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Tolley's Practical Tax by Michael Waterworth

In the first of two articles, Michael Waterworth, Barrister, takes a look at developments in the trust taxation field.On 10 December 2003, in his Pre-Budget Report, the Chancellor announced plans to modernise and to simplify the income tax and capital gains tax approach to private resident trusts, with the aim of introducing a new system with effect from 6 April 2005. The Chancellor’s announcement was followed on 17 December 2003 by the issue of a number of Discussion Papers concerned with reducing the number of definitions used in connection with the tax treatment of trusts and harmonising the types of trust for tax purposes.

The Revenue has invited and received comment from practitioners in the course of a consultation process which ended on 18 February this year and it is anticipated that draft legislation will be published at the time of the 2004 Pre-Budget Report with a view to the final version being included in the Finance Bill 2005. The legislation will, of course, need to be passed by Parliament. It is probable that there will be very little opportunity to consider the terms of the next Finance Bill before the new system is to take effect on 6 April 2005, so it is important that interested parties take heed of the draft legislation when it is published later this year.

The purpose of this article and its follow up is not to second guess the content of that draft legislation but to consider the stated rationale underlying the current proposals and the impact which they are likely to have for the practitioner.

The stated aims

In the Revenue Budget Note of 17 March 2004 the proposals are described as a package of measures to modernise the tax system for trusts; to simplify the regime for a large number of trusts, particularly those with relatively small amounts of income; and to bring the tax paid by trusts for the most vulnerable beneficiaries more in line with what it would have been had the beneficiaries held their assets directly.

In order to achieve those aims a number of matters need to be considered. An overview of the considerations is set out in the Partial Regulatory Impact Assessment and these are discussed in more detail in the discussion papers of 17 December 2003. In short, the matters which the Revenue is considering fall into the following categories:

- The introduction of a basic rate income tax band of £500 for all trusts which, it is estimated, will cover some 30,000 small trusts.

- Clarifying and reducing the number of definitions of settlement with a view to harmonising the income and capital gains tax treatment of trusts.

- Providing that certain vulnerable beneficiaries of trusts are to be treated as if they owned the underlying trust assets so that the trustees will be taxed on the basis of the beneficiary’s personal circumstances.

- The possibility of providing that the trustees might be exempted from the rate applicable to trusts where income and gains are streamed or passed rapidly on to trust beneficiaries.

- A clarification of what Trusts Management Expenses are and the extent to which they are allowable for tax purposes.

- Consideration of the way settlors of settlor-interested trusts are taxed.

- Changing the capital gains tax regime for deceased estates.

Some of these are considered in more detail below but it is notable that one boldly stated objective is to modernise the tax system for trusts so that it does not provide artificial incentives to set up a trust but, equally, avoids artificial obstacles to using trusts where they would bring significant non-tax benefits. The use of trusts as tax avoidance vehicles is to be taken off the menu. Indeed, the Revenue adopts as an open position the premise that anti-avoidance legislation is appropriate for those who use trusts to avoid tax, further blurring the distinction between tax avoidance and tax evasion.

The government intends to engineer a system which does not penalise beneficiaries where a trust is imposed upon them by statute, such as under the laws of intestacy, or where a trust exists to protect the vulnerable. In practice structured disabled trusts are relatively rare and it would appear that the government is not afraid of employing the Revenue under cover of a modernised tax system to penalise ‘ordinary’ beneficiaries with whom the voting public might have less sympathy. Practitioners should keep a careful eye on developments in this area.

The rate applicable to trusts

In discussing these topics it is important to bear in mind the linked but legislatively distinct increase in the rate applicable to trusts which took effect on 6 April 2004. The change, announced in the 2003 Pre-Budget Report, has the effect of providing that the rate applicable to trusts has increased from 34% to 40% while the corresponding dividend rate has increased from 25% to 32.5%: Finance Bill 2004 clause 29 amending TA 1988 s686.

The original rates of 34% and 25% were chosen as a compromise between the positions of beneficiaries who are basic rate taxpayers and those who are higher rate taxpayers. As is very often the case with compromises the result has been that any given beneficiary has suffered the administrative complication of accounting for a difference between his marginal rate and the rate applicable to trusts.

The increase in the rate applicable to trusts will affect all trusts: anecdotal evidence suggests that there is already an increase in work relating to breaking trusts and that is a trend which, with higher tax rates, is set to continue. The increased rate applicable to trusts is likely to have a particularly adverse effect on small trusts and those which the Revenue refers to as trusts for the vulnerable. In part, therefore, the scheme of modernisation of the tax system for trusts is tied to the increase in the rate applicable to trusts. The proposed introduction of a basic rate band and the proposals relating to trusts for the vulnerable are directly related to this increase in the rate applicable to trusts.

A wide variety of definitions

Trust practitioners well know that under the current law the three principal tax regimes of income, capital gains and inheritance tax are not consistent in their treatment of trusts whether on their creation, during their lifetime or at their termination. The Revenue claims to have identified at least twenty-seven different sorts of trusts for tax purposes with three different approaches to the definition of settlement and nine different tests for settlor-interested trusts. The exercise of counting these different definitions does not recommend itself as an amusing diversion: most apply only for the purpose of one tax regime but some apply to two or three different regimes simultaneously.

The range of definitions is also quite startling. At the technical end of the scale are employee benefit trusts, accumulation and maintenance trusts and disabled trusts with various tax treatments, some overlapping, but even in the apparently simple case of bare trusts there are two income tax treatments and one capital gains tax treatment while the concept is not recognised as such for inheritance tax purposes.

Reducing the variety of definitions would undoubtedly make it easier for trustees to understand and comply with their obligations to the Revenue but harmonising the definitions is no mean feat. The existing tax system for trusts is complex, in part because trusts are themselves complex creatures, blurring the ownership of assets which have grown up around and with the existing tax regime in a piecemeal way. To an extent the existence of such a variety of different types of trusts is due to the fact that the principal tax regimes treat different types of trusts in different ways and that is, in part, due to quite fundamental differences in the structure of the tax regimes themselves.

Thus, IHTA 1984 does not attempt to define ‘a trust’ but relies upon the concept of ‘a settlement’ defined by reference to a disposition of property (see IHTA 1984 s43(2)) while capital gains tax does not define ‘trust’ but relies on an unwritten understanding of what a trust is. Instead, capital gains tax starts with the concept of ‘settled property’ meaning property held in trust other than property held by nominees or bare trustees: TCGA 1992 ss60, 68.

For income tax purposes the terms ‘trust’ and ‘settlement’ are not defined, although trustees are chargeable to tax: ICTA 1988 refers to ‘the trustees of a settlement’ (TMA 1970 s8A) and ‘income arising to trustees’ (ICTA 1988 s686) without defining what a trust or a trustee is.

The difference of approach between inheritance tax and capital gains tax arises because inheritance tax is a tax on transfers of value while capital gains tax is a tax on chargeable gains and the key concept for capital gains tax purposes is between property treated as that of trustees and property treated as belonging to the beneficiaries. Thus, for the purposes of capital gains tax the trustees of the settlement are treated as being a single and continuing body of persons (distinct from the persons who may from time to time be the trustees). By far the more comprehensive code is that used for inheritance tax purposes.

A new definition?

The Revenue has proposed that there might be benefits to using the existing inheritance tax definition of settlement for capital gains and income tax purposes rather than using the income tax definition or designing a new definition. However, it is acknowledged that doing so might give rise to practical operational difficulties for trustees of trusts containing a number of separate funds, open up loopholes for exploitation and lead to the need to introduce further levels of anti-avoidance legislation. The result may be to yield a superficially simple modern tax system which, in practice, is as complicated as its predecessor.

The Revenue has suggested that one possible approach to taxing trusts for both income and capital gains tax purposes would be sequentially to define the different sorts of trust which would be taxed and then set out how the tax rules apply to those trusts. The suggestion, heavily influenced by the inheritance tax structure, is that the Revenue should start with settlements in which the settlor retains an interest (a concept wider than the trusts under discussion in the proposals) and then move down the line to non-settlor interested trusts separated into bare trusts; interest in possession trusts; discretionary and accumulation trusts; and other specialist trusts.

The settlor-interested trust

In the case of the settlor-interested trust the Revenue intends to tax the settlor as though he owned the assets in the trust. Thus, all the income arising to a settlor-interested trust would be treated as the income of the settlor. The trustees would pay tax at the rate applicable to trusts on all trust income with the settlor reclaiming any tax not due through self-assessment or the claims system. Any payments of income to beneficiaries other than the settlor would be treated as gifts made by the settlor to the beneficiary.

For capital gains tax purposes all gains and losses would be treated as the settlor’s so that trust losses might be set against personal gains and vice versa. Settling assets in such a trust would not be a disposal, neither would the transfer of assets out of the trust if they were transferred to the settlor.

In effect, under the current proposals both capital gains and income tax would ignore the trust aspect of the settlor-interested trust. That is a rather brutal form of simplification and one wonders why it would be necessary to preserve the charade of levying income tax on the trustees at the rate applicable to trusts if the essence of the approach is to treat the property as belonging to the settlor.

There is, it seems, an ongoing debate as to how to define a settlor-interested trust and as to how to treat existing settlor-interested trusts in which other beneficiaries have an interest, for example, by way of occupation of a trust property which might not attract private residence relief under the proposed new regime.

The bare trust

In the case of bare trusts the intention is similar but even more blunt. The beneficiary would be subject to income and capital gains tax on the basis not only that he owned the trust assets but as if the trust did not exist. The trustees would not be obliged to pay income tax or capital gains tax on behalf of the beneficiary. For capital gains tax purposes creating or ending the trust would not restart the taper clock or be treated as a disposal unless the beneficial owner of the assets changed.

The general trust

Other trusts might be described and taxed as ‘general trusts’ although the status of specialist vehicles would be preserved. These general trusts are to include discretionary trusts, accumulation trusts and interest in possession trusts, all taxed under a common regime with a single set of rules intended to simplify the tax treatment of each class of trust with the result that, for tax purposes, the distinctions should become less important.

The basic rate band

There are two ‘big ideas’ in the approach to general trusts. One is the introduction of a basic rate band of £500 for all trusts liable to the rate applicable to trusts. One aspect of the drive to introduce a basic rate band is entirely pragmatic: a self-assessment return has to be completed even where trustees have very little tax to pay and that is an administrative burden which all could well do without. The suggestion is that with the introduction of a basic rate band (but not an annual exempt amount) trusts with low income would be under no further liability if they received the income under deduction of tax or with an associated tax credit. That would not do away with the need for self-assessment returns altogether but these could be restricted so that their completion need not be an annual event.

There are likely to be further complications arising from the introduction of a basic rate band relating to the streaming proposals (the second ‘big idea’) and the tax pool. The Revenue’s proposals do not, as yet, offer a satisfactory answer to these.

Streaming of income and gains

The second idea is that where income and gains arise to trusts and are passed rapidly on to trust beneficiaries, there may be a case for exempting the trustees from the rate applicable to trusts and instead taxing them at no more than basic rate. In effect this suggestion derives from an extension of the rationale underlying the settlor-interested and bare trust proposals which seek, so far as possible, to ignore the trust and treat property as belonging to those beneficially entitled.

The idea is that income which arises to trustees of general trusts in which there is no interest in possession and is passed on to trust beneficiaries in a short space of time might be exempted from the rate applicable to trusts with the trustees being taxed at no more than basic rate. Problems would arise in relation to income received at the end of one tax year but passed on at the beginning of the next and so a more fluid approach might be required of the Revenue in order to ensure that the streaming proposals work.

There are similar proposals in relation to the streaming of capital gains which would provide for gains that are passed through to trust beneficiaries after a short period, or gains where beneficiaries become absolutely entitled to trust assets as against the trustees, to be taxable on those beneficiaries and not on the trustees. Once again, this appears to reflect a desire to treat the beneficiaries as owners of the underlying assets so far as possible.

These are bold proposals requiring quite a radical change of approach on the part of both the Revenue and practitioners. The form of the draft legislation expected at the time of the 2004 Pre-Budget Report will need to be carefully considered well in advance of the 2005 Budget and the start of the 2005/06 tax year.

The other areas in which the Revenue has made serious suggestions are trusts for the vulnerable and the tax treatment of estates in the course of administration. These will be dealt with in a later article.

MICHAEL WATERWORTH

Michael Waterworth was called to the bar in 1994. He undertakes advisory, drafting and litigation work in a variety of Chancery and commercial fields. He is a joint editor of Mellows: Taxation for Executors and Trustees, among other publications. He is available to lecture in his specialist fields. He may be contacted through his clerks on 020 7405 0758 or clerks@tenoldsquare.com

This article was first published in 'Tolley's Practical Tax' on 21 May 2004, and is reproduced with the kind permission of Lexis Nexis.