Technical article

BACKGROUND

A trust is a fiduciary arrangement that allows one party (the settlor) to transfer assets to a third party (the trustee) to hold those assets on behalf of a beneficiary(ies). The modern concept of trust law has its roots in English law arising from notions of feudal land ownership in the 12^th century and the ‘Statute of Uses’ in the 16^th century. Trust law over the years has developed to generally keep pace with changes in the ways of life and in doing business, and have a variety of uses, a number of which are relevant to financial planning.

 

INTRODUCTION

Most financial advisers in their professional life will, at some point or another, come across trusts, and a basic understanding of trusts will therefore be valuable, if not essential.

In financial planning, the following are the most common reasons for using a trust.

• to put aside property for a specific purpose (e.g. for the maintenance of children);
• to protect capital from being dissipated and to provide for future generations;
• to protect and provide for young and incapacitated persons (e.g. instead of giving them outright ownership);
• to keep control over the ultimate destination of property (for example in second or subsequent marriage situations);
• to protect capital from creditors (they will normally have no access to assets placed in trust if this is done a sufficient period of time before bankruptcy, as legally the settlor no longer owns them) and possibly divorcing partners;
• to avoid the need to obtain probate/letters of administration on a deceased person’s assets, thereby enabling those assets, if necessary, to be dealt with immediately on a person’s death;
• to protect a person’s assets from a claim by the local authority in respect of the provision of care home fees;
• to reduce tax – here the key is that the settlor will usually wish to remove income, capital and capital growth from his beneficial ownership thus reducing income tax, capital gains tax and inheritance tax.

The final reason stated above for using a trust is to reduce tax. The aim of this article, and the future articles in the series, is to provide a reminder on the basics of the taxation of trust income and trust capital gains. 

We begin with a consideration of the fundamental facts about trusts.

 

TRUST FUNDAMENTALS

1. The types of trust

There are four main types of trust

• A. Absolute (bare) trust

Here both capital and income are held by the trustees for the absolute benefit of the beneficiary or beneficiaries, normally a child or children. It should be noted that in the case of an absolute or bare trust, the beneficiary is entitled to both the capital and income of the trust. The fact that the trustees can accumulate the income on the beneficiary’s behalf whilst, say, they are a minor, is irrelevant. If the beneficiary is entitled to that income (and capital) and cannot be deprived of the gift, then it is an absolute trust.

• B. Interest in possession trust

Here a beneficiary has an immediate legal entitlement to the current enjoyment of the trust property. This will normally be an entitlement to any income (dividends, interest or rent) produced by the trust property as and when that income arises. Such a trust is frequently created where the settlor wishes a person to have the rent-free use of property or the entitlement to income from certain property during their lifetime but does not want the beneficiary to have outright access to the capital. This is known as a “life tenancy” or “life interest” and is often used in the wills of married couples/civil partners who wish to ensure that the assets of the first to die pass, intact, to the next generation, yet in the meantime give the entitlement to income (or rent-free occupation) to the surviving spouse.

A right to income may, however, exist for a limited period of years only. Alternatively, the trust may provide in fixed terms for a future entitlement to trust income and capital, e.g. income to X for life, then income to Y for 10 years and after that capital and income to A and B equally.

Despite giving an immediate entitlement to income, under an interest in possession trust that confers a power of appointment, (frequently known as a “flexible trust”), the trustees (or the settlor) would have the power to appoint the right to the trust capital and/or future income to other beneficiaries in a stated class. Income that has already arisen cannot be taken away from the beneficiary entitled to it.

•  C. Discretionary trust

As the name suggests, a discretionary trust gives the trustees total discretion as to the use of capital and the distribution of income. The trust will set out the names or classes of person who can benefit but the final decision as to the level and frequency of payments is left to the trustees (or the “appointor”). This means that until a distribution or appointment is made under the terms of the trust no beneficiary has the right to income or capital.

The appointor can be the trustees, or the settlor during their lifetime and then the trustees. Where it is the trustees, the settlor will frequently be able to inform the trustees of the people he would like to benefit, but without binding them, by giving them a letter of wishes. This can be particularly relevant in giving the trustees guidance as to whom to appoint benefits to after the settlor’s death.

• D. Accumulation and maintenance (A&M) trust

This type of trust exists primarily to benefit the settlor’s children or grandchildren in the future, generally on attaining a stipulated age between eighteen and twenty-five.

At the outset, the beneficiary has no entitlement to income or capital (although the trustees would normally be able to use the trust income or capital for his benefit at their discretion). This means that for income tax purposes the trust will be taxed in the same way as a discretionary trust. 

At some future point, the beneficiary will become entitled to trust income.  If entitlement from that point is to income only the trust will be taxed as an interest in possession trust. If entitlement is to both income and capital the trust will then be taxed as an absolute trust. Entitlement may also be initially to income then later to both income and capital. 

(ii)   The parties to a trust

There are three parties to any trust.

• The Settlor

This is the person who creates the trust. The settlor can be more than one person. For example, in cases where jointly owned property is transferred, the settlors will generally be the joint owners of that property.

Where property is transferred to a trust via a will on death, the settlor will be the testator/testatrix of the will or, in the case of a trust arising on intestacy, the intestate person.

• The Trustee(s)

These are the legal owners of the trust property who hold it and administer it for the benefit of the beneficiaries. The trustees will normally be named in the trust document and will frequently include the settlor. This will enable the settlor to have a degree of ongoing control over the trust property whilst alive. It is generally unwise for the settlor to be the sole trustee.

Where the trust arises on an individual’s death the trustees will frequently also be the executors of the will. Where the trust arises on an intestacy, the trustees will be the administrators of the estate.

(c)     The Beneficiary(ies)

Beneficiaries are the people for whose benefit the trust has been established. A beneficiary’s precise entitlement will depend upon the terms of the trust – they may be entitled to income (a life interest), income and capital (an absolute interest) or income/capital at the discretion of the trustees (a potential interest).

THE INCOME TAX TREATMENT OF ABSOLUTE AND INTEREST IN POSSESSION TRUSTS

A beneficiary will have an interest in possession (the current right to current income) in one of three potential situations:

1. they are absolutely entitled to trust capital and income (i.e. an absolute trust);

1. they are entitled to income whilst alive, with capital passing to another beneficiary on their death (a fixed life interest trust);

1. they are entitled to income in the absence of the trustees appointing income to another beneficiary (a flexible trust).

If the trust asset is residential property, the beneficiary with the interest in possession, for the time being, may have an entitlement to occupy the property rather than receive income from it.

Where an interest in possession trust produces income, the trustees are liable to tax on that income at the basic rate of income tax which is currently 20%. In a limited number of cases, tax will already have been deducted at source or be deemed to have been deducted at source. This will discharge the trustees’ liability.

Income will then be assessed on the beneficiary. An extra tax liability can arise if the beneficiary is liable to higher rate (or additional rate) tax. The income retains its original character in the hands of the beneficiary, so for a higher rate taxpayer, the liability will be at 40% (an extra 20%) on savings income and rent, and at 32.5% (an extra 25%) on dividend income.  For an additional rate taxpayer, the liability in 2020/21 will be at 45% (an extra 25%) on savings income and rent, and at 38.1% (an extra 30.6%) on UK and most foreign dividend income.

Since 6 April 2016, these extra liabilities only arise if savings income exceeds the higher rate taxpaying beneficiaries’ personal savings allowance of £500, or dividend income exceeds the beneficiaries’ dividend allowance of £2,000. Additional rate taxpayers are entitled to the dividend allowance but not to a personal savings allowance.

In cases where the trustees have mandated the trust income direct to the beneficiary, the beneficiary will be assessed on all trust income as it arises, and the trustees will not need to declare it on a trust and estate tax return. In the Paul Hogarth Trust case, the First-tier Tax Tribunal held that income will not be taxed on the trustees if the income is mandated to the beneficiary and paid to them directly from the source and not through the trust bank account.

In the above Hogarth case, all the income was mandated to the life tenant and the trust did not have any chargeable gains for the tax years in question. There were, therefore, no other tax liabilities or reporting duties on the trustees.

Again, if the income is dividend or savings income, the beneficiary is assessed as having received dividend or savings income as if it were income received directly and so can offset any personal savings allowance or dividend allowance (as appropriate) against that income.

Entitlement to income (not just receipt) is important in this respect; the beneficiary does not have to receive the income for it to be assessed on them – for example, it may be accumulated within the trust but held for their sole future benefit.

Please note that special rules apply where the settlor or their spouse (civil partner) can benefit or where the trust has been set up by a parent in favour of an unmarried minor child, who is not in a civil partnership.  We will cover these special rules in a later article. 

In the next article, we will look at the tax treatment of income arising in a discretionary trust and accumulation and maintenance trust.