Offshore trusts can be used for a variety of purposes to manage assets and shield them from tax. But new UK government tax rules seek to block one of the main uses of trusts – protection from inheritance tax. By Tim Hyam

What links the modern world of offshore finance with ancient imperial Rome? At first glance, not much – there are no plans for a Coliseum in the Cayman Islands, plumed helmets are out in Singapore, and the word in Guernsey is that togas are strictly for parties only.

But in fact one of the key offshore financial vehicles has its origins in Rome 2,000 years ago, where a Roman citizen wanted to bequeath his property to his young children. If his wife was not Roman, the law said that when he died, his wife and children could not inherit his property. So the father left all his property to a Roman friend who promised that when the father died he would use the property to take care of the father’s family. This way the father side-stepped the law and the idea of a trust was born.

Over the centuries the trust has evolved so that it is ow used for other purposes as well as inheritance protection - but the same principle applies: a trust is a legal entity that administers assets for the benefit of any specified person or group. For tax reasons, trusts are often set up in offshore jurisdictions, but the flexible structure can be used for many purposes.

In a nutshell, these are:

The assets included in a trust can be personal property, real estate, cash, investments, intellectual property or businesses. The trustees – who are trusted friends, specialist trustees, lawyers, bankers or investment managers – are required to administer the assets in accordance with the terms set out in the trust deed, which is drawn up when the trust is first established. In return they are paid a fee.

To set up a trust, initially you need to go to a good lawyer or a tax adviser experienced in this area. They will help select a beauty parade of trustees – not unlike the process of selecting an investment manager.

Tax threat

Though trusts have existed for centuries, their use has surged in recent years as people have used them to shelter their assets from taxation – especially from UK inheritance tax. This is done by giving away your property before you die while making arrangements to retain benefits from it while you are still living.

But new UK legislation will mean that, starting next April, this inheritance tax loophole will be closed. What’s more, the tax will apply to any property that ceased to be owned after 18 March 1986.

The main focus of the new legislation is the “double trust”, also known as a home loan plan or main residence scheme. These popular arrangements involve giving your home, or your share of it, to a trust in return for an IOU for the full market value. You then give the IOU to a second trust, which is set up for your beneficiaries. As the beneficiary of the first trust, you can continue to live in your home rent free. By creating the debt against your estate equal to the value of your home, your beneficiaries will not have to pay inheritance tax on that amount, provided you survive for seven years after the arrangements were made.

For those deemed to be domiciled in the UK, the tax will apply to their assets anywhere in the world. For those not UK domiciled, the charge will apply only to their UK assets. For taxpayers who have become UK domiciled, the charge will not apply to any non-UK assets that they ceased to own before they acquired that domicile.

The tax will have a big impact. The government says 30,000 schemes are in place that avoid inheritance tax by giving property away while retaining benefit from it. This affects about £15bn of assets. The Inland Revenue loses about £6bn over the lifetime of these schemes. Given that the annual inheritance tax yield is now about £2.5bn, the government considers this significant.

But many trust specialists see the new tax as unnecessarily harsh because it applies retrospectively to arrangements that may prove difficult to disentangle. “The new tax is unreasonable and unfair,” says Ian Burns, group managing director at Investec Trust in Guernsey.

“Over the years relatively wealthy people have taken good advice to organize their affairs to reduce their inheritance tax liability. This was a perfectly legal and acceptable thing to do. But the new legislation will penalise them for it,” Burns explains.

Alison Vine, senior tax manager at Ernst & Young in Guernsey, says: “No-one on the industry thinks that the Inland Revenue is losing that much through these arrangements. The tax is a massive sledgehammer to crack a small nut.”

She adds that the tax may penalise people who are not avoiding inheritance tax. “The tax will affect any individuals who have given away property but continue to benefit from it. Unfortunately the sledgehammer will crack a few nuts that it is not supposed to.”

Industry bodies have voiced their concerns to the Inland Revenue, which says it will respond next year. But the tax seems certain to go ahead.

So what should you do if you have arrangements that will be affected by the new tax? There are three choices: dismantle the existing arrangements before 5th April 2005; make an election before 31st January 2007 for the assets to remain liable for inheritance tax; or risk paying the new income tax on the benefit you receive from the property you gave away. Probably the first step to take if you have trust arrangements that you think will be affected by the new legislation is to go back to your tax adviser.

There still remain tax reasons for having a trust. The Inland Revenue has confirmed that no changes will be made to the tax exemptions currently enjoyed by employee share option trusts. And trusts for grandchildren still have a useful tax benefit in that if, for example, grandparents want to pay school fees, a trust is an efficient way of using up the grandchildren’s personal allowances.

For foreign domiciled people there are still distinct advantages to using trusts for tax purposes. And any foreigner contemplating moving to the UK is well advised to consider an offshore trust.

Future growth in trusts for UK-domiciled people, however, will be in non-tax business. Because the professional trustee business is undeveloped onshore, the expertise will still be found in the offshore market.

How much does a trust cost?

Setting up and maintaining a trust is expensive, so forming a trust is not usually worthwhile unless the assets are considerable – over about £300,000. The cost of setting up a trust depends on the complexity of the arrangements, but typically it is £5,000 to £10,000. On top of this there are usually administration charges over the life of the trust.