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09/01/24
Can You Trust The Foundations?
How to protect your family’s wealth — or perhaps how to protect your family from your wealth — has been a question asked by many people down the ages, and whether you use a trust or a foundation to help you do this has generally depended on the country where you decided to place your wealth. If you have chosen a country whose legal system is based upon common law, so the UK, US, the Crown Dependencies or British Overseas Territories, you are likely to be looking at a trust.
However, if you are looking at Europe, likely Switzerland or Liechtenstein but also Germany, France etc, then you are likely to select a foundation.
Interestingly, and to me suggestive of the flexibility of common-law jurisdictions, you can find foundations in common-law jurisdictions, such as Jersey or Guernsey, whereas you will not generally find trusts under civil law. This is because foundations are normally creatures of statute, whereas a trust can be set up with a verbal agreement, and common-law countries can generally introduce a law allowing foundations, but civil law countries will not do so for trusts (and why would they, when they already have foundations?) However, it is worth noting that a civil law country may well recognise a ‘foreign’ trust even if one cannot be formed under its own law.
Look After This For Me Please?
The UK is a common-law jurisdiction, indeed arguably the first one, and the flexibility common law gives is often beneficial but can also cause problems, not least because there is no legal definition of a trust. It is simply a legal relationship, generally concerning how certain assets are to be looked after and used/applied for defined people. The person who provides the initial assets is the settlor, the person who looks after the assets, the trustee, and the person who is to benefit, the beneficiary.
Generally, to form a trust you need to know that the settlor intended to create the trust, which assets are to be in the trust, and be clear who is to benefit from the trust.
The question then arises as to the type of trust, and this is very important from a tax point of view.
At one end of the spectrum, you have the bare trust where it is clear that the trustee is merely a placeholder for the “real” owner who makes all of the decisions. For example, I buy a drink from the bar and ask you to make sure that no one takes it while I’m away for a moment. I’ve asked you to take guardianship of my possession while I’m away, the drink is clearly the item to be covered, and I am clearly the beneficiary as I’ll be drinking the drink when I return, therefore I could be said to have created a bare trust. The important point here is that despite you becoming the guardian of the asset, I retain the benefit and I can decide what to do with it when I return.
The next type/level of trust is ‘interest in possession’ where the beneficiary has the right to receive any income generated by the asset as it arises, but the capital may be due to someone else. This often occurs where, say, a person dies and states that the income from an investment property may be due to the spouse while that spouse is alive (to provide them with some income), but the underlying property is held in trust for their children. This way the surviving spouse has some income while they are alive, but the asset passes to the children.
The final type of trust we are looking at here is the discretionary trust. This is perhaps the trust that is most thought of by the public, where the trustees have full powers over both the income and the capital within the trust. That means it is at the trustee’s discretion whether and what they give to the beneficiaries. The settlor will often give the trustees a letter of wishes to guide them as they run the trust, but it is important that this letter is just a guide and that the trustees make the decisions as to what happens with the assets and income within the terms of the trust.
For UK resident and domiciled individuals, discretionary trusts can be inefficient, as assets transferred to such a trust may be charged to Inheritance Tax (IHT) straight away, may then be subject to a periodic IHT charge, income can be taxed at the top rates of tax, and both income and gains can be attributed to the settlor.
Further, distributions from the trust are a different source of income from that received by it, and therefore, without special rules, the beneficiary can face actual double taxation.
The rules around trusts are well known and can be taken into account when deciding on the structure that is required, but these issues can lead to foundations being suggested as an alternative.
Foundations May Not Be As Solid As They Appear
Where the family is based or looking at a civil law jurisdiction, they may well decide upon a foundation. These are generally legal persons in their own right, with the ability to sue and be sued, etc.
A foundation will often share many characteristics with companies and, indeed, may be a company under their domestic law.
However, from a UK point of view, you do not just accept the foreign classification. Instead, although you do look at the local law, you also look at the founding documents and how the foundation operates, then apply the UK law.
Therefore, although a foundation may look like a company and be treated as such under its local law, and non-UK founders and advisers may expect this to be honoured for UK tax law, especially as generally under UK law the “corporate veil” is generally respected, often foundations are treated as trusts for UK tax purposes.
Indeed, in the 2009 joint declaration by the Liechtenstein and UK Governments, they agree that the starting position for Liechtenstein foundations is that they will be treated as trusts for UK tax purposes.
This can cause absolute havoc, either with planning or structures that come within the UK tax net.
Do As I Say, Not As I Do
This is especially the case where the founder, in keeping with their expectations under their own law and practice, keeps de facto control of the assets. For example, a foundation is set up with a management board and a protector, and the founder puts the shares of their family company within the foundation.
However, the founder often retains the right to appoint both the members of the board and the protector, if they don’t take those positions themselves. Also, there is often a power that any distributions from the foundation have to be agreed by the founder.
This is when another facet of common-law tends to come into its own, that of substance over form. In such a situation, HMRC are likely to argue that the founder has not actually given up control of the assets as they are either running the foundation or have the power to appoint the people who do, including themselves, and also to control whether the foundation makes payments and to whom.
They would then look to treat the foundation as a bare trust and assess the founder on any income or gains as they arise.
This has come as quite a shock to UK residents who have set up foundations, especially in Liechtenstein or Switzerland, as they may have been informed that the foundation was a “blocker” for their tax affairs, and it may be in Switzerland or Liechtenstein, just not in the UK.
It also causes problems where the person has given up control of the assets too. If their foundation is considered to be a trust, and they have given actual control of it to the management board and protector etc, then it could be a discretionary trust and this can lead to IHT charges, which may apply even if the person has not moved to the UK if they transfer a UK situs asset into the foundation/trust.
Stick To What You Know
The mixture of common law and civil law can cause expensive headaches if not handled carefully. In an ideal world, if you are based in a common-law country, you will just use trusts, and in a civil law country, foundations, but if you have to mix and match, make sure that your choice is thoroughly reviewed.
This is doubly important because trusts and foundations have been in HMRC’s sights for a long time, and when they are based in a different jurisdiction to the settlor or founder, HMRC’s knee jerk reaction is to assume they are an avoidance device and to start asking questions.
Therefore, it is important to know what treatment your vehicle is going to face before these questions are asked.
Of course, you could use a family investment vehicle instead of either, but that is a discussion for another day.
Andrew Parkes
Andrew is the National Technical Director for Andersen in the UK. He specialises in international tax, including interpretation and application of Double Taxation Treaties.
