HMRC. This treatment could be challenged – for example, if the beneficiary had no intention to repay the loan then the borrowed sum could also be exposed to UK tax.

(4) In theory, difficulties may arise if a person is treated as being taxed on income from a different source in each jurisdiction; a life tenant may be regarded as being entitled to the trust's net income as of right or as only having a right to hold the trustees to account for the net income. In practice, where the United States has primary taxing rights, HMRC will give a tax credit to a beneficiary even where there is a mismatch in the source of income.

(5) In the context of managing a beneficiary's exposure to double taxation, this article refers to the English-qualified author's understanding of certain US tax rules.