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Tangled trusts

28 June 2011
A client is the beneficiary of a US non-grantor trust which is invested solely in a US partnership, and of another trust fund. How should the US capital gains be treated in the client’s UK tax returns? The reply notes that it can be problematic translating US trust reporting for UK tax and suggests the need for some forensic accounting.

Our client, Z, was born in the USA in 1970 and a US trust ‘A’ was created in her name. Upon reaching 21 in 1991 she became the grantor of her own trust and, having assigned various assets to be held in trust, her parents among others were nominated as trustees. Having reached the age of 35 she could withdraw up to 50% of the value of the fund and at age 40 could withdraw the remaining capital without any restraints. This trust is currently solely invested in a US partnership ‘W’.

Z’s mother also created an individual trust fund ‘B’ in 2007 (expiring 2017) for Z and separate trusts for Z’s husband and children, all of whom are UK nationals. The money from this trust was then used to buy part of her mother’s US share in the same partnership ‘W’, which has numerous underlying worldwide investments including many partnership interests. Capital (at the discretion of the trustees) has been paid from this trust to my client.

Each trust (A and B) is therefore allocated their portion of interest, dividends and capital gains/losses etc and is disclosed in Z’s US tax return, but I am having difficulty in preparing the UK return. HMRC say we can apportion capital gains on a pro-rata basis due to the complexity of the US return, but this information is not received until after the UK filing date and I am not sure if US computations vary greatly from UK legislation.

Can readers advise (for past and future years) on how to treat US capital gains in UK returns, the treatment of stockpiled gains (their computations and dates relevant to UK), and the apportionment of US taxes paid between capital gains and interest received and capital distributions from each trust. No trust returns have been filed in the UK, so to ensure full compliance with the UK tax authorities from which year do I begin to submit returns for interest received and capital gains arising in the USA?

Information on this specialist area would be gratefully received.

Query 17,818 – NI.


Reply by Andrew Aldridge and David Treitel, US Tax & Financial Services Ltd

The 1970 trust ‘A’ would appear to have been a US non-grantor trust. As a general rule for US tax purposes, income and gains realised by the trust were taxable either to the trust, if it retained income and gains, or to the beneficiary if distributed to her during the year. The trust should have been filing a form 1041 (trust return of US trusts) and should have provided the beneficiary with an annual K-1 form detailing the beneficiaries’ share of income or gains as well as any distributions to her.

The 1991 trust set up by the US citizen which took over assets from trust ‘A’ would appear to be a US ‘grantor trust’. The settlor of a grantor trust is taxed under US rules on income and capital gains realised by the trust on a transparent basis. This treatment would apply even though the settlement has restrictions on distributions of capital. Again, the trust would file form 1041 and form K-1, but as a grantor trust. The client would report all of the trust income/gains on her annual US return – form 1040. This trust would appear to have been imported into the UK in 2002.

We cannot tell from the information provided whether the 2007 trust fund ‘B’ is a US or non-US trust. If it is a US trust then, as above, either the trust or the beneficiaries would be subject to income tax on the trust income depending on whether income or gains were retained or distributed. If the trust is a non-US trust, then it would be a grantor trust with respect to the mother and she, and not the beneficiaries, would be subject to tax on the realised income or gains.

It is frequently problematic translating US trust reporting for UK tax purposes. If we assume that a K-1 shows that a beneficiary is taxable on, say $100 of dividend income, $100 of capital gains and $200 of distributions these figures may not be adequate for UK tax purposes. Dividends could be UK taxable with or without the 10% notional credit and with or without credit for US tax depending on the type of underlying investments. Capital gains might need to be recorded as offshore income gains or simply not provide sufficient details to translate into sterling at dates of purchase and sale. Distributions might well include stockpiled gains. To avoid double taxation, some kinds of US income that become UK taxable would need to be ‘resourced’ as foreign source on the US returns so that relief is given in the US under the UK/US double tax treaty. Existing US individual returns may therefore also need to be amended at this stage.

It seems likely that trust ‘A’ (at least) is already UK resident; in essence none of the data on the K-1s will enable accurate UK trust and personal returns to be prepared. The family, trustees or the professional advisers in the US should be asked to provide copies of trust accounts for all trusts for every year for each of the trusts. A good volume of forensic accounting will be required at this stage to re-calculate each number correctly in accordance with UK trust and tax rules and prepare UK returns.

As noted in the question, the trusts’ investments in partnership and lower-tiered partnerships would, for US purposes, flow up into the trusts, and then, depending on distribution patterns, be taxable to either the trusts or the beneficiaries. For UK purposes an opinion would be needed if this is truly a partnership, or rather co-ownership and on the tax consequences that would follow. Once again, UK reporting may require careful review depending on the quality of data available.

The children who are beneficiaries of trust ‘B’ must not be forgotten. They are US citizens (UK domiciled) and may well have annual US and UK filing obligations of their own.

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