Welcome relief? Mitigating double taxation of beneficiaries of US trusts who are both US citizens and tax resident in the UK
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/USA 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 a UK resident may benefit from a US trust 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 ability of the taxpayer(s) to claim treaty relief and can result in double taxation. Set out in the table below are the persons chargeable to tax in each jurisdiction on income and gains arising in US domestic trusts that are not UK resident.
|Type of US domestic trust||Taxpayer for US purposes||Taxpayer for UK purposes|
|Grantor trust||Grantors are taxable on the trust’s income and gains as if they owned the trust’s assets||Beneficiaries2 are only subject to UK tax on the receipt of payments or benefits from the trust|
|Non-grantor trust (NGT)||The trustees are taxable on the trust’s income and gains as they arise, unless “distributable net income” (DNI) is distributed to a beneficiary (where the liability rests with the beneficiary)||As with grantor trusts, a UK tax liability only arises on receipt of payments or benefits from the trust|
In the case of grantor trusts, to the extent that both a grantor (in the US) and a beneficiary (in the UK) 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.
In the case of a US citizen who is UK tax resident for UK domestic and Treaty purposes, primary taxing rights rest with the US only in the following instances:
- US source dividends up to the 15% US tax allowed under the Treaty.
- Income and gains derived from US real estate.
- Income and gains effectively connected with US trade or business.
In general, there is no time limit for claiming a credit for any US tax liability against the UK tax where the US has primary taxing rights. By contrast, if those rights rest with the UK, time limits apply in the US to 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.
Managing the exposure to double taxation
A UK resident US citizen could be taxed twice if:
- He/she is taxed on the arising basis and he/she receives the distribution.
- He/she is a remittance basis taxpayer and the distribution is remitted to the UK.
- 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 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 HMRC’s official rate (2.25 per cent 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 per cent of the value of the loan per annum.
Give UK beneficiaries a right to the US trust’s income
If the net income of the trust were distributed regularly, say each quarter, to the beneficiary who is UK resident and a US citizen, any UK income tax paid on the income could be claimed as a foreign tax credit in the US, provided the UK tax was paid either in the calendar year in which the income arose or by the end of the subsequent year.4
Using capital payments to match the 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 are able to include gains within a trust’s DNI for US tax purposes, consideration could be given to making “capital payments” (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 trust’s relevant income in priority to its realised gains.
However, making annual distributions of the 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 and may be exempt from generation-skipping transfer tax for US purposes.
The 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, the timing of tax payments in both jurisdictions and the selection of appropriate investments (for example, US mutual funds without UK reporting status are not suitable) must also be carefully monitored.
George Mitchell is a Senior Associate in the Private Client team. He is a UK qualified lawyer and, although he does not advise on US law, the comments in this article on the US tax position are based on years of experience of advising on matters with a US connection.
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 only taxed 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 and in that scenario 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 US has primary taxing rights, HMRC will give a tax credit to a beneficiary even where there is a mismatch in the source of income. ↩