As Offshore Trusts have become more readily accessible by the average individual, so too have they become the vehicle of choice for tax structuring. Having an Offshore Trust and Loan to Beneficiary has been one of the chief mechanisms for avoiding tax on distributions. However, it isn’t as straightforward as it might first seem, and, in this guide, I will explain why.
How Does an Offshore Trust and Loan to Beneficiary Work ?
Firstly, let me start by saying that it very much depends on what country you live in as to how your trust distributions are taxed. Every nation does it slightly differently and here I will, primarily, highlight the UK and New Zealand/Australian treatment of these transactions. It also presupposes that you disclose the transactions because, as many of you are aware, lots of offshore trust transactions are never disclosed to the national tax agency. Having said that, let’s crack on with the explanation…
It is not uncommon for offshore trustees to provide loans to domestic beneficiaries from the body of the trust assets. These loans can come in many forms, but the basic idea is that you, as a trustee, advance capital to the beneficiary on commercial terms. An appropriate interest rate must be charged, for it to be considered a legitimate transaction, and then the beneficiary is supposed to make payments on the loan per the agreed terms.
However, in practice what happens is that the loan is made, interest is levied, but no repayments are ever made. This provides the recipient with the benefit of the money without the real need to pay it back. Upon death, or another agreed event, the trustee simply writes the loan and interest off and you, therefore, avoid paying tax on the received income.
Sounds great right?
Is it treated as Income or Capital Distribution?
Unfortunately, nothing in tax is ever that straightforward and you could very well find yourself in hot water with the IRS/HMRC/ATO if you undertook such a transaction. The reality is that most countries have laws that target such trust abuses as this. In most cases, the writing down of debt would be considered income to the recipient even if no cash changed hands.
In the New Zealand case, you could even find yourself paying tax on capital distributions from the trust (the trust corpus or body) if you are unable to get documentation to provide it was a capital distribution and not trust income. New laws were implemented in April of 2020 to deal with the loophole that was foreign trust distributions. The UK also has similar rules on the treatment of transactions and loans so you would be well advised to make yourself aware of the changes over the past few years.
Additionally, offshore trusts are generally treated as an enhanced AML risk, and you will find that there is significant interest from tax agencies around the world in these sorts of structures. This is why it pays to have all the documentation in place to support the arms-length nature of the transactions.
What Happens When I Die?
The thought may have crossed your mind to leave the loan facility in place until you pass away and then be done with it. However, you should be aware that a final tax return from your estate is required, and any debt needs to be satisfied by your executor before the estate is distributed to your heirs. This means that the debt write-down would still be considered income and could weigh heavy upon your estate.
Subsequently, offshore trusts often significantly complicate your estate settlement process if they are not handled appropriately before you pass on. Ultimately, these key questions should be answered early on in the trust establishment process:
- What is the Settlor’s residence at the time assets is moved to the Trust
- What is the Settlor’s residence when distributions of foreign income are made
- What is the Beneficiary’s residence at the time of distribution
- The ultimate source of the distribution (income/corpus)
Upon your passing, the procedures taken by the offshore trustees will very much depend on the provisions contained within your trust agreement and, potentially, your letter of wishes. Most of these offshore trusts are discretionary trusts and this means that the trustee has discretion over the distribution of trust capital to the beneficiaries. Therefore, it is important to include provisions regarding what happens when you pass away and to who your benefits pass.
Is it Worth it to Setup an Offshore Trust and Loan to Beneficiary ?
Offshore foreign trusts remain a valuable structure to avoid liability and the burden of forced heirship upon death. However, anyone looking to sidestep the income tax rules through the use of loans should be very careful that the transaction is not deemed as avoidance or income. Given the enhanced scrutiny over the use of trusts, it is important that you retain the required documentation to prove what is trust income, and what is capital, as far as distributions are concerned.
Many countries now require you to prove whether the trust distribution is income or capital and, without proof, you may very well find yourself being taxed at the highest marginal tax rate on the money received.
Ultimately, this is where you need to bring an expert in to assist with the structuring of the trust and pre-planning the transactions that you intend to make. That way, you can retain your independence as the settlor and/or beneficiary whilst also reaping the benefits of the trust’s assets. Otherwise, you and/or your estate could be facing significant tax bills and penalties and even, potentially, double taxation depending on where your trust is based.
If you would like further advice on the establishment of an offshore trust please feel free to reach out to our consulting arm: