As we approach the end of the tax year, this is a good opportunity to review the taxation of trusts.
It may be useful to start with a recap of the different type of trust before looking at the tax treatment of each. As well as income and capital gains tax, I have also included the inheritance tax position for each type of trust.
We will use the types of trusts and definitions as used by HM Revenue & Customs in its manuals and we will just look at the main types of trusts and not include trusts for the vulnerable, etc.
A bare or simple trust is one in which each beneficiary has an immediate and absolute title to both capital and income.
Some people refer to bare trusts (also known as absolute trusts) as a nominee account for the beneficiaries, which in a way is true, as they are the only people who will get hold of the trust fund.
Interest in possession trust
“…An interest in possession ’exists’ [in a trust] where the person having the interest has the immediate entitlement… to any income produced… as the income arises…”
So if any income arises, it belongs to the income beneficiary, otherwise known as the life tenant, or life renter in Scotland. When the life tenant dies, the trust fund will usually go to named beneficiaries of the capital value, otherwise known as the remaindermen, or fiars in Scotland.
“…Any trust where the trustees can accumulate income or pay it at their discretion.” No beneficiary has any right to trust income and who gets what and when is completely at the discretion of the trustees.
Although we are just discussing discretionary trusts in this article, the way their income and capital gains are taxed is also applied to accumulation & maintenance trusts. These were discretionary trusts for children or grandchildren which, provided they satisfied certain conditions, benefited from favourable inheritance tax treatment before the rules were changed in March 2006.
We will now look at the tax levied on trusts, in broad terms.
The beneficiary is assessed for income tax on any income received by the trust. With trusts set up by parents for minors, the child’s income from the trust is deemed to be the income of the settlor for income tax purposes.
However, if the income arising from all parental gifts made by a parent to a child is less than £100 gross in a tax year, the income is not counted as the parent’s income.
A minor for this purpose is a person who has not yet reached age 18 and is not married or in a registered civil partnership (age 16 in Scotland).
Interest in possession trust
Tax is payable by the trustees on income received by them at the basic rate (currently 20 per cent) except for dividend income which is received net with a 10 per cent tax credit (currently) and not subject to further tax.
The beneficiary entitled to the income is then liable at their marginal rate and a non-taxpayer may be able to reclaim some or all of the tax deducted.
Alternatively, if they are higher or additional-rate taxpayer, they will have to pay additional tax on the income received.
There is a standard rate band, which applies to the first £1,000 of income or deemed income and the tax rate is 20 per cent (10 per cent on dividends).
If the person who set up the trust – the settlor – has set up more than one trust, the £1,000 standard rate band is divided equally among the trusts. However, if the settlor has set up five or more trusts, the standard rate band for each trust is £200.
All other income is taxed on the trustees at the trust rate which is 50 per cent, except for dividend income which is taxed at 42.5 per cent. Here is an example of the tax paid on dividend income at trust level:
Trustees’ dividend income £10,000
Gross-up dividend £11,111
Tax @ 42.5% £4,722
Tax credit £1,111
Trustees’ tax bill £4,722 – £1,111 = £3,611
Net income £6,389
Unlike the two other main types of trust, the trustees now have a decision as to what they are going to do with this money. They could simply keep the £6,389 in the trust and invest it for the future. It is worth mentioning that before trust tax rates went up two years ago, in 2009/10 they would have had £7,500 net.
If they decide to distribute the income, there is a further complication if dividend income received by the trustees is then paid to a beneficiary, because this income does not leave the trust as dividend income but as trust income.
Trust income must be taxed at 50 per cent and the 10 per cent notional tax credit is not available for this purpose, which means that the trustees must pay additional tax.
Income distribution £6,389
Tax deducted £1,389
Net distribution to beneficiaries £5,000
The beneficiary that receives the payment now has a tax credit of £5,000 (£3,611 + £1,389).
If they are not a taxpayer, a basic-rate taxpayer or even a higher-rate taxpayer, they should be able to reclaim some or all of the tax deducted. This is because the income has effectively been taxed at 50 per cent.
Special rules apply if the settlor or the settlor’s spouse can benefit under the trust. Namely, all trust income will be taxed on the settlor, although the trustees still have the initial liability at the trust rates described above, effectively paying tax on the settlor’s behalf.
Again, if the settlor is not an additional (50 per cent) rate taxpayer, they may recover the excess tax from HMRC, although they must then pay it back to the trust.
Capital Gains Tax
Gains are assessed personally on the beneficiaries at the appropriate rate (18 or 28 per cent) and the full annual exemption (£10,600 currently) may be available.
Interest in possession/ discretionary trust
Gains are assessed on the trustees at 28 per cent with a maximum of half the individual annual exemption available (£5,300 currently).
If the person who created the trust (the settlor) sets up more than one UK-resident trust, including trusts of insurance policies, the trustees must divide the annual exempt amount by the number of trusts. If they have more than five, an exempt amount of £1,060 applies to each trust (this only applies to trusts set up after March 9, 1981).
The transfer of assets into the trust is treated as a potentially exempt transfer.
The appropriate share of the trust asset value would be included in a beneficiary’s estate if they were to die.
Interest in possession trust
If the trust was established prior to March 22, 2006, and has not subsequently been corrupted and brought within the relevant property regime, then the asset value would be included in an income beneficiary’s estate if they were to die.
A trust would be corrupted if additional funds were added (except for contractual renewal and top-up premiums) or a beneficiary was changed in their lifetime.
Interest in possession trusts established after March 22, 2006 fall under the discretionary trust rules as detailed below. Before that date, gifts to interest in possession trusts were Pets.
The transfer of assets into the trust is treated as a chargeable lifetime transfer.
If that CLT plus the value of any other CLTs set up in the previous seven years exceeds the nil rate band at commencement, then there will be an entry charge payable at 20 per cent on the excess above the current NRB.
There is also the possibility of a periodic charge on each 10th anniversary and an exit charge when any property leaves the trust.