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Tolley's Practical Tax by Michael Waterworth

In the second part of his article on the reformed taxation of trusts, Michael Waterworth, Barrister, looks at how the new provisions will affect special types of trusts and looks to the future.

Trusts for the vulnerable

Under the current law, trusts for the vulnerable are given special recognition as disabled trusts i.e. trusts for persons who are incapable of administering their property or managing their affairs, extended for inheritance and capital gains tax purposes to include a person in receipt of attendance allowance or disability living allowance: IHTA 1984 s89 and TCGA 1992, Sch 1(1)(1).

Disabled trusts are accorded special inheritance tax treatment under IHTA 1984 s89 so that where the conditions of the section are satisfied, the disabled person is treated for inheritance tax purposes as being beneficially entitled to an interest in possession. Even if the settlement is drafted as a discretionary trust the ten-year charge and exit charges do not apply. For capital gains tax purposes the trustees are able to claim the full annual exemption amount as an individual and not the reduced rate usually applicable to trustees. There are no specific income tax benefits of a disabled trust.

The requirements are, however, inconsistent in that to attract the full capital gains tax exemption the disabled person must have an interest in possession in at least half of the fund and that breaches the inheritance tax requirements. The difficulty can be avoided during the accumulation period but after that one advantage has to be sacrificed.

The Revenue has acknowledged that raising the rate applicable to trusts to 40% has the potential to disadvantage trusts established to benefit the vulnerable. In an attempt to mitigate the effect of this tax increase on such trusts the Revenue propose that under the modernised tax system, trusts for vulnerable persons should continue to attract special treatment. The proposal is that there should be an election providing for certain vulnerable beneficiaries of trusts to be treated as if they owned the underlying trust assets themselves with the result that the Revenue would tax the trustees on the basis of the beneficiary’s personal circumstances.

How such a proposal is to work in practice is, as yet, unclear but it seems that the Revenue have in mind two classes of vulnerable beneficiaries: disabled people and minor orphaned children.

Trusts for Disabled Persons

In the former case the proposal is that not only should structured settlements for disabled people continue to be treated differently, as now, but also that certain general trusts created for disabled people could irrevocably elect to be treated as settlor-interested trusts where the disabled person would be treated as the settlor. Such an election would not be treated as a disposal for capital gains tax purposes.

The Revenue acknowledge that these trusts are established for the long-term benefit of the disabled person, and it is not usually desirable for trustees to have to pay out all the income received in any one year. It is accepted that for income tax purposes the retained income will suffer tax at the rate applicable to trusts unless special provision is made for it. The suggestion is that all trusts established for the benefit of disabled people will be settlor-interested for income tax purposes.

For capital gains tax purposes the intent is that all gains and losses would be treated as the beneficiary’s so that the disabled beneficiary would therefore have his or her annual exempt amount available to set against the gains and could set losses against them. On the death of the disabled person the capital gains tax uplift would continue to apply. It is also intended that transferring assets out of the trust would not be treated as a disposal if those assets were transferred to the disabled beneficiary but that a transfer to someone else would be a disposal by the beneficiary. This would appear to necessitate an approach fundamentally different from that adopted by the TCGA 1992 and it may be that it takes some little while for practitioners to get used to the change.

It is believed that the Revenue have not yet settled on a workable definition of trusts in respect of which an election might be made but the published intention in respect of both income and capital gains tax is to start with the definition for inheritance tax purposes employed by IHTA 1984 s89. A revised definition which removes the inconsistency between the inheritance and capital gains tax definitions of disabled trusts is to be welcomed.

Of some practical concern to practitioners is the Revenue’s statement that ‘the interaction with the various rules for benefits and tax credits would need to be considered’. It is possible that the comment is an innocent consequence of the Government’s drive to merge the benefit and tax systems but the worrying inference is that the intention is to ensure that a disabled person’s interest in a trust is offset against state benefits which could result in a reduction in the usefulness and popularity of such trusts.

Trusts for minor orphans

As to the second category, there is no ready explanation as to quite why the Revenue should draw a distinction between orphans and other vulnerable minors but the suggestion is that trusts for minor children whose parents die intestate and trusts arising by imposition of law where a parent makes an absolute bequest to a minor could elect to be treated as settlor-interested trusts with the child or children treated as settlor. The Revenue appear to be open to the suggestion that some will trusts could also elect to be treated in this way but there are believed to be no firm proposals as yet.

As with trusts for disabled persons the rationale is that income will often be accumulated and that the accumulated income will be subject to the 40% rate applicable to trusts unless special provision is made.

Once again, in order to avoid exploitation, the Revenue intends that the election ought to be irrevocable but that it would not be treated as a disposal for capital gains tax purposes. The effect would be to reduce the tax paid on the trust assets from the rate applicable to trusts to the marginal rates applicable to the minor beneficiary and appropriate to that beneficiary’s individual circumstances.

Estates in the course of administration

The Revenue tentatively consider that it might be possible to bring estates in the course of administration into the same tax regime as trusts. The suggestion has practical attractions in that estates in the course of administration use the same Self Assessment return as trusts and many provide for the creation of trusts on completion of administration.

There are, however, some fundamental difficulties with an approach which seeks to treat estates as general trusts. After all, under the general law beneficiaries have no specific interest in any of the property comprising the residue until the residue has been ascertained in due course of administration. It is largely for that reason that the tax regime applicable to estates in the course of administration differs from that applicable to trusts. Merging the two may require a reappraisal by the Revenue of its acceptance of the general principles applicable to the administration of estates. There is likely to be considerable tension and not a little conflict between the two approaches.

The difficulties identified by the Revenue include the fact that payments out of an estate which are treated as income in the hands of beneficiaries can include capital payments and that there is no limit between the time income arises to the estate and the time it can be paid out as income to beneficiaries. Further differences between the two approaches include the provision of a full capital gains tax annual exempt amount for personal representatives for the tax year in which a person dies and the two following years and the different approach to deductible expenses.

The Revenue would like to consider whether there is potential for extending the flow-through treatment for streamed chargeable gains to estates or whether beneficiaries who have the proceeds of sale of an asset passed on to them could be treated as though they had disposed of the asset, or their share of it, by election or otherwise.

No specific solution has been posited by the Revenue and it may be that the distinction under the general law is too great an obstacle for the Revenue to overcome by way of modernisation.

What next?

There is much food for thought in the Revenue’s proposals. It seems that there is a strong desire on the part of the Revenue to modernise the tax system for trusts in such a way as to ignore the trust and the trustees where possible and to tax the beneficiaries as if they owned the underlying assets. In some areas the suggestions might come to nothing because of difficulties in applying this approach to the general law but if anything is to come of the proposals practitioners will face quite a radical overhaul of the taxation of trusts and should be prepared to face a new system from 6 April 2005.

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 4 June 2004, and is reproduced with the kind permission of Lexis Nexis.