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Capital Tax Review by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP

Matthew Hutton MA, CTA (fellow), AIIT, TEP author of Capital Tax Review, comments on the amended discussion paper issued by HM Revenue & Customs in June 2005 on the treatment of trust management expenses.

Context

HM Revenue & Customs (HMRC) issued in September 2004 what was called an ‘explanatory note’ on the subject, of which some fairly trenchant criticism was made by the Chartered Institute of Taxation (CIOT), among other bodies. Having been promised a response to this in Budget 2005, a revised version of the paper was issued on 16 June 2005.

At first glance much of the revised paper is identical to the original, although we have been told that a further note on trustee remuneration (which generally HMRC say is not allowable for income tax purposes!) is promised. In cases where the CIOT appealed to decided cases to challenge the HMRC interpretation, the text just seems to reappear - restating the principle merely, without reference to the cases.

Certainly, the specific examples given in the final section 9 show that HMRC’s interpretation generally remains more rather than less restrictive. What follows summarises a few points made in the revised paper (on which further representations are being made). Presumably HMRC are expecting that tax returns for 2004/05 and subsequent years will reflect the new guidance.

General points

The basic, and correct, distinction is made between distributions of income and payment of expenses. Distributions are not expenses and so can never be allowable Trust Management Expenses (TMEs).

Incurred as they are in the capacity of trustee, TMEs are not like other expenses for tax purposes. Notions of ‘capital’ and ‘income’ are those that apply to trust law and not to more general tax law purposes.

TMEs in trust law

Section 2.5 of the revised paper says ‘The approach of Judges in decided cases is that if an expense is incurred solely for the benefit of, or in the course of the husbanding of, the income fund held by trustees then it should be paid out of income. Otherwise it should be paid out of capital.’ Husbanding ‘the income fund’ means managing the trust assets in a manner calculated to procure, maintain or improve a satisfactory income pool and/or flow. Very few categories of expenses can be said to be incurred solely for this purpose.

Comment: the above test, which prevails through the whole of the paper, is too narrow.

Accumulation/discretionary trusts

Section 3.6 states that trustees’ remuneration is not allowable because it is not an ‘expense of the trustees’: TA 1988 s 686(2AA) limits allowable expenses to such expenses.

Section 4.7 states that income ‘applied in defraying the expenses’ of the trustees as referred to in statute, means that the amounts must actually be paid and it is not enough that they are incurred. In other words accruals of expenses are not allowed for tax, according to HMRC.

Interest in possession trusts

Taken out of the beneficiary’s income entitlement and therefore his tax liability are:

• charges properly met by the trustees out of income, eg annuities;

• income which the deed directs needs to be applied for specific purposes, e.g. the redemption of a lease or mortgage; and

• trust management expenses properly chargeable to income.

As the beneficiary is taxable on income as it arises, it follows that TMEs should be allowed on an ‘incurred’ basis rather than when paid (5.12).

Subject to taking out of account for tax purposes items mentioned above, the beneficiary is entitled to the untaxed amount of the income net of income expenses including TMEs. Therefore, it is a net amount which is grossed up at the appropriate tax rates to arrive at the amount included in the beneficiaries’ income for income tax purposes. As stated at 6.3, the income tax paid by the trustees on that part of the income used to defray the TMEs and other items excluded from the beneficiary’s entitlement is not part of his entitlement, because the income out of which the tax is paid is not part of that entitlement. But the rest of the tax paid by the trustees represents income to which he is entitled.

Example at 6.3

An IIP trust receives income in 2003-2004: rental income £1,000 and bank interest £800 (lower rate tax of £200 has been deducted at source). Trustee pays TMEs properly chargeable to income of £250.

TRUSTEE’S POSITION

	Rent	Interest
Gross income	1,000	1,000
Tax due	220	200
Net income	780	800

The trustee receives credit for the tax deducted at source from the bank interest (£200) so has to pay £220 tax. TMEs do not affect the trustee's position.

BENEFICIARY’S POSITION

	Rent	Interest
Net income (as above)	780	800
Minus TMEs (set primarily against lower rate income)	--	(250)
	780	550
grossed up (@ 22%)	1,000 (@ 20%)	687.50

grossed up (@ 22%) 1,000 (@ 20%) 687.50

In the example above the entries on the form R185 (Trust Income) given by the trustees to the beneficiary would be:

Net amount		Tax credit		Tax amount
7.4	780	7.5	220	7.6	1,000
7.7	550	7.8	137.50	7.9	687.50

The beneficiary uses the information on form R185 (Trust Income) to make his or her tax return or to claim repayment. The beneficiary is taxable on the gross amounts at boxes 7.6 and 7.9 at his or her marginal rate, and is given credit for the amounts at 7.5 and 7.8.

Settlor-interested trusts

No trust management expenses are allowed over and above the normal deductions for each source of income. So the settlor is taxed on the gross taxed income. Under TA 1988 s 660A the settlor is also taxable on the trust management expenses (8.1 and 8.2).

Specific items

The cost of having trust accounts prepared is allowable insofar as relating to accounting for the trust income. Similarly, the cost of having trust accounts audited and the cost of preparing trust tax returns.

Tax advice is allowable only if related directly to the preparation of income tax returns.

The allowability of bank charges and interest depends on what those charges secure and the actual use of the funds advanced (which must be questionable). In many cases therefore HMRC would say that they are not allowable.

Other non-allowable items according to HMRC include:

• depreciation;

• costs of distributing income;

• insurance premiums for trust assets (subject to specific exceptions);

• interest (except where on a loan to purchase an income-producing asset or some bank interest – see above);

• interest on unpaid or overdue tax unless where inheritance tax or under TMA 1970 s86;

• personal expenses of beneficiaries;

• property costs (except where the property is properly held for the occupation of a beneficiary);

• administration costs; and

• travel and subsistence costs, generally.

(Trust Management Expenses Discussion Paper June 2005: Trust Management Expenses – Explanatory Note)

Comment

It is understandable that HMRC should be unhappy at what are seen to be extravagant claims to expenses in, especially, accumulation and discretionary trusts in the past. However, the hardline approach adopted in this revised explanatory note seems quite ‘over the top’, both in applying established case authority and in over-riding previous HMRC practice. Further strong criticism can be expected.

August 2005

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

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.

Matthew Hutton’s Autumn Series of Estate Planning Conferences resume on 15 September 2005 in Stratford-upon-Avon. The dates and venues are listed below.

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