The taxation of trust income and gains (Part 4)

Introduction 

In this final article in our series of four we review the tax treatment of capital gains arising in connection with UK-resident trusts. The first two articles covered the income tax aspects and the third looked at the capital gains tax (CGT) implications on the transfer of assets into trust and the management of the trust assets by the trustees.

 

CGT on payments out of trust - Beneficiary becoming absolutely entitled 

A charge to CGT will arise when a beneficiary becomes absolutely entitled to the trust property. As mentioned in the last article, if the trust is a bare trust, the beneficiary is absolutely entitled from the time the trust is created and so there is no disposal by the trustees when the beneficiary, for example, reaches the age of 18 and the trustees transfer the trust assets into his or her name. 

In the case of trusts other than bare trusts, beneficiaries may become absolutely entitled when they satisfy a contingency (such as reaching a certain age), on the death of a person with a prior interest or on an appointment made in their favour by the trustees of a discretionary or flexible type of trust.

Frequently, it will be possible for the trustees to make a claim for holdover relief on the beneficiary becoming absolutely entitled to trust assets so that any gains will be treated as reducing the beneficiary’s acquisition cost. This can apply where:

• the assets are business assets;

• the disposal is also subject to IHT (for example if property is leaving a trust taxed as a discretionary trust and an exit charge could arise); or

• subject to certain conditions, the entitlement arises from an accumulation and maintenance trust under which no interest in possession exists at the time of payment (e.g. because the beneficiary becomes entitled to income and capital at the same time).

 

Termination of a life interest 

A beneficiary may also become entitled on the termination of a prior life interest under a trust. The CGT consequences of the termination of a life interest vary, in general, according to when the trust was created and the reason for the termination.

(i)      Trusts created before 22 March 2006

No chargeable gain for CGT will arise on the termination of a life interest as a result of the death of a life tenant with a pre-22 March 2006 interest in possession.

Instead, a revaluation will occur, the trustees or new owner will be treated as acquiring the assets at the uplifted market value and any gain held over on the creation of the trust will then crystallise. For example, a claim for holdover relief may have been made in a case where the original gift was a chargeable lifetime transfer or consisted of a gift of business assets.

This means that (other than with regard to held-over gains) a charge to CGT will arise only where the life interest ends otherwise than on the death of the life tenant and the property comes out of the trust because a beneficiary then becomes absolutely entitled to it (see above).

(ii)     Trusts created on or after 22 March 2006

Most interest in possession trusts created during the lifetime of the settlor after 21 March 2006 are now subject to the IHT relevant property regime.

As such, there are no CGT implications on the trust assets on the death of the life tenant (and equally there will be no uplift to market value at that time).

Certain interest in possession trusts created after 21 March 2006 will, however, benefit from the same CGT treatment as pre-22 March 2006 trusts (see above). Broadly, these are “qualifying interest in possession” trusts. This term includes trust interests created after 21 March 2006 that qualify either as:

• a disabled person’s interest;
• an immediate post-death interest;
• a transitional serial interest; or
• a bereaved minor trust.

As with pre-22 March 2006 interest in possession trusts, a revaluation will occur on the death of the beneficiary, and the trustees or new owner will be treated as acquiring the assets at the uplifted market value (with any deferred gains becoming chargeable at that time).

If a beneficiary becomes entitled to the trust capital otherwise than on death of the life tenant, the trustees will make a disposal (or part disposal) at that time. Holdover relief may be available if the disposal also gives rise to an occasion of charge for IHT (see above).

 

Terminating a trust 

It may be the case that a trust has outlived its usefulness or is in a format that is tax-inefficient (for example there is an elderly life tenant and on her death all the trust assets will form part of her estate and suffer inheritance tax (IHT)). In such cases the question arises as to whether the trust can be brought to an end.

Trusts can be brought to an end in a number of ways.

First, the trust may come to an end as a natural conclusion of the terms of the trust or the actions of trustees. For example, the trustees of a discretionary trust may decide to appoint all of the capital absolutely and irrevocably to a beneficiary. On the distribution of all of the trust property to that beneficiary, the trust would come to an end.

Second, under a fixed life interest trust, the life tenant may die, meaning that the remainderman becomes absolutely entitled and the trustees distribute the capital to them.

But is it possible, in other cases, for a trust to be brought to an end and the trust assets distributed to the beneficiaries? The answer to this is, yes – but only if the rule in Saunders v Vautier is satisfied. This rule states that for a trust to be brought to an end all the beneficiaries must agree, be capable of being identified and be sui juris (i.e. adult and of sound mind).

This requirement means that it would normally be very difficult (if not impossible) to bring a discretionary trust to an end because the potential beneficiary class usually includes issue and remoter issue so may include currently unborn beneficiaries. Even if there was no prospect of there being any future beneficiaries, the current beneficiaries may be minors and so would not be able to comply with the Saunders v Vautier rule.

On the other hand, in cases where a trust had an adult life tenant who was, say, an elderly widow and on the life tenant’s death, her named children (who are adults) become absolutely entitled, the trust fund could be dismantled. However, much depends on the precise wording of the trust. Difficulties would arise if the trust wording stated that the adult children would only be entitled if they were alive at the date of their mother’s death and, if they weren’t, their children would take their entitlement. Here one could be dealing with minor children (or even unborn children or beneficiaries).

 

Special trusts 

(a)     Trusts for vulnerable beneficiaries

As stated in the last article most trusts are eligible for an annual CGT exemption equal to one-half of that available to an individual (ie £6,150 for tax year 2020/21).  The annual exemption can be reduced proportionately (but not below £1,230 for tax year 2020/21) when a settlor has created more than one trust.

Some trusts for disabled people or children get special tax treatment.  These are called  ‘trusts for vulnerable beneficiaries’. 

A vulnerable beneficiary is either someone under age 18 whose parent has died, or a disabled person who is eligible for specified State Benefits, such as the Personal Independent Payment or Disability Living Allowance (either the care component at the highest or middle rate, or the mobility component at the higher rate). 

A vulnerable beneficiary can also be someone who is unable to manage their own affairs because of a mental health condition.

On satisfactory completion of the Vulnerable Person Election form by the beneficiary (if able) and trustees the resulting effect is that trustees are taxed on the basis of the vulnerable beneficiary’s individual circumstances and so normally benefit from a full individual’s annual CGT exemption of £12,300 for tax year 2020/21.

(b)     Parental trusts

Unlike the application of the special income tax anti-avoidance rules that apply to trusts created by parents for their minor unmarried children not in a civil partnership, there are no special CGT anti-avoidance rules when chargeable capital gains arise under such trusts (however, see the section on holdover relief below).

 

Tax reliefs  

• Business asset disposal relief (BADR)

Previously called entrepreneurs’ relief, BADR may be claimed by the trustees, with the permission of the beneficiary, if certain business assets are disposed of by the trustees and the beneficiary (the life tenant of an interest in possession trust) qualifies for BADR on their holding of the same assets.  The permission of the beneficiary is required because such a claim  will use some of the beneficiary’s £1 million lifetime maximum BADR limit. BADR is never available on a gain generated by a discretionary trust. The trustees pay tax on qualifying gains at 10% instead of 20%.

• Private residence relief

Trustees will be entitled to private residence relief if one of the beneficiaries of the trust occupies a property (under the terms of the trust) owned by the trustees as their main residence.  However, there are some anti-avoidance rules, which were introduced in 2003, that may preclude this if holdover relief has been previously claimed on the property.

(iii)      Holdover relief

This topic was covered in more detail in the last article but because of its particular importance to the subject it is briefly included again here.

Remember that where a trust exists under which a settlor, settlor’s spouse/registered civil partner or the settlor’s minor unmarried child not in a civil partnership can benefit, the facility to hold over any capital gain on the transfer of assets into such a trust is not permitted, but there is no such prohibition on exit from the trust if the transfer would otherwise benefit from holdover relief.

In addition, the calculation of chargeable gains can be hampered if an asset of the trust has been subject to a previous holdover relief claim.  This will have occurred where the settlor has a CGT liability and IHT liability at the same time, eg on making a gift.  As a result of this the settlor may have been eligible to defer their CGT liability until the trustees later disposed of the gifted asset.  The relief works on the basis that the held-over gain reduces the base cost of the trust asset gifted so that a higher chargeable gain arises on the ultimate sale of the asset.

 

CGT reporting during the lifetime of a trust 

• Absolute (Bare) trusts

Trustees

Capital gains of an absolute trust belong to and are assessed to tax on the beneficiary, so the trustees do not need to complete a tax return.

Beneficiaries

The beneficiary is responsible for reporting any capital gains, and if the beneficiary is a minor this responsibility will fall on the minor’s parent or guardian.

• Interest in possession and discretionary trusts

Trustees

The trustees must complete the capital gains tax supplementary pages (SA905) where there is a disposal or deemed disposal of a chargeable asset.

The SA905 will be required where

• The proceeds of disposal are four times or more the annual exempt amount for individuals (this would be £49,200 for tax year 2020/21; or

• The total chargeable gains (before any losses) are more than the trust’s annual exempt amount (minimum amount £1,230 for tax year 2020/21); or

• The trustees wish to claim an allowable loss or make any other claim or election for the year.

Beneficiary

There are no reporting requirements for capital gains.

• Reporting deadlines

Paper tax returns are normally due by 31 October following the end of the tax year in which the disposal takes place. Returns submitted online are normally due by 1 January following the end of the tax year in which the disposal takes place.

Since 6 April 2020, UK-resident trustees disposing of a residential property in the UK making a gain which is liable to CGT, such as a buy-to-let property, have 30 calendar days from the date of completion to tell HMRC and pay any CGT owed, using a new online service. The gain will also have to be reported as part of the self-assessment return for the tax year in question so that the correct tax liability can be calculated. 

The due date by which the payment of CGT in normally made is 31 January following the end of the tax year in which the disposal took place.