IHT When Partner Not Domiciled in the UK

An inheritance tax (IHT) liability might arise from a transfer of assets between spouses or civil partners if the assets pass to a spouse / civil partner who is not domiciled in the UK for IHT purposes.

There is one major restriction on the IHT spouse / civil partner exemption. The exemption is limited to £325,000 if assets pass to a spouse or civil partner who is not domiciled in the UK for IHT purposes.

The best way to deal with this situation is generally to make outright lifetime transfers to the non-UK-domiciled partner, which will rank as potentially exempt transfers and insure the potential IHT liability for the seven-year period. Failing that, life assurance to cover the potential liability on transfers at death is a simple and flexible approach.

Taxation Of Life Assurance Policies In Trust

Life Assurance Policies In Trust

Here is an outline of the rules that apply to life policies in trust:

Income Tax on Life Policies In Trust

Life policies do not produce income and so income tax rules are not applicable. However, withdrawals from life policies that are in trust are regarded as ‘income’, even though the withdrawal is a withdrawal of capital rather than income. Therefore, a chargeable event may occur on a life policy under trust and thus a chargeable gain can arise.

Policy in Trust

If a policy is subject to a trust, the person chargeable is the individual who created the trust (the settlor), provided he or she is alive and UK tax resident.

A chargeable event gain is taxable on the settlor while alive and UK resident. If this is not the case, a chargeable event gain is taxable on UK resident trustees or, failing this, on UK resident beneficiaries to the extent that they benefit. Here are the scenarios:

Settlor Is Alive and UK Resident

If the settlor is alive (or the chargeable event occurred in the tax year of their death) and UK resident immediately before the chargeable event, the gain is treated as part of the settlor’s income meaning the settlor is taxable on it. Any tax paid can be recovered from the trustees.

Settlor Is Dead Or Resident Outside UK

If the settlor is dead, or resident outside the UK, immediately before the chargeable event and the trustees are resident in the UK, the trustees are chargeable on the gain.

Chargeable Trust Rates

The charge is at trust rates, which are 45% for income above the trust’s standard rate band and 2O% within it.

To the extent that gains exceed the available standard rate band, there is a 25% liability for a UK policy because of the basic rate tax credit.

No tax credit is given in relation to offshore policies, so the effective tax rates are 20% in the standard rate band and 45% thereafter. This tax cannot be reclaimed by the trust beneficiaries, even if they would not have been liable in their own right because they were well below the higher rate threshold.

Trustees Not Resident in the UK

If the trustees are not resident in the UK, they cannot be held liable for any tax but any UK resident beneficiaries receiving a benefit under the trust from the gain will be taxable on that amount at their tax rates (but with no top-slicing).

Note if trustees surrender the policy in the same tax year as the settlor’s death, the tax liability falls on the settlor.

Transfers of Assets Must Be Absolute And Unconditional

A person who is a higher rate taxpayer and is seeking to transfer income-producing assets to their non-working spouse for tax planning purposes should understand that the transfer must be absolute and unconditional to be effective.

The transferor spouse/partner must not have a future benefit from the transferred income or income-producing asset. One factor that must always be considered is the risk of divorce. This risk may mean that an individual is unhappy to undertake tax planning of this nature.

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