Most of us would like to keep the taxman’s hands off our hard-earned assets when we die so that they go to our loved ones. Trusts are one tool that can be utilised to make that happen. In order to ascertain whether a trust could be used to reduce your IHT liability, you need to get your head around the frequently misunderstood concept of domicile. Below is our useful summary of the three different types of domicile.
The three types of domicile
1. Domicile of origin
This is your place of birth or, if you are under 18, your father’s place of birth. It does not change throughout your life unless you elect to change it.
2. Domicile of choice
It is possible to elect to change your domicile of origin to a domicile of choice, but it is an arduous process and can be contested if ties are maintained with your domicile of origin. These ties could include bank accounts, property, assets or even a burial plot.
The latter is the reason why Richard Burton, who lived in Switzerland for 27 years to avoid paying tax in the UK, was deemed UK domiciled after his death. Although he was never buried in the plot, the fact that it was deemed he had a tie meant that £2.4million of his £5million estate went to the UK taxman.
The rub with a domicile of choice is that it will only be contested after your death, so you will have no chance to defend yourself if HMRC decides you were UK domiciled after all.
3. Deemed domicile
Deemed domicile is when you automatically take on a new domicile due to residence. For example, anyone who has lived in the UK for 15 of the last 20 years is deemed UK domiciled, and this can have a significant impact on their UK inheritance tax (IHT) liability.
Being clear about your domicile will give you an insight into what your inheritance liability might be. Here are some important things to note about inheritance tax in the UK and how it is levied.
The eight most important things expats need to know about UK inheritance tax
1. In the UK, IHT is charged at 40% and levied on the worldwide assets of anyone who is UK domiciled.
2. Individuals who are non-UK domiciled will also pay IHT if they own UK assets, but only on the UK assets, not their worldwide assets.
3. The Nil Rate Band (NRB) of £325,000 is applied to all estates in the UK. IHT is payable on estates in excess of this amount.
4. There is also a Main Residence Nil Rate Band (MRNRB) which is applied to the main residence which has been lived in by the deceased and which passes to a direct lineal descendant, including children, grandchildren, stepchildren and adopted children. If you have no children, you do not benefit from it. This has risen to £175,000 as of April 2020, the last in a series of increases made since its introduction in 2017. No further increases are planned at present.
5. Interspousal transfers between two UK domiciled individuals are exempt from UK IHT.
6. Transfers to a non-UK domiciled spouse are called a spousal exemption and are equal to the NRB i.e. £325,000. The spousal exemption is in addition to the NRB, so £650,000 can be passed from a UK domiciled individual to a non-UK domiciled spouse before IHT is payable.
7. With the right combination of NRBs, an estate can theoretically be IHT-free for up to £1million, although this is rare.
8. Pensions, including SIPPs, QROPS, and QNUPS, are exempt from IHT.
If you would like to reduce your potential IHT liability in the UK, take a look at the third post in this series, which outlines five different ways to do it.
Disclaimer: Please note that this post is for information only. Trusts and inheritance tax planning are complex subjects with no one-size-fits-all solution. You should always seek expert advice from a qualified professional before making important financial decisions.
The Extent of UK Inheritance Tax
The degree to which a person’s assets will be subjected to UK inheritance tax will depend on that person’s status of domicile at the time of event occurrence. Domicile, a notion of general law, is much more adherent than simply residency. Domicile refers to the place that a person considers to be the permanent home and where they have the most roots and ties.
A person is regarded as domiciled in the UK if they remain a UK resident for a minimum of fifteen years of the last two decades’ tax years, as of the sixth of April, 2017. If a person is deemed domicile or is a UK domicile at the time of assessment during a given tax year, their worldwide assets will be subject to inheritance tax, exemptions, and tax reliefs.
Those who are not considered domiciled in the UK will only be subjected to inheritance tax on their UK assets and not their non-UK assets. As of April 2017, any non-UK company shares that hold UK residential property are deemed UK assets for IHT purposes. If a non-UK company holds UK commercial property, shares aren’t subject to UK inheritance tax as of yet.
Although whether the beneficiary is a UK tax resident or a non-UK resident is irrelevant for UK IHT purposes, some jurisdictions entail inheritance tax charges or tax on gifts received by a resident of the relevant country. Therefore, it is important to take particular care if any cross-border inheritance or gifts are involved, as double taxation will be a plausible risk. However, domestic law or a treaty often offers double tax relief in such cases.
Tax Rate
Every person can offset their chargeable UK assets according to their Nil Rate Band. Furthermore, an additional Residential Nil Rate Band may be utilised if the main residence of the deceased is considered in their chargeable estates and is passed on to their descendants.
Civil Partners and Spouses
Assets passing on to a civil partner or spouse is generally exempt from UK inheritance tax regardless of the value. The only exception to this concept is when a UK deemed domiciled person passes assets to a non-UK domicile. When this occurs, the spouse exemption has a limit of 325 000 pounds.
If there is still a residual amount left of a person’s nil rate band at the time of his or her death, the residual amount can be passed to the surviving spouse.
Debt Deductibility
There are three distinct circumstances where debt cannot be deducted, according to general inheritance tax rules.
- Debt used to get excluded property
When debt earnings are directly or indirectly used to receive, sustain, or optimise excluded property, the debt is dismissed for IHT purposes.
However, the debt is allowable if the excluded property is sold and the profits are taxable assets of the estate of the deceased or when the assets aren’t considered excluded UK property anymore.
- A property that qualifies for other reliefs is acquired with debt
Debt cannot be deducted if such properties include liabilities that were incurred after or on the date of the sixth of April, 2013. This rule means that the loan is set on the relievable assets, decreasing their value. If the loan value exceeds the relievable assets’ value, the residual amount may be deducted against the remainder of the taxable estate.
- Unpaid Debts at the time of death
Debts are only deductible from an estate’s value if it’s repaid out of the estate after the event of death. This is applicable if there isn’t a commercial reason for leaving the debt unpaid and there is no arrangement where a tax advantage is involved.
Offshore Trusts
Non-UK Assets that a non-domiciled individual settles into an offshore trust before they are deemed domicile are considered excluded property and reside outside the UK inheritance tax reach if there isn’t any UK residential property involved.
The trust assets will continue to benefit from having an excluded property status after the trust settlor receives deemed domicile status due to being a UK resident for fifteen years of the last two decades’ tax years.
If non-UK domiciled individuals settle a trust, the trust will benefit from impactful capital gains tax and UK income tax advantages. If a person is considering setting up an offshore trust, it is recommended they take professional advice due to UK tax rules being such a complex subject.
UK Residential Property
It used to be commonplace for a non-UK domiciled individual to possess UK real estate by means of an offshore company for preferential tax purposes. The foreign assets were effectively deemed non-UK assets and thereby excluded property in possession of the non-domiciled individual.
The new rules instated in April 2017 included all UK residential property within reach of UK IHT, along with particular loans taken out to buy UK residential property.
The new legislation brings all of the below into the scope of UK inheritance tax:
- All interests in non-UK companies and foreign partnerships that get their value from UK residential property.
- All loans used to get, maintain, or optimise UK residential property.
- All assets given as collateral, security, or guarantee by a third party or a borrower associated with a loan.
- The profits of a loan used to obtain assets if the assets are sold and used to invest in UK residential property.
The lender of funds used to purchase or enhance a UK residential property is subject to UK inheritance tax. Therefore, lenders need to be aware of the intentions of the loan and get specialist advice regarding the best way to proceed, as the lender is liable for UK inheritance tax if the loan is used to invest in UK residential property. Non-domiciled individuals may face challenges if they do not fully comprehend the implications of UK tax rules
Moreover, non-UK resident trustees making the loan will need to take care on behalf of the beneficiaries. Trustees are required to enquire about the purpose of the loan and understand IHT implications if beneficiaries want to use the loan to invest in a UK residential property.
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