The taxation of trust income and gains (Part 2)

Introduction

In the first article we explained the fundamental facts about the four main types of trust. We then reviewed the tax treatment of income arising under absolute and interest in possession trusts.  Broadly, under these two types of trust the trustees are liable to income tax on trust income at the basic rate.  The beneficiaries entitled to the income are liable for tax on the income at their own tax rates, with a credit for the tax at the basic rate paid by the trustees.

In this article we cover the tax treatment of income arising under discretionary and accumulation and maintenance trusts (sometimes referred to as accumulation trusts).  When we consider an accumulation and maintenance trust it is before any interest in possession arises. 

We also look at the special tax rules that apply to parental trusts and settlor-interested trusts which can apply whatever type of trust is used. 

The income tax treatment of discretionary and accumulation and maintenance trusts

The tax treatment of income is more complicated for these two types of trust because no beneficiary is entitled to income except at the discretion of the trustees (except where an accumulation and maintenance trust has become an interest in possession trust).  This means that income can be accumulated (stockpiled) by the trustees for later distribution by the trustees – normally as capital - to a beneficiary(ies), rather than being distributed as it arises.

• Tax on the accumulation of income

Because income can be accumulated, the trustees are liable to tax on income received in the trust at the special trust rates.  These rates are 45% for savings and non-savings/non-dividend income and 38.1% for dividend income.  Unlike for individuals the trustees are not entitled to the £2,000 annual dividend allowance, the personal savings allowance (PSA), the savings starting rate band (SSRB), or a personal allowance.

A standard rate band is available for any trust whose income for a tax year includes income taxed at the special trust rates.  The standard rate band is £1,000 (but see later for when an individual has created more than one such trust).  The standard rate band applies to the first £1,000 of income in a tax year.   

Income falling within the standard rate band is taxed at the basic rate (20%) for savings and non-savings/non-dividend income and the dividend ordinary rate (7½%) for dividends.  Where total income in a tax year exceeds £1,000 income taxed at the 20% basic rate is treated as forming the lowest part of total income.  

Chargeable event gains under life assurance policies are treated as savings income for these purposes. 

The standard rate band – an example

 

 

A discretionary trust has property income of £500, building society interest of £250 and UK dividends of £550.  Expenses are ignored and it is the only trust created by the settlor.

The tax position

                                                                                                                  £

Property income £500 – basic rate tax @ 20%                                              100

Building society interest £250 - basic rate tax @ 20%                                    50

Dividends £250 - dividend ordinary rate @ 7½%                                           18.75

Tax on first £1,000 income                                                                         168.75

Tax on next £300 dividend income – dividend trust rate @ 38.1%                  114.30

Total tax                                                                                                   283.05            

If there is more than one current trust entitled to the £1,000 standard rate band created by the same settlor, the standard rate band will be spread equally between the trusts but currently will not be less than £200 per trust per annum. 

The trust has to keep an annual tally of the tax it has paid to HMRC, and this tally is called the ‘tax pool’ – see the next section. 

(ii)     Tax on the distribution of income to beneficiaries

Any income paid to a beneficiary by the trustees is treated as having been received net of a tax credit of 45% in respect of tax paid by the trustees regardless of the rate of tax the trustees actually paid.  The beneficiary will therefore need to gross up the net income received from the trustees appropriately.  To enable the beneficiary to do this the trustees will issue them with a summary of the income tax paid by them on HMRC Form R185 (Trust Income).

The grossed-up income received by the beneficiary is treated as non-savings income regardless of its source (compare this with income arising in an interest in possession trust which keeps its nature as dividend income or other income) which is taxed at nil, 20%, 40% and/or 45% (as appropriate).  As it is treated as non-savings income neither the dividend allowance, the PSA nor the SSRB is available to the beneficiary.

The tax credit of 45% on the distributed income must be covered by the tax paid by the trustees treated as entering the tax pool.  In simple terms this means that, for example, on dividend income distributed, the trustees would need to pay additional tax of 6.9% (ie 45%-38.1%) – see example (i) below.

The beneficiary will be able to offset the 45% tax credit against his or her personal tax liability on the trust income which should result in a tax reclaim unless the beneficiary is an additional rate taxpayer.

Examples

• The Red Discretionary Trust has interest which uses its standard rate band. If the trustees also received £1,000 of dividend income that income would suffer tax at 38.1% (the dividend trust rate) meaning that a tax liability of £381 arises.   

If the trustees are to pay all of this to a beneficiary they will need to have paid tax at 45% as follows:-        

                                                                                            £

Gross dividend received by the trustees                                 1,000

Tax paid at 38.1%                                                                    381

                                                                                              619

Additional tax at 6.9% due from trustees                                     69

Amount received by the beneficiary                                            550

(2)       The Yellow Discretionary Trust has interest of £2000.  £1,000 of this uses its standard rate band.  The balance interest of £1,000 will suffer tax at 45% (the non-dividend trust rate).

If the trustees are to pay this amount to a beneficiary the position is straightforward as the trustees will have already paid tax at 45% on this interest.

                                                                                                  £

Gross interest received by the trustees                                        1,000

Tax paid at 45%                                                                           450

Amount received by the beneficiary                                                 550 

(3)       The Blue Discretionary Trust has a full standard rate band available.  It receives rental income of £4,000 and dividends of £6,000. 

 

The tax position is as follows:-

                                                                                                    £

Gross rental income of £1,000 within standard

rate band taxed @ 20%                                                                 200

Gross rental income of £3,000 taxed @ 45%                                   1,350

Dividends of £6,000 taxed @ 38.1%                                               2,286

Total tax                                                                                       3,836

Tax of £3,836 has been paid on £10,000 gross income and forms a tax pool of £3,836.  The trustees decide to accumulate the income which means the tax pool is carried forward for use to frank income payments made to beneficiaries in later years.

Anti-avoidance provisions

Two important anti-avoidance provisions apply:

• Parental trusts

Special anti-avoidance provisions apply to trusts created by parents for their children who are under the age of 18, unmarried and not in a civil partnership. In these circumstances, generally speaking, all income is assessed on the parental settlor unless the total income from such a trust (or all such trusts) does not exceed £100 gross per parental settlor in a tax year. It should be noted that to the extent that income has been accumulated but not capitalised (so that a formal decision was not made by the trustees to capitalise the income) and it is proposed to appoint capital out of the trust, such a capital payment will be treated as income to the extent there is undistributed income in the trust and taxed accordingly. 

These provisions as regards the assessment of income apply to all trusts made on or after 9 March 1999, and income derived from monies added to a pre-9 March 1999 trust on or after 9 March 1999. For trusts created before 9 March 1999 this £100 rule is applied in a slightly different way.  

• Settlor-interested trusts – settlor or spouse (civil partner) a beneficiary

Another important anti-avoidance provision is that if the settlor or their spouse (which in this context includes a civil partner) is included as one of the beneficiaries under the trust (or could at any time benefit under the trust) then the trust will be “settlor-interested” and all the income arising under the trust will be treated as that of the settlor for income tax purposes.

However, under a discretionary or accumulation and maintenance trust, despite the settlor being assessed, the trustees are liable at the trust rates described above (i.e. 45% and 38.1%), effectively paying tax on behalf of the settlor, and the settlor is then entitled to a credit for the tax paid by the trustees. If the settlor is not an additional (i.e. 45%) rate taxpayer, any excess tax paid by the trustees may be reclaimed from HMRC. Any tax reclaimed this way must be paid back to the trust by the settlor.

It should be noted that if income is distributed out of a settlor-interested trust to a beneficiary who is not the settlor, that beneficiary will have no income tax liability in respect of the trust income. However, it will still count as the highest part of the beneficiary’s income, and so can still affect the calculation of tax on certain other income (eg. chargeable event gains under single premium bonds). Payments to beneficiaries of settlor-interested trusts are treated differently from other payments as they do not carry a tax credit at the trust rate.

A trust will not be settlor-interested simply because a widow/widower of the settlor is a potential beneficiary. This can often provide a useful form of future flexibility for those settlors who are concerned to provide for their spouses after their death.

In the past, HMRC has taken the view that payments which may be capital as far as the trustees are concerned may nonetheless be treated as income in the hands of the beneficiary if they have assumed the character of income (for example, where they are made to satisfy an income entitlement as in Re Brodie’s Trustees). Even a single payment may be so treated if it is a payment of “pure income profit” and is capable of recurrence. In appropriate circumstances, HMRC will argue that the payment has assumed the character of income in the hands of the beneficiary and will attempt to tax it as such.

Therefore, great care is necessary, especially where the trustees have invested in non-income producing assets such as single premium life assurance policies. This is particularly so with life policies where “tax-deferred” 5% withdrawals are taken. If the trustees take these withdrawals, tax free at the time (but strictly tax-deferred) under the life policy taxation provisions, and pass them to a beneficiary, HMRC could argue that such payments had assumed the character of income in the hands of the beneficiary.

Previously, it may have been difficult to refute this argument if regular payments were made. Fortunately, the 1987 Court of Appeal decision in Stevenson v Wishart has taken away a great deal of impetus from any HMRC argument. It is understood that HMRC (at least under a discretionary trust) will now treat advances of capital to a trust beneficiary as capital and not income in their hands unless, broadly speaking:

• the trust provides that advances of capital are to be made to augment the beneficiary’s income, to maintain their standard of living; or

• the capital payments amount to an annuity or are otherwise paid for an income purpose.

This risk is clearly at its greatest when such advancements are made to a beneficiary whose only right under the trust is to income. It is therefore recommended that specific directions to augment income should not be included in the trust. It is preferable to give the trustees power to advance capital only and not make any specific direction to augment or replace income with capital or pay a regular sum/annuity. 

In the next article, we will consider the capital gains treatment of trusts.