Capital Tax Review by Matthew Hutton MA, CTA (fellow), AIIT, TEP
Matthew Hutton MA, CTA (fellow), AIIT, TEP author of Capital Tax Review, considers the mechanics of tax compliance for trustees and settlors.Context
With regard to the FA 2006 change to TA 1988 s 686(2)(b), the effect is that, whereas before 2006/07 the trustees’ liability to the rate applicable to trusts would not apply to income of a settlor-interested trust, it now does. The question therefore is how things work out in practice.The issue was put by the CIOT Capital Taxes Sub-Committee (to which I belong) to HMRC whose reply has now been received. Incidentally that letter also raised:
• a technical issue relating to own share purchases following on from the new TA 1988 s 686A; and
• whether the outstanding trust modernisation issues on income streaming/tax pools and deceased estates are still in contemplation.
The HMRC response on those other two issues is still awaited.
HMRC’s response
ITTOIA 2005, s 624(1) treats income of a settlor-interested trust as the ‘income of the settlor and of the settlor alone’.ITTOIA 2005, s 622 states that the person liable to tax is the settlor.
ITTOIA 2005, s 646(8) says that ‘nothing in section 624 .... is to be read as excluding a charge to tax on the trustees as persons by whom any income is received’.
The current code, whereby the income is treated as that of the settlor for all tax purposes dates back to the changes made in 1995. The subsections mentioned above have been part of the current code since then – s 624(1) previously appeared as TA 1988, s 660A(1) and s 646(8) as TA 1988, s 660D(3). Before the changes made in 1995 the majority of the tax charges on the settlor under TA 1988 Part XV were for the purposes of higher rate tax only (or surtax if one goes back earlier than 1972).
So we have, since 1995, had an overlapping charge on both the trustees and on the settlor. Tax paid by settlor-interested trusts does not enter the tax pool and is not available to beneficiaries. Section 646 sets out the relationship between settlor and trustees and, recognising the fact that the settlor is being taxed on income he or she may never receive, gives the settlor power to require the trustees to reimburse any tax liability suffered by the settlor under s 624.
Looking at the overall picture, we have a regime which treats the income arising under a settlement as that of the settlor and no other person, but also expects the trustees to reimburse the settlor for any additional tax suffered as a result of their income being deemed to belong to the settlor. In the absence of s 646(8) no tax would be payable by the trustees, but they would be required to make good the tax paid by the settlor on the income deemed to the settlor's under s 624.
It is relevant that s 646(8) provides for a charge on the trustees as recipients [in fact, it provides that ’Nothing in sections 624 to 632 is to be read as excluding a charge to tax on the trustees as persons by whom any income is received’]. In the context of the underlying purpose of the settlements legislation .(which is to ensure that tax is paid at the settlor's marginal rate - not to tax income twice), the tax paid by trustees of settlor-interested trusts is treated as tax paid on behalf of the settlor. Take the simple example of the trustees of a settlor-interested trust receiving property income of £10,000.
In the year ended 5 April 2006, assuming a higher rate settlor and ignoring the starting rate, the situation is as follows:
Trustees 10,000 @ 22% - £2,200
Settlor 10,000 @ 40% - £4,000
If HMRC did not treat the tax paid by the trustees as paid on behalf of the settlor HMRC would collect £6,200 tax on £10,000 of income. HMRC do not do that - the SA return gives credit for tax paid by the trustees at the appropriate rate. On the 2005/06 return settlors are asked to use boxes 7.4 to 7.6 for basic rate tax items and boxes 7.10 to 7.12 for dividend rate items.
What has changed?
FA 2006 amended s 686 so that settlor-interested trusts (provided they are discretionary or accumulation trusts) are no longer taken out of the charge at the special trust rates (40% and 32.5%). So, using the same example as above, the situation in 2006/07 is as follows:Trustees 10,000 @ 40% - £4,000
Settlor 10,000 @ 40% - £4,000
As before, HMRC will still treat the tax paid by the trustees as paid on behalf of the settlor and HMRC will not collect £8,000 on £10,000 of income. Guidance will be provided in the 2006/07 SA return and credit will be given for tax paid by the trustees by using the relevant boxes on the trust pages. The credit will be given at the appropriate rates and (leaving aside the 10% non-repayable credit on dividend income) the tax will be available for repayment if the settlor is not a higher rate taxpayer.
Compliance mechanism
Concern has been expressed about the lack of a formal mechanism and HMRC have also been asked how, in the absence of forms R185, the settlor is supposed to know what to put on the return. Forms R185 are used for payments to beneficiaries and are not appropriate for the deemed income of the settlor. HMRC’s assumption is that settlors are given the necessary information by the trustees in an informal manner. This is not a new issue - without the trustees passing this information to settlors it is difficult to see how settlors have been able to complete their SA returns over the last 11 years.(Letter from CAR Charity, Assets & Residence Trusts Head Office to CIOT 7.9.06)
Matthew Hutton MA, CTA (fellow), AIIT, TEP
October 2006
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