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Tony Wickenden: Discretionary and bare trusts- what you need to know

Tony WickendenEverything you and your clients need to know about the most popular trusts

The subject of trusts can generate some complex tax and legal questions, so it is important to remind ourselves of the fundamentals. Trusts can be extremely useful not only for inheritance tax planning but also in ensuring money ends up in the right hands at the right time, and is subject to appropriate levels of control.

A trust is usually set up by an individual, called the “settlor”, who passes control of the assets to the “trustees”, whose job it is to look after them for the “beneficiary” (or beneficiaries).

Here, I want to look at the two most commonly used trusts: the discretionary trust and the bare trust.

These are used in their pure form in connection with protection plans and straightforward gifts of single premium bonds, and in an adapted form with loan trusts, discounted gift trusts and variations on these themes.

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The majority of trust planning is carried out with insurance-based products (protection plans and single premium bonds not directly producing income or capital gains for the individual or trustee), but most planning can be carried out with collective investments too – it is just that you must then deal with the income and capital gains from these investments.

Bare trusts
With a bare trust, the beneficiary is entitled to the trust assets. It is a simple trust where they take control at age 18 (or 16 in Scotland).

Bare trusts are usually set up for children by parents or grandparents who want to provide funds for their future.

When it comes to protection policies, a bare trust is usually chosen because the donor wishes to be certain the beneficiary will receive the policy proceeds.

With regards to single premium bonds, a bare trust may be used as the foundation for a discounted gift trust where, in return for an absence of flexibility, the donor can ensure the transfer to the trust is a potentially exempt one. Useful once the available nil-rate band has been exhausted.

Control, certainty and taxation
The trustees are the legal owners of the assets, holding them for the beneficiary. It is normal for the settlor to be the first-named trustee and to have specified administrative powers, often acting alone.

Once the beneficiary has been named, they cannot be changed. This is the corollary to a less complex tax regime.

The bare trust offers the thinnest of legal wrappers in that, aside from some anti-avoidance provisions (notably where parents have set one up for minor unmarried children not in a civil partnership), the assets are attributed to the beneficiary.

As mentioned, the fact the transfer of assets to a bare trust is potentially exempt is one of the key drivers for using one.

Where the underlying assets have the capacity to produce capital gains, parents and grandparents can transfer funds to a bare trust for children and use the child’s personal CGT annual exemption.

Clearly, this would be relevant where the trust asset was a collective investment, rather than an insurance-based one.

Discretionary trusts
Discretionary trusts are the most-used in financial services. The main reason is that trustees have control over who gets what, when, and flexibility to change or add beneficiaries if circumstances change.

The thing is, this valuable flexibility comes at a tax price. Let’s look at what that is exactly.

Inheritance tax
The tax price here reflects the fact assets held in a discretionary trust are not in any individual’s taxable estate. This comes in the form of entry, periodic and exit charges.

Entry charge
A gift to a discretionary trust creates a chargeable lifetime transfer.

This may cause an immediate IHT charge at the lifetime rate of 20 per cent if the value of the gift, when added to any other CLTs made in the previous seven years, exceeds the settlor’s NRB.

Helping clients manage the 10-year charge on trusts

The 20 per cent charge (which is equivalent to half the death rate of 40 per cent) is applied to the excess over the available NRB. If the settlor dies within seven years of making the CLT, a further liability may arise.

CLTs drop out of the calculation after seven years if no PETs are made after. If the settlor makes a mixture of PETs and CLTs, this can lead to a 14-year timeline, if a PET made after an earlier CLT fails.

Here, CLTs made less than seven years before the later failed PET are deemed to have absorbed some or all of the NRB that would otherwise have been available to offset against the failed PET, thus potentially going back 14 years. CLTs eat into the NRB in chronological order.

Ten-yearly charge
This is often referred to as the periodic charge and arises when the trust reaches its 10-year anniversary.

The value of the trust must be ascertained to see if any IHT is due on every 10th anniversary until all the assets have been distributed to beneficiaries.

Business property relief and agricultural property relief, subject to the usual qualifying conditions, can be deducted to arrive at the chargeable value.

The calculation of the 10-yearly charge can be complex – particularly if there are related settlements or property has been added to the trust since commencement – but, broadly, the trustees value the fund then deduct the NRB available to the trust, and the balance will be taxed at 6 per cent.

Exit charge
This is often referred to as the proportionate charge and arises when the trustees make a capital distribution from the fund.

The calculation is based on the rate used at the last 10-yearly charge and the number of quarters the property exiting has been relevant property, since the most recent 10-year anniversary.

For discretionary trusts of investments where the value of the assets does not exceed the NRB, and pretty much all protection plans, there should be little or no IHT payable.

Income tax
Income tax is most relevant when the underlying trust asset is not an insurance product, though there is a standalone income tax charge to consider when a chargeable event arises on a non-qualifying insurance policy (e.g. a single premium bond) held in trust.

Dividends
Where UK trustees are taxable, the first £1,000 of trust income is taxed at the standard rate of 7.5 per cent for dividends. Any dividends that do not fall within the £1,000 standard rate band will be taxed at the dividend trust rate of 38.1 per cent.

Trustees are not entitled to the dividend NRB of £2,000.

The £1,000 standard rate band applies to all trust income, including savings income and dividends.

Savings income
Savings income incorporates interest, interest distributions from fixed interest collectives and single premium bond chargeable event gains. Any savings income within the £1,000 amount taxed at the standard rate is taxed at 20 per cent.

All other savings income in excess of £1,000 will be taxed at the trust rate of 45 per cent.

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Trustees are not entitled to the starting rate for savings income or the personal savings allowance.

When income is distributed to a beneficiary from a discretionary trust, it is treated as trust income in the hands of the beneficiary.

Consequently, it is paid out with an accompanying tax credit of 45 per cent, meaning trustees will need to pay an additional amount of tax if the income was originally received in the form of a dividend.

The beneficiary who receives the income can reclaim some or all of the tax paid if they are not an additional rate taxpayer.

Settlor-interested trusts
If the trust is settlor-interested (i.e. either the settlor or their spouse can benefit), income will be assessed with reference to the settlor’s tax position. However, the trustees must first pay tax on the income at the trust rates and the settlor would then reclaim any overpaid tax through self-assessment. Any overpayment must be returned to the trustees. Income distributed to a beneficiary from a settlor-interested trust is not subject to any further tax in the hands of the beneficiary, but the beneficiary is unable to reclaim tax paid at higher rates than they would pay themselves.

Parental settlements
Income will also be attributed to the settlor under the parental settlement rules if it becomes payable to a minor unmarried child not in a civil partnership.

Chargeable event gains on single premium bonds
Where a chargeable event occurs under a non-qualifying insurance policy held in a discretionary trust, the gain is assessed on the settlor if alive and UK-resident, or if the chargeable event occurs in the tax year in which the settlor dies.

Thereafter, it falls on any UK-resident trustees; if there are none, on UK-resident beneficiaries when and to the extent they receive a benefit under the trust.

The rate of tax charged on the gain for UK trustees is 25 per cent for an onshore single premium bond and 45 per cent for an offshore single premium bond.

If the trust is a bare trust, the gain will be assessed on the beneficiaries, with reference to their individual tax positions.

The exception to this is where the beneficiaries are the unmarried minor children of the settlor not in a civil partnership, in which case the parental settlement rules will apply.

Where the beneficiaries are aged 18 or over (16 in Scotland), it may pay for the trustees to assign segments to beneficiaries for them to encash outside of the trust and with reference to their own tax positions.

The assignment would not give rise to a chargeable event and the beneficiaries often pay tax at a lower rate than that of the trustees.

Capital gains tax
CGT will only be relevant for non-insurance-based assets. Each trust has an annual exempt amount which is half the individual’s exemption, i.e. £11,700/2 = £5,850 for 2018/19.

This is then split between the number of trusts the settlor has created throughout their lifetime. The minimum AEA for a trust is £1,170 for 2018/19.

All gains above the AEA will be taxed at the trustee rate of 20 per cent, or 28 per cent, which applies to residential property not eligible for the private residence relief and carried interest gains.

Remember that a life policy which has a trust wrapped around it will dilute the AEA for other trusts, even if there is no value within the trust.

Tony Wickenden is joint managing director of Technical Connection (a St James’s Place Wealth Management group company). You can find him Tweeting @tecconn

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