With all the furore over changes to the inheritance tax treatment of trusts from March 22, 2006, advisers should not lose sight of the fact that there have been very significant changes to the income tax treatment of trusts in the last few years.
For interest in possession trusts, the income tax position has not been affected by the changes. Trustees are liable for basic-rate income tax on income received by the trust and their liability may thus be at 10, 20 or 22 per cent depending on the source of income. Beneficiaries get a basic-rate credit for tax deducted by the trustees and may be able to reclaim some of the tax or may have to pay additional tax, depending on their own tax position.
Discretionary trusts and accumulation & maintenance trusts have the power to accumulate income and pay tax at the rate applicable to trusts, which increased from 25 to 32.5 per cent in the case of dividend income and from 34 to 40 per cent for all other income from April 6, 2004.
Where income is paid out to beneficiaries, this change is tax neutral for them as they are simply able to reclaim tax if appropriate. Higher-rate taxpayers have no further tax to pay. However, the increases improve cashflow for HM Revenue & Customs as it receives tax at 40 or 32.5 per cent when the income accrues to the trustees and needs only refund lower taxpaying beneficiaries when that income is subsequently paid out and a claim is made.
Further changes were made to the income tax treatment of trusts in 2005, when the Finance Act introduced a £500 standard-rate tax band for discretionary and A&M trusts. Where trust income was within this figure, the trustees only needed to account for the appropriate level of basic-rate tax and did not have to concern themselves with the rate applicable to trusts. The standard-rate band was subsequently increased to £1,000 from April 6, 2006.
If the same settlor sets up several trusts, the £1,000 standard-rate band will be apportioned between them so, if two trusts are established, each will have a £500 standard-rate band. The minimum standard-rate band is £200, no matter how many trusts have been established by the same settlor.
The introduction of the standard-rate band is to be applauded as it has reduced the administrative burden imposed on trustees. It is estimated that around one-third of discretionary and A&M trusts no longer need to pay the rate applicable to trusts as a result of this change. These trusts will also normally only have to complete self-assessment tax returns once every five years.
However, it should be borne in mind that, where income exceeds the £1,000 standard-rate band, trustees will continue to be liable to pay the rate applicable to trusts on the excess.
Finally, on the income tax treatment of discretionary and A&M trusts, the original proposals for modernising trust taxation included income streaming, the principle of which was that if the income arising within such trusts was to be passed rapidly to the beneficiaries, that income should be treated as the income of the beneficiaries in the tax year in which it was paid out. Instead of paying the rate applicable to trusts, the trustees would pay income tax at the basic, lower or dividend rate depending on the nature of the source income. Where income was received net of tax, such as bank or building society interest, or with a tax credit, as in the case of dividend income, the trustees’ tax liability would be fully covered.
The beneficiaries would receive a credit for the tax paid by the trustees on the income, so basic-rate taxpayers would have no further tax to pay. In effect, the trust would be treated as transparent for tax purposes, with the income and associated tax credit in the case of dividend income flowing through to the beneficiaries.
However, HMRC’s 2006 Budget Note 35 stated that “the proposals for income streaming are not being taken forward at this time”.
In my next article, I shall look at how these changes impact on the attractiveness of insurance bonds as a trustee investment.
Brian Murphy is financial planning manager at Axa Sun Life.