This week I would like to continue my review of what was proposed in the pre-Budget report and accompanying documentation. I will start where I left off last week on the matter of capital gains tax and the fact that the trust rate will be 40 per cent from April 6, 2004 for income (32 per cent for dividend income) and capital gains, except for bare trusts and settlor-interested trusts where different rules apply.
Under a bare trust, all gains and income are assessed on the beneficiary, regardless of whether the gains or income are paid out. Where the trust was established by a parent of an unmarried minor beneficiary, the trust income will be assessed on the parent if it exceeds £100 gross in a tax year per beneficiary per parental settlor. There is no such parental anti-avoidance provision in respect of capital gains. More on this later.
Under settlor-interested trusts (defined as UK trusts under which the settlor or the settlor's spouse can benefit), all the trust gains or income are assessed on the settlor regardless of whether such gains or income are paid or applied for the benefit of the settlor or spouse. Again, more on this later.
Where an asset is transferred for no consideration, for example, into trust, or for a consideration of less than its market value, a chargeable gain or allowable loss will generally accrue to the transferor. The transferor is treated for capital gains tax purposes as if he had sold the asset for a consideration of an amount equal to its market value at the time of the transfer. On the future disposal of the asset by the transferee, any chargeable gain or allowable loss arising is calculated on the basis that that amount (its market value) was given to acquire the asset.
Holdover (gifts) relief may apply to defer a charge to tax on chargeable gains arising on the transfer of an asset, which is not made by way of a bargain at arm's length, if the transferor is an individual or the trustees of a settlement, provided that it falls into one of three categories which include a gift to a discretionary trust (which is a chargeable transfer for inheritance tax purposes) and a gift of shares in an unquoted trading company (which would include shares held by an employee in such an employer company).
Where the conditions for holdover relief are satisfied, the transferor and transferee may together make a claim for the relief. Where the transfer is to the trustees of a settlement, however, the transferor may make the claim unilaterally. The chargeable gain on which he would otherwise have to pay tax is then reduced by the amount of the heldover gain.
When the transferee comes to dispose of the asset, the amount he is entitled to deduct from the sale proceeds in computing any chargeable gain or loss is reduced by the amount of the heldover gain. The result is that the heldover gain becomes chargeable on the transferee. Holdover relief therefore represents tax deferral to the transferor.
Capital gains tax holdover relief can therefore be a useful relief for somebody who wishes to gift assets without an immediate capital gains tax liability. By making the gift into a discretionary trust and so triggering an inheritance tax lifetime chargeable transfer, it is possible to avoid immediate capital gains tax by claiming holdover relief.
The Government believes that the ability to use holdover relief on gifts (including those to discretionary trusts) has been abused for tax avoidance purposes in two ways and has now announced that legislation, that came into effect on December 10, 2003, will combat the use of such schemes. Details of the two changes are as follows:
New provisions will be introduced to prevent people using trusts to exploit the interaction between private residence relief and holdover relief with a view to avoiding capital gains tax. The main purpose of the new provisions is to counter tax-avoidance schemes which are designed to secure that gains arising on the disposal of properties that are not the main residence of the settlor are able to benefit from private residence relief.
Provisions will prevent holdover relief (gifts) under either section 165 (gifts of business assets) or section 260 (gifts to discretionary trusts) of the Taxation of Chargeable Gains Act 1992 being available in respect of transfers of assets, including residential property, to the trustees of settlor-interested settlements if certain conditions are satisfied.
I referred earlier to settlor-interested trusts and bare trusts. The consultation document on modernising the tax system for trusts, issued on December 11, 2003, proposed that, among other things, the definition of settlor-interested trust is extended, possibly to mirror that applying to offshore trusts.
That would mean that most private trusts would be caught as having the settlor, settlor's spouse, settlor's children or grandchildren as beneficiaries or potential beneficiaries would bring a trust within such a definition.
There is also mention of the fact that the income tax and capital gains tax rules for bare trusts under which the settlor is the parent and the beneficiary is a minor unmarried child are different and that this should be reviewed in the interest of consistency.