In a recent article in a leading tax journal a method by which the trustees of a discretionary trust could possibly avoid some of the tax problems that arise from trustees distributing income that emanates from UK dividend income was described.
The argument put forward in the article is that the trustees, in effect, make a temporary appointment to determine that, until further notice, a certain beneficiary will receive income from the trust. It is argued that this would not prevent them from accumulating income or appointing the income to another beneficiary in the future. The objective behind making arrangements such as this is to achieve a situation whereby it is the beneficiary who receives the income (and not the trustees) thus avoiding the dividend tax problems that arise because of the trustees having to pay tax at 34% on distributed income but without taking account of the 10% tax credit on the dividend. The arrangement is manufactured to achieve a situation which on a literal interpretation of the legislation means that the income falls outside of section 686 ICTA 1988.
The problem with this suggestion are twofold. Firstly, it gives no guarantee that the desired tax implications would result. That in itself would not be a drawback if there were no downsides. However, I believe the arrangements could have possible downsides and this is the second issue to address.
As regards the first issue, there appears to be other possible interpretations of the arrangement and there is no guarantee that the Inland Revenue would accept that the income is received by the beneficiary for income tax purposes. More likely they could argue that this is merely a convenient short cut and that the income is still held on discretionary trusts at the time it is paid but that the trustees have decided to appoint to the beneficiary in question. Therefore the trustees still have to discharge their additional rate liability.
If there was merely a risk of this alone, this would not be a problem but if the argument that this income is received by the beneficiary without being received by the trustees is taken too far, the Revenue may in effect then take the view that the trustees have created an interest in possession in favour of that beneficiary.
Looking at this implication in more detail therefore, if the trustees instruct a registrar to pay dividends to a beneficiary until further notice, it must at the very least be questionable whether this amounts to an implied appointment of a revocable life interest to that beneficiary. This will mean that the income in question will no longer be held on discretionary trusts, and a revocable interest in possession trust will then have arisen. As well as this not being what the trustees require from a practical standpoint and meaning that income would be taxed on the beneficiary, it would create an inheritance tax exit charge. Also there may well be inheritance tax repercussions (potentially exempt transfers) if the trustees later instruct that income payments should cease and future payments made to other beneficiaries.
In effect there is a danger that in making these arguments to the Inland Revenue that the Inland Revenue will then regard an interest in possession as having been created with the adverse implications thereof. This needs to be carefully taken into account in determining the appropriate strategy.
This is just another potential twist in the already tortuous issue of discretionary trust taxation. In the light of the uncertainty it is certainly worth raising the issue of dividend taxation with the trustees of discretionary trusts as it may well be that through thoughtful advice, amounts distributed to beneficiaries could be increased by changing investments.