Lend in Haste, Repent at Leisure: Loans and Trusts – UK Tax Traps

Introduction

Few requests seem as innocuous as a loan to a beneficiary. A beneficiary needs funds, the trust has cash – what could go wrong? Potentially, a great deal… An ill-advised loan can result in severe UK tax consequences for both the beneficiary and the trustees, and the traps are more numerous than many trustees realise.

Loans within trust structures take many forms. Trustees may lend to beneficiaries, to settlors, to underlying companies, or to other trusts. Each scenario brings its own complications. None should be treated as routine.

The changes to the UK inheritance tax (IHT) rules from April 2025 (including new long-term residence provisions and an expansion of the types of trusts within the relevant property regime) have widened the circumstances in which trust assets, including loans, attract UK IHT charges. The margin for error has narrowed.

This article sets out the principal issues trustees should consider before making a loan. The core message is simple: loans are useful, but they carry real risk, and professional advice is required.  Trustees should also take advice before entering into borrowing which is a separate topic.

Purpose of the Loan: Questions to Ask

First the trustee should consider: why are we making this loan and on what terms should the loan be made?

Start with the trust instrument. Does it contain an express power to lend? If the trustees rely instead on a general investment power, that power will shape the permissible terms of the loan. An investment power obliges trustees to seek a reasonable return: lending interest-free or on concessionary terms may not be permissible under an investment power and would require an express lending power. A specific power to lend gives greater flexibility over interest rates, repayment schedules, and security, but trustees must still exercise that flexibility prudently and in the interests of the beneficiaries as a whole.

Next the trustee must ask how the borrower intends to use the funds. If the money will be used to purchase, maintain, or improve UK residential property or agricultural property (even if indirectly, for example if the borrower is non-UK resident and then transfers the loan funds to someone  else who buys a UK house), the loan may be subject to IHT  under the relevant property regime. This regularly catches trustees off-guard, especially where such a loan brings a trust which otherwise holds excluded property within the UK tax net.

If a loan will be secured over UK residential property, the trustees may also be undertaking a regulated activity under the Financial Services and Markets Act 2000 and should take advice on this.

It is just as important to consider whether the borrower and lender genuinely expect the loan to be repaid. If the borrower has no realistic means or intention of repaying, HMRC may treat the loan as a distribution. The potential consequences include income tax and/or capital gains tax (CGT) charges for the beneficiary, IHT exit charges for the trust, and HMRC scrutiny of the trust more widely.

UK Tax Treatment of Loans

The UK tax treatment of loans made by trustees can require considerable technical analysis. Several distinct charges to different taxes and different people may arise.

Inheritance tax: situs and the relevant property regime

The situs of a debt follows the residence of the debtor. A loan to a UK-resident individual or company can be a UK situs asset if it is not a specialty debt. If a loan is a UK situs asset it will come within the relevant property regime and the loan's value may attract periodic charges at ten-year anniversaries (at the tax rate of up to 6%) and proportionate exit charges when value leaves the trust (also charged at the rate of up to 6%). Trustees who lend to UK residents may therefore be accidentally bringing the trust within scope of UK IHT and associated reporting, even if the trust is established offshore. It might be possible to prevent this by documenting the loan as a specialty debt and keeping the instrument outside the UK.  HMRC are known not to favour this approach but it remains current law that an unsecured specialty debt is situated where the instrument is held.

Income tax and CGT for the beneficiary : interest-free or low interest loans

If a loan is made to a UK resident beneficiary with a rate of interest that is below HMRC’s official rate of interest (or interest-free), the interest foregone will be treated as a benefit from the trust, potentially triggering an income tax and/or CGT charge on the beneficiary under the UK’s anti-avoidance rules. One option is to charge interest at HMRC’s official rate for beneficial loans.  The rate changes from time to time, so trustees should ensure that interest is charged at the correct rate (and is actually paid to the trustee each year). However, this has other potential UK tax implications (see below) so advice should be sought whether or not to charge interest on the facts. Trustees and beneficiaries might think to compare the costs and benefits of a trust loan against a commercial (bank) loan. In terms of the costs of a trustee loan, beneficiaries need to be aware that the tax costs of a loan that is in place for many years may eventually be higher than the tax costs of an outright distribution.

Income tax for the trustee: trustees should also consider whether any interest received is UK source income

Assessing whether interest is in fact UK source income is not straightforward and professional advice may be needed. The residence of the debtor is only one of several relevant factors. If the interest received by the trustee is UK source income, the consequences for non-UK resident trustees are significant. The beneficiary will be required to withhold basic rate income tax on the interest and pay it to HMRC, and the trust will have a further UK income tax liability, requiring the trustees to file UK self-assessment tax returns. It may also bring the trust within the scope of the UK Trust Registration Service (TRS), obliging the trustees to register and maintain up-to-date beneficial ownership information with HMRC – an administrative burden that many offshore trustees would prefer to avoid.

Loans to settlors: the capital sums regime

Trustees and settlors should be aware that a loan to the settlor can mean the settlor becomes taxable on the trust income under the so called “capital sums” regime. These rules can apply even where the settlor is excluded from benefit, or where the loan was made before the settlor became resident in the UK. This is an area of close scrutiny by HMRC. The capital sums rules are complex, but trustees should be aware that loans made to settlors can engage them.

Repayments: timing matters

Where a loan from a trustee to an individual has been used by the borrower to purchase, maintain or enhance UK residential property or agricultural property, the IHT implications do not end when the loan is repaid. Under the IHT rules, this debt repayment carries a two-year "tail": the repaid value will still be treated as relevant property within the IHT rules for two years following the date of repayment.  Such loans should therefore be repaid well before a ten-year anniversary to ensure that the value of the loan repayment is not subject to IHT.  In contrast, assuming the loan is not in relation to UK land, securing repayment before the beneficiary's death can help manage the IHT position for the trust (and the beneficiary's estate if the beneficiary is also a settlor of the trust).

Monitoring the Loans: Documentation and Tracking

A loan is an ongoing arrangement.  Trustees should aim to:

• Document the terms properly from the outset with a loan agreement setting out the principal amount lent, the interest rate, any repayment schedule, and details of any security.
• Track interest payments closely. Before April 2025, annual interest payments made under loans to UK resident settlors were critical to preserving ‘protected settlement’ status. Late or missed payments could cause the settlement to lose protected status, resulting in the trust becoming “tainted” so that the income and gains of the trust were attributed to the settlor (assuming the settlor had an “interest” in the trust fund). Even where past protected status is not in issue, a failure to collect interest suggests the loan is not a genuine commercial arrangement, raising the risk that HMRC could seek to characterise the loan as a distribution.
• Monitor the outstanding balance. If unpaid interest accrues or additional borrowing inflates the loan, the trust's tax exposure at a ten-year anniversary or on exit can grow sharply.  
• Be aware of the borrower's residence status. A change of tax residence can alter the loan's tax treatment entirely, for example bringing it within, or removing it from, the scope of UK tax.

A further trap arises where trust cash is lent to one individual who then gifts the funds to a third party. This raises questions about whether the original loan was a loan at all, or a distribution to the ultimate recipient. There are complicated rules about onward gifting which can give rise to unexpected tax charges.

Watch Out for Insolvent Trusts

Suppose trustees lend a substantial sum to a UK resident beneficiary who later cannot repay. Waiving the loan or appointing the debt out to the beneficiary could trigger an IHT exit charge for the trustee and potentially tax charges for the beneficiary. But if the loan is the trust's only significant asset, there is no cash to pay the IHT charge, and the beneficiary may not be able to pay their own tax bill. The trustees cannot meet their tax obligations, yet they cannot recover the debt and also risk bankrupting the beneficiary or forcing them to sell their home or other investments.

Depending on the terms of the trust, acting as trustee of an insolvent trust with liabilities exceeding assets may expose trustees to personal liability for unpaid tax and to claims from beneficiaries or creditors.

Waivers

Forgiving a loan is not mere housekeeping. A waiver means value leaving the trust as the trustees give up an asset. If the loan is within the scope of the IHT rules, waiving it can trigger an IHT exit charge, calculated by reference to the loan's value at the time of waiver.

The same applies where trustees distribute the debt to the beneficiary, i.e., extinguishing the debt by appointing the benefit to the debtor. In both cases, trustees should model the tax cost first and ensure the trust has liquidity to meet any charge.

Trust-to-Trust Loans

Where one trust lends to another, all the issues in this article apply, with additional complexities. Each trust has its own tax profile, IHT anniversary dates, and class of beneficiaries. Such a loan may create a UK situs asset within the lending trust if the borrowing trust is UK-resident. Making such a loan also raises questions about the lending trustees' powers: are they authorised to lend to another trust, and are the terms consistent with their duties to their own beneficiaries?

Trust-to-trust loans require careful coordination. Document the terms, justify the interest rate commercially, and ensure both sets of trustees take independent advice, especially where the trusts share trustees or beneficiaries and conflicts of interest arise.

Some Cautionary Tales

Three examples show how easily loan arrangements go wrong.

First, loans to UK residents. If the debt is outstanding when the settlor dies, its value may form part of the settlor's estate  under the "gifts with reservation of benefit" (or GROB) rules which apply where the settlor is not excluded from benefitting under the terms of the trust.  If the loan is outstanding at a ten-year anniversary  of the trust, the trust faces a periodic charge on the loan value. A double IHT charge is therefore a real risk.

Second, sister company loans. If a trust-owned company lends to another company within the structure which uses the funds to buy UK residential property or agricultural property, the first consideration would be that the property-owning company gets a deduction for the loan. What is often missed is that the lending company is also within the IHT rules.

Third, irrecoverable loans. If a trust lends most of its capital to the settlor over several years, and the settlor's finances deteriorate and repayment became impossible, the trust will end up holding a large, irrecoverable debt, and the remaining beneficiaries (who had no part in the trustee’s decision to lend to the settlor) are left with a trust fund worth next to nothing. Claims against the trustees in those circumstances are a real prospect.

Loans Can Be a Good Thing

Despite these risks, loans used properly are valuable. Families appreciate that beneficiaries have access to cash, but that capital value is retained within the safety net of the trust structure.

Loans are also a useful tool for trustees to inject cash into underlying companies, as this moves value to the company but retains a tax-efficient route to return it to the trustee in due course.

Conclusion

Most trustees would describe loans as an indispensable tool. They offer flexibility, preserve capital, and serve legitimate objectives, but the tax consequences are not simple. The UK tax rules are complex, interlocking, and unforgiving and a straightforward-looking loan can generate unexpected IHT, income tax, and CGT charges and expose trustees to personal liability. Where there are UK residents or UK real estate involved, take advice before you lend.