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Tolley's Practical Tax by Matthew Hutton MA, CTA (fellow), AIIT, TEP

Matthew Hutton MA, CTA (fellow), AIIT, TEP, author of Tottel’s Trusts and Estates Annual 2006-07, describes the taxation of trusts following Finance Act 2006.Trusts (or settlements) have for many hundreds of years been an established part of the English legal system. While their creation and maintenance might be dictated largely by non-fiscal issues, the tax advantages (or disadvantages) of particular types of trust should not be overlooked – and this is the subject of a new three-part series.

This first article in the series considers in broad terms the income tax and capital gains tax (CGT) treatment of different types of UK resident trust. Part 2 will deal with inheritance tax (IHT) and Part 3 will focus on planning opportunities and pitfalls, suggesting in which circumstances trusts of one type or another might be used.

Although the new regime introduced by Finance Act 2006 has generally sought to impose the single ‘relevant property’ IHT regime on all trusts created on or after 22 March 2006, there remains a transitional regime for trusts in being at that date – and for other reasons the distinctions between various types of trusts do remain significant – even though no new accumulation and maintenance settlements can be made after 21 March 2006. The articles will be limited to the three main types of trust found in practice, viz discretionary, accumulation and maintenance and interest in possession (or life interest) – and will be restricted to trusts made by and for UK resident and domiciled persons. Remember, however, that there are a variety of other types.

The consultation on modernisation

This series of articles is written in the light of (a) the current modernisation of the income tax and CGT treatment of UK resident trusts; and (b) the new IHT regime for trusts introduced without warning on 22 March 2006. 2004/05 saw an increase in the ‘rate applicable to trusts’ (RAT) from 34% to 40%, as well as the introduction of the special regime for vulnerable beneficiaries. In 2005/06 a special standard-rate band was introduced for discretionary and accumulation trusts, the first £500 of income (increased to £1,000 from 2006/07) of such a trust in any tax year not being taxed at more than 22%. Most recently, in 2006/07 FA 2006 confirms certain definitions for income tax and CGT, introduces an extended definition of ‘settlor-interested’ for CGT purposes and provides a special sub-fund regime for CGT.

New rules for residence for CGT from 2007/08 have been enacted by FA 2006 adopting the present income tax rule, but without the ability for certain UK resident trustees to elect in relation to a trust made by someone resident and domiciled outside the UK that they should be treated as non-UK resident. (The original proposal for an equivalent provision having been withdrawn as constituting unauthorised State Aid.)

There remains one outstanding issue, namely the ‘income streaming’ proposal that income distributed to a beneficiary from an accumulation or discretionary trust on or before the 31 December following the end of the tax year should not attract the RAT, but should be treated as if (subject to deduction of the dividend ordinary rate or lower or basic rates) it were the income of the beneficiary. Aligned to this, also deferred, is the suggestion for gradually phasing out existing tax pools over a period of time, whether three or more years. No mention was made of these issues at Budget 2006 and it is unknown whether they will proceed.

Income tax

Trustees in receipt of income are a taxpayer like any other. This means that, under self assessment, the trustees must duly return their income and pay the correct amount of tax by, generally, the 31 January following the end of the tax year. It is good practice when making a trust to notify its existence by sending the non-statutory form 41G Trusts to one of the three specialist trust districts within HMRC. This will generate the annual self assessment SA 900.

On making a payment of income to a beneficiary, the trustees must also complete a tax voucher (R185) showing the gross income, tax at the 10%, lower or basic rate or the RAT and the net sum to which the beneficiary is entitled. This voucher will then enable the beneficiary to complete his own self assessment.

Settlor-interested trusts

Where the settlor has an ‘interest in the settlement’, viz the trust property or any property derived from it could be applied for his benefit or for the benefit of his spouse, the entire trust income is treated as that of the settlor (ITTOIA 2005, s 624).
Under a further anti-avoidance rule, in ITTOIA 2005, s 629, a settlement for the benefit of the settlor’s minor children will or may have the income assessed on the parent settlor (subject to a de minimis limit of £100 per child per parent per annum for all such income). Where the settlement was made before 9 March 1999, the rule applies only to the extent that income is paid out. However, for settlements made on or after that date and for income from capital added on or after that date to existing settlements, s 629 applies whether the income is paid out or is retained by the trustees.

The settlor has a statutory right of indemnity to claim back from the trustees any tax which he has paid on income which he has not received. Significantly, FA 2006 provides that the trustees will be liable to the RAT on the income of a discretionary or accumulation settlor-interested trust. HMRC have said that the settlor will receive a credit for tax paid by the trustees.

Life interest trusts

Where the beneficiary is entitled to the income as it arises, he has an interest in possession or life interest. While the trustees may deduct proper income expenses, the income will otherwise be his. Note that there may be some trustees’ receipts which are capital as a matter of trust law but income for tax purposes (eg premiums received under leases granted for less than 50 years, under ITTOIA 2005, s 277); however, such receipts do not become income of the life tenant.

Although the life tenant may not physically receive the income until after the end of a tax year, it is his income for that tax year and it is the rates of tax in force for that year which determine both how much tax the trustees should withhold on account of lower rate or basic rate tax and the liability of the beneficiary to higher rate tax if any.

Discretionary or accumulation trusts

Here, the same income tax treatment applies where the trust is discretionary or accumulation in character. The first £1,000 (£500 for 2005/06) of income in any tax year cannot attract more than the standard 22% rate (subject to anti-fragmentation rules for settlements made by the same settlor). Above this limit, the trustees have to pay the RAT at such a rate as brings the total tax paid by them to 40% (or 32.5% for dividends). The mechanism for the RAT arises under ICTA 1988, s 686: note that there is quite a separate procedure under s 687 which arises where payments are made by trustees to the beneficiary.

Trustees may receive income falling into different categories:

 Dividend income from UK companies will carry a non-repayable tax credit of 10%. This is dividend income which in the hands of discretionary or accumulation trustees is subject to tax at the ‘dividend trust rate’ of 32.5%, of which 10% is met by the tax credit, leaving a further 22.5% of the gross to be paid by the trustees.

 Interest income received subject to deduction of the lower rate of 20%. Here out of gross income of £100 the trustees receive £80 and must pay to HMRC a further £20 to produce a total tax liability of 40%.

 Income received gross, eg rental income. Here the trustees must pay 40%.

Discretionary payments

A special charging regime operates under ICTA 1988, s 687 where trustees make payments of income in exercise of a discretion. By definition s 687 cannot apply to accumulations of income, which are generally added to capital net of the s 686 charge. That said, however, a trust deed may empower trustees to make payments out of accumulated income as if they were income of the current year. In that case s 687 will apply.

Liability of the beneficiary

The thinking behind s 687 is that, for any payment made to a discretionary beneficiary, it must be clear that tax of 40% (or 32.5% when dividend income) has been borne by the trustees and paid over to HMRC. Except to the extent that that tax relates to the 10% non-repayable credit on dividends, the beneficiary may then recover all or part of the tax.

The tax pool

The trustees may not have to pay 40% tax, because their liability can be covered by tax which they have already paid (known as the tax pool). At the beginning of each tax year a discretionary settlement will typically have a tax pool (except for example in the circumstance where it was set up since 6 April 1999 and has only ever had dividend income or where it simply pays out all its income each year). The change in dividend taxation from 6 April 1999 has made a significant difference in so far as the notional tax credit on dividends does not enter the tax pool, although the additional 22.5% making it up to the dividend trust rate does go into the pool.

Trusts for vulnerable persons

FA 2005 established a special regime, with effect from 2004/05, for trusts for vulnerable persons. These are defined as either a disabled person or a minor, at least one of whose parents has died. By election the normal rate applicable to trusts can be disapplied and the income and gains of the trust taxed as if they had risen directly to the beneficiary. Note, however, that an election does not disapply the s 687 mechanism. That is, the trustees must be able to show on making any payments of income to the beneficiary that that payment is franked by income which has borne 40% income tax in the hands of the trust. This is a curious anomaly.

Trust management expenses

An expense may be deducted from trust income if:

 it is under trust law properly chargeable against income, eg management expenses of a property within a property business; and

 it is actually paid out of income for the year.

HMRC published revised guidance on deductible trust expenses on 2 February 2006. The general rule, applying the 1985 House of Lords’ decision in Carver v Duncan, is that while a deduction against income may be given for expenses of a revenue nature or which are recurrent, this will not apply if the expenses are incurred for the benefit of the whole estate or are otherwise attributable to capital. Only in the case of certain accountancy and audit charges is apportionment allowed by HMRC. Otherwise, in a way which will represent a dramatic change from previous common practice, an expense will not be deductible. Most contentious is the treatment of trustee management fees which HMRC say are not apportionable in any circumstances except where they clearly relate wholly to income. A test case is anticipated on this latter point.

Life interest trusts

Subject to specific deductions in calculating taxable income, eg for trade or property purposes, trust management expenses are deducted from the life tenant’s net share of income which is then grossed up to produce the statutory taxable income.

Discretionary or accumulation trusts

Trust management expenses may be deducted from the income taxed at the RAT or the dividend trust rate. However, such expenses cannot be deducted in calculating the income taxed only at the 10% dividend rate, the 20% lower rate or the 22% basic rate.

Expenses are deducted in order (which is most useful to the beneficiary), viz:

 UK dividend or scrip dividends which carry a non-repayable 10% tax credit;

 Foreign dividends;

 20% savings income; and

 22% rate income, eg rents.

Capital gains tax

Actual and deemed disposals

CGT is payable on actual disposals, which include a gift. CGT is charged also on deemed disposals, eg where one or more beneficiaries becomes absolutely entitled to the property against the trustees (except on death of the life tenant treated as owning the property for IHT purposes).

Computing the gain

The gain has to be calculated. In simple terms the gain is the sale proceeds less the cost of acquisition (or 31 March 1982 value if later), with a deduction for professional and other incidental costs of acquisition and disposal. Indexation allowance was ‘frozen’ at April 1998. In the case of a gift, the market value of the date of the gift is taken. The same ‘market value’ rule (under TCGA 1992, s 17) applies where the trustees make a disposal, even by way of sale, to a ‘connected person’, eg the settlor or anyone related with him.

Various reliefs

Trustees benefit from certain reliefs, some of which depend upon a claim:

 Main residence relief (TCGA 1992, s 225): in parallel to the relief given to individuals, trustees making a gain on disposing of a house which has been used as the only or main residence of a beneficiary may have the gain wholly or partly relieved.

 Taper relief was introduced in 1998 (TCGA 1992, Sch A1). It is designed to relieve the impact of CGT according to the length of time the particular asset has been owned, with very significant favour being given to business assets.

 Roll-over relief (TCGA 1992, s 152) is a relief given to trustees who trade, whether by themselves or in partnership, in allowing a claim for deferral of a gain realised on the sale of one qualifying business asset into the acquisition cost of another.

 Enterprise investment scheme (TCGA 1992, Sch 5B para 17) allows trustees of certain settlements to claim to defer a gain realised on any asset by making an investment in a qualifying EIS company. Venture capital relief is not available to trustees.

 Hold-over relief (TCGA 1992, s 165 and s 260). The trustees may claim to defer CGT which accrues on a gain when they dispose of certain assets to a UK resident beneficiary, whether under s 165 for business assets or under s 260 where there is a chargeable transfer for IHT purposes. The in-built gain is charged to tax when the beneficiary comes to sell the asset.

Settlor-interested trusts

There is a similar rule for CGT to ITTOIA 2005, s 624 for income tax discussed above. The CGT rule is found in TCGA 1992, s 77, as extended by FA 2006. A trust will be settlor-interested not only if (subject to certain limited exceptions) the settlor or spouse can benefit, but also where (from 2006/07) the settlor’s minor unmarried children not in a civil partnership can benefit. Gains of a trust which are settlor-interested are treated as those of the settlor and not of the trustees. In certain circumstances this rule could be advantageous, if for example the effect is to assess the settlor to tax at 20% rather than 40% and to have the benefit of the settlor’s annual exemption of £8,800 for 2006/07 rather than say the trustees’ exemption of £4,400 (and see below) – or indeed if the settlor has allowable losses.

Losses

If the trustees realise a loss by making a disposal to a ‘connected person’ eg the settlor or a relative or a settlor, they cannot offset that loss generally against their gains (TCGA 1992, s 18(3)). The loss must be carried for forward for use only against a gain which arises from the trustees disposing of another asset to that same connected person.

Rate of tax

Trustees are assessed on their gains at 40%.

The annual exemption

The annual exemption, ie within which gains will be tax free, is £4,400 for most trusts for 2006/07. This is one half of the individual’s exemption.

The anti-fragmentation rule

An anti-avoidance rule operates in circumstances where the same settlor has made more than one ‘qualifying settlement’ since 6 June 1978. This is to prevent a person making a number of settlements, each benefiting from the £4,400 annual exemption (2006/07). If there is more than one qualifying settlement in a group, the annual exemption is divided between them, up to a maximum of five. That is, the annual exemption for a trust can never be less than £880 (£4,400 : 5 or £8,800 : 10).

‘Qualifying settlement’

The expression does not include charitable trusts, or trust death benefits of certain pension policies. The ‘certain pension policies’ extends to old style retirement annuity policies, but not to personal pension schemes. Otherwise, the expression will include almost every type of settlement, even settlements which do not realise a gain and indeed settler-interested trusts. This means that there could be a total of five qualifying settlements, only one of which is making a gain in the tax year, but it gets the benefit of an annual exemption of only £880, ie in 2006/07 £3,520 of annual exemption is wasted forfeiting £1,408 in tax potentially saved and now payable @ 40%.

The trust and estate tax return

The form for returning chargeable gains is supplementary page SA 905 (to be included within the main trust and estate return SA 900).

The only circumstances in which SA 905 need not be completed are:

 The assets disposed of say in 2005/06 realise net proceeds of £34,000 or less in total (ignoring exempt assets), and

 The total chargeable gains were less than, or equal to the annual exempt amount.

Form SA 905 is used:

 To claim allowable losses which may be deducted from future gains; or

 To make other claims or elections which require reference to, and completion of, other HMRC forms.


Matthew Hutton MA, CTA (fellow), AIIT, TEP
September 2006

More Information

The above article has been taken from Matthew Hutton’s Capital Tax Review, a quarterly update for professional advisers of private clients. For more information, visit http://www.taxationweb.co.uk/books/capital_tax_review.php.

About the Author

Matthew Hutton is a non-practising solicitor (admitted 1979), who has specialised in tax for over 25 years. Having run his own consultancy (latterly through Matthew Hutton Ltd) until 30th September 2000, he now devotes his professional time to writing and lecturing.

THE FIFTH ESTATE PLANNING CONFERENCE: CURRENT ISSUES 2006

London
Tuesday 31 October
The Law Society’s Hall

For further details, brochures and booking forms please contact Matthew Hutton: email – mhutton@paston.co.uk or telephone – 01508 528388 (Ref: TaxationWeb).