Taxation Practitioner by Mark McLaughlin ATII TEPAn introduction to UK trusts. What is a 'trust' and 'settlement', and what are the advantages and pitfalls? The income tax treatment of the most commonly-encountered types of UK trust are explained.
(Trusts and Income Tax)
The very mention of the words 'trust' or 'settlement' seems to strike fear and apprehension into the hearts of some practitioners, and can cause students to suffer mental blocks or panic attacks! However, by providing an introduction to UK trusts and explaining their income tax treatment, it is hoped to demonstrate that the general principles of trust taxation, whilst undoubtedly challenging, are perhaps less intimidating than often perceived. Trust me! (all references are to TA 1988 unless otherwise stated).
What is a 'trust' and 'settlement'?
The words 'trust' and 'settlement' are often mentioned in the same context, implying that they share the same meaning. In fact, a settlement is very widely defined, and 'includes any disposition, trust, covenant, agreement, arrangement or transfer of assets' (s. 660G(1)). Generally speaking, a trust is created and structured more formally, usually by a written document, either during an individual's lifetime (a trust 'deed' or 'instrument'), or perhaps to commence upon death (a 'will trust').
A trust has been defined as 'an equitable obligation, binding a person (who is called a trustee) to deal with property (which is called the trust property), for the benefit of persons (who are called the beneficiaries) of whom he himself may be one, and any one of whom may enforce the obligation' (Underhill's Law of Trusts and Trustees, 14th Edition).
What are the advantages?
A trust or settlement is an alternative form of gift to an outright disposition between individuals. By acting as a trustee, the settlor may retain a degree of control over the trust property, whilst giving away a right to the underlying income.
A discretionary trust or settlement allows flexibility in the choice of beneficiaries and the timing of income or capital payments by the trustees. The beneficiary's entitlement can be made subject to particular events, such as reaching a specified age or upon marriage.
Aside from lifetime and estate planning for inheritance tax and capital gains tax purposes (which subjects are outside the scope of this article), a trust or settlement can be a tax-efficient means of giving away income. Trusts of a discretionary nature attract tax at a rate of 34 per cent on non-dividend income (and capital gains), compared with a maximum rate of 40 per cent for individuals. A discretionary distribution of income to an individual beneficiary is grossed-up at 34 per cent and is potentially repayable, in whole or in part, to the extent that personal allowances are available to offset against it, and the degree to which the beneficiary is taxable at a lower marginal rate. On the other hand, an outright gift between individuals may already have suffered tax at up to 40 per cent, which cannot be reclaimed.
... and the pitfalls?
The scope for income tax planning is restricted by anti-avoidance legislation regarding settlements, which is contained in Part XV. The following main provisions effectively treat income derived from trust property as the settlor's for income tax purposes:
Settlor-interested settlements (s 660A)Income arising under settlements in which the settlor or spouse retains an interest is caught by the legislation. It is therefore important to ensure that the settlement deed excludes the settlor and his/her spouse from any benefit or potential benefit, however remote.
Settlements for the settlor's children (s 660B)General-income arising under a settlement during the life of the settlor which is applied to or for the benefit of an unmarried minor child of the settlor is similarly caught, to the extent that the income exceeds £100 for a particular child.
Recent changes-prior to amendments in Finance Act 1999, it was considered that s. 660B did not apply where a parent created a bare trust (see below) under which the unmarried minor child held an absolute vested interest in the income and capital, where the trustees accumulated the income until the child attained 18 or married under that age. The income was not paid to or for the benefit of the child but was treated as the child's income, and not the settlor's, under s. 660B. However, for settlements made or property added to existing settlements from 9 March 1999, this income is treated as the settlor's, subject to the overall £100 limit.
A further measure affects settlement income that has been accumulated and treated as income of the child, where it is subsequently paid or applied for his or her benefit whilst still unmarried and a minor. Previously, this income may have been covered by the minor's personal allowances, and could therefore be distributed tax-free to the minor at a later stage. Section 660B, which previously prevented an income tax charge on the parent settlor, has been amended to treat this type of income as the settlor's in relation to any payments or applications from 9 March 1999, subject to the normal £100 threshold.
Capital sums paid to settlor (s 677)Any capital sum (such as a loan) paid directly or indirectly by the trustees to the settlor or spouse is treated as the settlor's income for the year to the extent that it can be matched with undistributed settlement income, within certain defined limits.
A settlement may be created inadvertently, in respect of an arrangement that contains an "element of bounty", a test applied in Bulmer v CIR ( 44 TC 1) and approved in IRC v Plummer ( STC 793). In the latter case, the taxpayer agreed to make five annual payments of £500 each to a charity, in consideration of the sum of £2,480. The House of Lords determined that the arrangement was a bona fide commercial transaction. In Lord Wilberforce's view, an arrangement falls within the definition of "settlement" where the taxpayer gives away income or assets; a disposition in which there is no "element of bounty" therefore falls outside that definition.
More recently, in Young v Pearce; Young v Scrutton ( STC 743), a reorganisation of share capital resulting in an allotment of preference shares to the taxpayers' spouses was held to constitute a disposition, which was wholly or substantially a right to income. The "arrangement" was therefore a settlement, and the preference dividends fell to be treated as income of the taxpayers.
Income Tax and UK residence
The remainder of this article concentrates on income tax for trusts, as opposed to unintentional settlements or the above anti-avoidance provisions. Liability to UK tax depends on residence status and the particular sources of trust income. There are separate and distinct rules for determining the residence status of trustees for income tax and capital gains tax purposes, which make it possible for trustees to be liable to one tax but not the other.
Residence of trustees and settlorThe income tax legislation governing the residence of trustees is contained in FA 1989 s. 110. In the case of mixed (UK and non-UK) resident trustees, their liability to income tax depends upon the domicile and residence status of the settlor. The trustees are jointly treated as UK resident if the settlor was resident, ordinarily resident or domiciled in the UK when funds were provided to the settlement (or at the time of the settlor's death, in relation to testamentary dispositions). Alternatively, the trustees are jointly regarded as non-UK resident if the settlor was neither resident, ordinarily resident or domiciled in the UK at any 'relevant time' (FA 1989 ss. (2), (3)).
Residence of beneficiariesIf the trustees are treated as UK resident for income tax purposes, strictly speaking they are liable in respect of both UK and overseas income. However, exemption may be in point for that part of the income to which a beneficiary who is non-resident, not ordinarily resident or not domiciled in the UK is entitled, provided that the income would have been exempt if arising directly to that beneficiary. In Williams v Singer ( 7 TC 387), assessments on UK-resident trustees in respect of foreign company dividends paid direct to non-resident beneficiaries were discharged. Based upon the subsequent judgement in Archer-Shee v Baker ( 11 TC 749), in appropriate situations it would also seem that the UK-resident status of trustees may be disregarded where the income is not paid directly to a non-resident beneficiary.
Trusts with an 'interest in possession'
There is no definition of 'interest in possession' on the current statute. However, in a press release dated 12 February 1976, the Revenue stated that such an interest in settled property exists 'where the person having the interest has the immediate entitlement ...to any income produced by that property as the income arises'. In Pearson and others v IRC ( STC 318), an interest in possession was more succinctly defined as 'a present right of present enjoyment'.
Bare trustA bare trustee holds the trust property as its legal owner. However, the beneficiary is absolutely entitled to the property, and to any income or gains arising. The beneficiary is therefore taxable on the trust income, notwithstanding that the trustees may retain that income (for example, in the case of a bare trust for a minor, until the age of 18). In practical terms, self-assessment returns are not necessarily required by bare trustees (see TM3019), although the Revenue's guidance notes for trust and estate returns indicate that trustees may complete the return and account for any lower or basic rate tax on income received gross, if this is acceptable to the beneficiaries. In any event, beneficiaries are required to enter all trust income on their own tax return or repayment claim form (although see above regarding s. 660B, and the Finance Act 1999 amendments in relation to parental bare trusts for unmarried minors).
Interest in possession trustThe trustees of an interest in possession trust hold the trust property, whilst the beneficiary has a right to enjoy that property and any income arising for a specified period of time, possibly for life. The trustees are liable to income tax in a representative capacity where a beneficiary is absolutely entitled to the trust income, generally in accordance with the nature of that income. For example, the rate of tax on savings income is 20 per cent; property income (net of allowable expenses) is taxable at 23 per cent; and a 10 per cent rate now applies to UK dividends.
A trustee is not an 'individual' within s. 256, and is therefore not entitled to personal reliefs or allowances (although a trustee is a 'person' for purposes of claiming loss relief, error or mistake relief, relief for capital expenditure, and so on (see TM3301)).
Next month we will look at some computational aspects of interest in possession trusts, before moving on to consider other types of trust.