George Bernard Shaw once wrote that the US and UK are "two countries divided by a common language".
In our increasingly interconnected world, it is easy to assume that the laws of two English-speaking jurisdictions refer to the same thing when they use the same word.
However, in the world of tax and estate planning this is as perilous as your American neighbour asking to see the new suspenders you have just purchased.
US revocable living trusts
Nowhere is this better exemplified in the context of inheriting US wealth than with US revocable living trusts.
Here the US parent (the "grantor") holds their wealth under a separate trust so that, on their death, the trustees need not apply for a grant of probate.
This common US planning is US tax-neutral because the grantor is treated as owning the trust assets, but avoids the (frequently) expensive and time-consuming US probate process.
It may be that the trust is treated in the UK as a mere nominee arrangement (or "bare trust").
Here, the UK tax treatment for a UK recipient may be the same as if a legacy had been received directly under the parent’s will, with no further UK taxation and the assets uplifted to their open market value for UK capital gains tax purposes.
However, HM Revenue & Customs does not always agree with this favourable treatment. Sometimes living trusts are treated as more than bare trusts, and an "inheritance" is taxed instead as a distribution from a non-UK trust.
Depending on the specific provisions of the trust, HMRC may seek to impose UK capital gains tax on distributions at up to 32 per cent (at current rates).
Broadly speaking, this tax is applied on any undistributed capital gains made by the trustees during the life of the grantor, as well as possibly any unrealised gains in the trust’s assets at the grantor’s death.
As well as HMRC’s characterisation relying upon specific provisions in a trust deed, their analysis may also depend on the grantor’s mental capacity.
It is common in many living trust deeds to allow the grantor considerable unilateral authority to withdraw funds from the trust.
However, this authority may also be curtailed automatically if the grantor loses capacity, transferring control of the trust over to a newly appointed trustee.
The ceding of grantor authority to another trustee in those circumstances may change HMRC’s view of the trust for the worse.
Please note, if that new trustee is a UK resident, this may have further adverse UK tax consequences (see below).
There are several solutions to this potential problem that can improve the potential UK tax position:
- The grantor may be happy to revoke the living trust in favour of direct ownership of their assets. Instead, they would leave their wealth directly to their family under a will. However, this usually means accepting that the estate will pass through the US probate process. Even if the cost and complexity of that process would be outweighed by the UK tax consequences in the alternative, the perception is often that this plan is simply unviable to many Americans.
- While the grantor is alive, they often retain the ability to amend the trust provisions. Amending the least favourable provisions is frequently a balanced way to mitigate the risk of unfavourable UK tax treatment without affecting the US planning.
- If the grantor has just died, consider winding up the trust in favour of the US and UK heirs at the same time, so as to minimise any potential UK capital gains tax.
- If a UK beneficiary is about to return to the US, consider deferring the distribution until they have left the UK. However, watch for potential UK tax if the individual returns to the UK too quickly. The same guidance can work in reverse for a US beneficiary about to arrive in the UK.
UK inheritance tax protection
Drafted correctly and depending on the level of wealth, a US parent leaving a trust for the benefit of the UK family can still be highly UK tax efficient, particularly if the parent can use their very generous US federal estate tax exemption – currently around $13mn (£10.3mn) per person – significant wealth can be placed perpetually outside the scope of UK inheritance tax and similarly outside the US estate tax net.