Transferring a portion of your assets into a trust can be an effective strategy for mitigating inheritance tax exposure and preserving wealth for your beneficiaries. However, traditional trusts often involve irrevocable transfer of capital, which may not suit the financial and estate planning objectives of many UK expats.
Loan trusts address this issue by allowing flexible access to the invested capital while still delivering potential estate planning benefits. This guide will explain how a loan trust works and outline the tax implications, pros, and cons associated with establishing a loan trust as a UK expat.
What You Will Learn
- What is a loan trust, and how does it work?
- What are the primary types of loan trusts?
- How are loan trusts taxed?
- What are the pros and cons of establishing a loan trust?
What Is a Loan Trust?
Like all types of trust, a loan trust is a legal arrangement that ensures your assets are transferred to your chosen beneficiaries after death, while also potentially reducing your inheritance tax (IHT) liability.
However, instead of permanently giving away your assets, loan trusts allow you to lend funds to the trust with the possibility of requesting repayment of the original capital at any time. This structure makes loan trusts particularly suitable for high-net-worth expats seeking tax-efficient estate planning solutions without fully relinquishing access to their capital.
Once you make an interest-free lump sum loan to the trust, the funds are typically invested in assets like investment bonds to facilitate tax-efficient growth. Withdrawals from investment bonds are tax-deferred up to a certain amount and may be used to gradually repay the original loan. Any investment gains generated within the trust may be transferred to your beneficiaries upon your death, free from inheritance tax.
Who Is Involved in Establishing a Loan Trust?
Establishing a loan trust involves three types of individuals:
- Settlor: The person who establishes the trust and lends the initial capital.
- Trustees: The individuals or businesses who manage the trust and its investments.
- Beneficiaries: The persons, usually your family members, who are entitled to receive trust benefits upon your death.
As the settlor of the trust, you may also serve as one of its trustees, which allows you to maintain control over the management and distribution of your assets. Still, it’s essential to appoint at least one additional trustee, such as a family member, close friend, or a company, to ensure your assets are administered and distributed according to your wishes in the event of incapacity or death.
What Types of Loan Trusts Are Available?
When establishing a loan trust, you can choose between two main types:
- Absolute loan trust
- Discretionary loan trust
Absolute Loan Trust
Absolute loan trusts require you to appoint the beneficiaries and specify their respective shares while establishing the trust, without the option to change your decision subsequently. This type of trust is most appropriate for UK expats who have clearly defined estate distribution plans and do not anticipate changes in their intentions.
A significant advantage of absolute loan trusts is their exemption from periodic or exit IHT charges commonly associated with other types of trusts. While the original amount loaned to the trust remains subject to IHT until it’s repaid, gains generated within the trust fall immediately outside your taxable estate. In addition, each beneficiary’s share of the trust fund is considered a part of their estate and is therefore liable for IHT.
Absolute trusts enable beneficiaries to access investment gains when they turn 18, but they can’t withdraw the loan’s outstanding balance.
Discretionary Loan Trust
Discretionary loan trusts provide more flexibility over the distribution of the trust assets. They allow trustees to decide who will benefit from the trust, in what amounts, and when. However, the trustees can only allocate funds to individuals named as potential beneficiaries in the trust deed.
Unlike absolute loan trusts, discretionary loan trusts are subject to occasional IHT charges. For instance, the trust is liable for IHT if its value on the ten-year anniversary exceeds the nil-rate band (NRB) of £325,000. This means you must pay tax on every tenth anniversary of the date you established the trust.
These trusts are also subject to exit charges if the assets are transferred out of the trust within ten years of establishment. These charges don’t apply to loan repayments, but may arise if the capital is paid out to beneficiaries. In such cases, the NRB is reduced by any capital payments subject to exit charges, leading to higher IHT liability in the future.
Any chargeable lifetime transfers (CLT) made during the seven years preceding the year you established a discretionary loan trust will also reduce your NRB. A CLT is a gift that isn’t considered a potentially exempt transfer (PET) and is thus immediately liable for IHT.
Transfers to absolute trusts are typically regarded as PETs, meaning you can transfer an unlimited asset value without incurring tax, provided certain conditions are met. Meanwhile, gifts made to discretionary trusts, including discretionary loan trusts, are typically considered CLTs.
Distinguishing between PETs and CLTs with respect to discretionary loan trusts is essential for ensuring tax compliance. Settlors don’t typically gift funds to these trusts—they make a loan instead. However, waiving the right to the loan is considered a gift and is therefore classified as a CLT and subject to tax.
Gifts will be considered PETs if you survive for seven years after making a gift. Otherwise, they become CLTs for IHT purposes. Although CLTs are subject to immediate IHT, you will only have to pay the charge if the gift value exceeds the available NRB.
Consulting a financial adviser, like those available at Titan Wealth International, ensures you choose a loan trust that aligns with your financial circumstances, minimising inheritance tax and maximising investment returns.
How Does a Loan Trust Work?
Leveraging the benefits of a loan trust as a part of your estate planning strategy involves three essential steps:
- Establishing a loan trust
- Investing the funds
- Requesting a repayment
Establishing a Loan Trust
Setting up a loan trust involves choosing the type of trust that meets your estate planning and financial goals. Discretionary loan trusts provide greater flexibility over the distribution of your assets, but are subject to occasional tax charges and potentially lower NRBs. Meanwhile, absolute loan trusts reduce your exposure to IHT, but include limited flexibility over asset allocation.
Once a loan trust is established, you are required to appoint trustees. While you may serve as one of the trustees, you must appoint at least one additional trustee.
Although the loan is made to the trust (not to an individual), for legal and administrative clarity, you should not act as the sole trustee.
The loan made to the trust is a lump sum cash amount that’s interest-free and repayable on demand.
Investing the Funds
Your trustees, possibly including yourself, invest the loaned capital into an investment bond to facilitate asset growth. You can invest in onshore or offshore bonds depending on your financial goals.
Both types of investment bonds allocate capital toward assets like stocks, funds, and property and enable tax-deferred growth. This means that the personal tax liability is deferred until a chargeable event occurs, which includes withdrawals exceeding the 5% allowance.
Offshore bonds are typically more suitable for UK expats, as unlike onshore bonds, they provide the following advantages:
| Offshore Bond Benefits | Explanation |
|---|---|
| Tax efficiency for non-residents | If you move from the UK to a low-tax jurisdiction like the UAE and become a resident there, offshore bond withdrawals are subject to tax based on the local tax laws, meaning they may be tax-free. |
| Capital gains tax protection | Offshore bonds are assignable, meaning they can be gifted without triggering capital gains tax. However, withdrawals and gains are subject to income tax rather than capital gains tax, so any realised growth on encashment or assignment may still be taxable as income. |
| Cross-border taxation | If you repatriate to the UK, the time apportionment relief (TAR) mechanism allows you to avoid UK taxation of any chargeable gains you accrued while being a UK non-resident, reducing your total taxable income. |
Time Apportionment Relief applies primarily to offshore bonds. It allows UK expats to reduce UK tax liability on gains accrued during periods of non-UK residency. This relief does not apply to onshore bonds after 6 April 2013.
Requesting a Repayment
You can request repayment from the outstanding loan trust at any time and receive it as a lump sum, occasional payments, or regular instalments. The repayments are funded through investment bond withdrawals that the trustees make on your behalf.
Investment bonds held within the trust allow withdrawals of up to 5% per year of the original premium without triggering immediate income tax. This 5% allowance is cumulative and can be carried forward for up to 20 years. However, it does not directly affect the IHT treatment of loan trust repayments.
As you aren’t obligated to withdraw 5% each year, you may carry forward any unused annual allowance for up to 20 years, allowing for larger withdrawals in the future. While you may serve as one of the trustees, you must name at least one other person, as the same individual cannot legally act as both lender and borrower.
You can opt for two types of repayments:
- Partial surrender: Involves taking equal cash amounts from the policy.
- Full segment surrender: Involves fully cashing in one or more bond segments.
What Are the Tax Implications of Establishing a Loan Trust?
Transferring funds to a loan trust isn’t considered a gift, so there is no transfer of value while establishing the trust. Since you’re still entitled to the funds placed into a loan trust, the loaned amount remains a part of your estate until it’s repaid. If the loan isn’t repaid at the time of your death, any remaining funds will be liable for a 40% IHT.
Each repayment you receive reduces the outstanding loan, as well as the value of your estate, resulting in lower IHT liability. However, this reduction only applies if you spend or gift the withdrawn funds. Otherwise, they will remain a part of your estate and be subject to IHT.
Total repayments must not exceed the value of the original loan to avoid adverse tax consequences. If, for instance, you receive some of the trust’s investment gains as part of a repayment, the entire trust value may become liable for IHT, as the HMRC will consider the transfer a gift with reservation of benefit.
A gift with reservation of benefit (GROB) is an anti-avoidance measure that prevents you from transferring assets to someone else and continuing to benefit from them. Any gift that doesn’t include a full transfer of ownership to another person won’t be considered a PET and can be subject to IHT.
Meanwhile, the growth within the trust belongs to the trust, which means it isn’t regarded as your estate and is thus exempt from inheritance tax. Still, depending on the type of loan trust, the trustees or the beneficiaries are liable for income tax on the gains generated within the trust, as follows:
| Types of Loan Trusts | Income Tax Rates |
|---|---|
| Absolute or bare loan trusts | The beneficiaries must pay tax on the received income according to their marginal rates of up to 45%. |
| Discretionary loan trusts | The trustees must pay a 39.35% tax rate on dividend-type income and 45% on all other income. |
What Other Factors Should You Consider Before Setting Up a Loan Trust?
Before you establish a loan trust, consider the following factors to ensure its features align with your estate planning goals:
- Rules for waiving the right to the loan
- Treatment of a loan trust upon death
Rules for Waiving the Right to the Loan
If you no longer need access to the outstanding loan, you may waive the full or partial right to the loan. Doing so releases the trustees from the obligation to repay the loan, and the bond is then held solely for the benefit of the beneficiaries. As a result, the loan trust is reclassified as a gift for inheritance tax purposes.
Once the trust is considered a gift, it’s treated as a transfer of value for IHT purposes. The transfer will be considered either a potentially exempt transfer (PET) for absolute trusts or a chargeable lifetime transfer (CLT) for discretionary trusts.
If you die within seven years of making an absolute loan trust gift, the PET is converted to a CLT and becomes subject to tax. Meanwhile, CLT for discretionary trusts is only taxable if it exceeds the IHT-free allowance of £325,000.
Alternatively, if you no longer require the loan, you may renounce it using the following methods:
- Waiving the loan in instalments: You can leverage the annual tax-free gift allowance of £3,000 to waive smaller amounts free of inheritance tax.
- Transferring the right to another person: You can transfer the rights to the loan repayments to your spouse or civil partner tax-free since there is no IHT on gifts between spouses or civil partners in the UK.
Treatment of a Loan Trust Upon Death
If you (the settlor of the trust) die before the outstanding loan is repaid, the remaining amount is generally classified as part of your estate and subject to IHT. The trustees can choose between two options:
- Repay the loan to your estate: In this case, the value of the trust’s assets is reduced by the outstanding loan amount before the assets are distributed to the beneficiaries, lowering the portion of the trust that is potentially subject to IHT.
- Maintain the loan: If the settlor retains the loan, the beneficiaries will inherit the investment returns and the loan, meaning they will be responsible for repaying the outstanding loan to the settlor’s estate.
If a trustee dies and only one trustee remains, it’s necessary to appoint a new person for the role to ensure the trust continues to be properly administered. Meanwhile, in case of a beneficiary’s death, the value of the loan trust fund will be included in the beneficiary’s estate and subject to IHT. The beneficiary’s heir(s) will only be able to benefit from the trust once the settlor passes away.
What Are the Benefits of Establishing a Loan Trust?
Setting up a loan trust entails the following advantages:
- Inheritance tax benefits: Loan trusts enable you to transfer assets to your beneficiaries without incurring IHT, provided you meet the necessary conditions.
- Asset control: You can maintain control over your assets by appointing yourself as one of the trustees. This ensures your assets are managed and distributed according to your wishes. You also retain access to the outstanding loan, eliminating the need to give up your assets permanently.
- Flexibility: Loan trusts, particularly discretionary ones, allow you to choose the amount and timing of asset distribution to your chosen beneficiaries.
What Are the Risks Associated With Creating a Loan Trust?
Loans trusts include the following risks and drawbacks:
- Limited access to capital: While you can access the initial capital you place in a loan trust through loan repayments, you can’t withdraw investment returns without triggering income tax.
- Reduced asset control: Since your assets in a loan trust are held by the trustees on behalf of the beneficiaries, you partially lose control over the assets, even if you appoint yourself as one of the trustees.
Secure Your Estate with a Bespoke Loan Trust Strategy
In just 15 minutes with Titan Wealth International’s cross-border estate planning experts, you will:
- Understand whether a discretionary or absolute loan trust suits your IHT position.
- Learn how to retain access to your capital while reducing your taxable estate.
- Explore offshore investment bond options tailored to your expat residency and long-term goals.
Key Takeaway
Establishing a loan trust enables you to mitigate inheritance tax exposure while ensuring your assets are passed on according to your wishes. It also allows you to retain control over asset distributions and maintain access to the original capital.
This guide outlined two primary types of loan trusts and explained their structure and mechanism. It also examined the tax implications and pros and cons associated with establishing loan trusts. Additionally, it clarified the rules for waiving the loan in a loan trust and explained how these trusts are treated after your death.
At Titan Wealth International, our expat financial advisers offer personalised estate planning strategies designed to grow your wealth and pass it on to future generations in a tax-efficient manner.
We provide expert guidance on the full range of trust options and help you select the most suitable structure that meets your long-term financial objectives.
