Before you start what will turn out to be a truly riveting read, you ought to know (if you didn’t already) that the tax treatment of a discretionary trust is usually considerably more complex than that of an interest in possession trust.Under the discretionary trust, no beneficiary has a vested right to income. The trustees usually have wide powers to appoint benefits and lend funds to a typically wide class of beneficiaries including the deceased’s spouse. In the same way as for the interest in possession trust, the transfer should be managed so as to fall within the transferor’s nil-rate band, with any balance being held on trust for the surviving spouse. If this is not possible, then the gift to trust will usually be subject to inheritance tax to the extent that it exceeds the available nil-rate band. Where the investment being used in the nil-rate band planning is a collective investment (more likely where a will trust is being used), the investor’s death will also cause the wiping out for tax purposes of all unrealised capital gains in the investment. I will look first at income although, of course, this will not be relevant if the trust asset is an investment bond. As no beneficiary has a right to income, all trust income is assessed on the trustees. The trustee tax rate is 40 per cent for other than dividend income. Dividend income is grossed up to take account of the 10 per cent tax credit and then assessed at the dividend trust rate of 32.5 per cent, with the tax credit then being deducted to arrive at the tax actually payable. This means that, in effect, additional tax of 25 per cent of the net dividend is due. Income received with a tax credit of 20 per cent, for example, interest, will be grossed up, assessed at 40 per cent and the tax credit taken off in arriving at the trustees’ actual liability. Special rules apply to determine the tax payable when and if the trustees exercise their discretion to make an income payment to beneficiaries. In this context, it is important to note that the trustees, in satisfying their tax responsibilities when making an income payment out of the trust, cannot take account of any tax credit on dividends as the credit does not represent tax actually paid by them. It is also important to note that, in contrast with the interest in possession trust, no one is entitled to trust income as of right. When it comes to capital gains, as for the interest in possession trust, as no beneficiary has a vested right to trust capital, any realised gains will be asses- sed on the trustees, after any taper relief and the annual exemption, at the rate of 40 per cent. Again, if the investment in the trust is an investment bond, this tax will not be relevant. It is when you get to inheritance tax that mat- ters get a little more dem- anding under discretion- ary trusts. Once the trust has been established, the IHT treatment of the dis- cretionary trust is relativ- ely complex. However, for the adviser who is prepared to spend the time familiarising themselves with these provisions, clarity can emerge where previously confusion may have reigned. Clients appreciate clarity, so the payback is likely to be appreciable. Before looking at IHT in detail (I love to keep you in suspense), we must remember that, all other things being equal, the discretionary trust certainly gives the greatest amount of flexibility. Where the trust asset is income-producing, as nobody has an entitlement to the income, the trustees do not have to specifically deal with it by paying it out or identifying, holding and investing it for the benefit of the persons entitled to it. This can be a particular problem for the interest in possession trust if the investment is a collective where the income is to be reinvested. This gets even worse if dividends are reinvested back into the original investment with no identifiable new units or shares resulting from them. Identification is then next to impossible and it will be essential to be able to pay out the income if this is to be avoided. Of course, these prob- lems do not arise with an investment bond, where all income arises to the life company and is a factor in determining the value of the bond. There are, however, no tax implications for the trustees until they trigger a chargeable event gain under the bond. This potential difficulty with the identification of income needs to be taken into account in determining the most appropriate investment for the trust. Tax is not the be all and end all (there, I said it) but it is important. When considering the choice of trust where the underlying investment is to be income-producing, it may well be that this is an important determin- ant leading to the choice of trust. Alternatively, where the underlying investment does not have to be an income-producing collective, the need to identify and deal with income will not be a significant factor. The discretionary trust certainly enables the administrative difficulty connected with income identification to be side-stepped but it does have other consequences. One of the main such consequences is inherit- ance tax. A special inheritance tax regime exists for discretionary trusts. This regime takes account of the fact that no person has an interest in possession and so the trust property is not (without special provisions) in the estate of any particular person. The legislation, by way of compensation, requires a hypothesis and I will look at this next week.