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Taxation Practitioner by Mark McLaughlin ATII TEP

An 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.Following last month's introduction to the basic structure of trusts and trust income, it is time to turn to some computational aspects of interest in possession trusts, before looking at other types of trust (NB all references are to ICTA 1988 unless otherwise stated.)

Interest in possession trusts

Trust management expenses are not allowable deductions in calculating the tax liability of a trust (non-discretionary or discretionary) at the 10 per cent, 20 per cent or 23 per cent rates, and effectively reduce the income available to the beneficiary. Where the trust deed specifies the payment of an annuity to a beneficiary prior to the distribution of the remaining income, it is paid under deduction of basic rate tax. The gross annuity is deducted from gross trust income, for purposes of determining the balance available for distribution.

The net income of the trust, after deduction of management expenses and annuities, is grossed-up at the rate of tax applicable to the income source. The order in which management expenses are set against income is therefore significant, particularly since the 10 per cent tax credit on dividend income is non-repayable from 6 April 1999, for both trusts and individuals. The rules for offsetting trust management expenses generally are set out in sections 686 and 689 A, B. The specified order is as follows:

1) against Schedule F income (such as UK dividends) and certain other income carrying a notional non-repayable tax credit (ss. 233(1A),(1B), 249(6) and 421(1)(a));

2) against foreign income dividends (s. 1A(3)(b));

3) against savings income (s. 1A), taxable at the lower rate or carrying a lower rate tax credit; and

4) against other income taxable at the basic rate.

The set-off order for trust management expenses therefore favours those categories of net income being retained for distribution that generate repayable tax credits, in preference to those giving rise to non-repayable tax credits (see Example 1).

Example 1 - pro-forma trust income statement 1999-2000

Tax £		Total £	Dividends £	Interest £	Sch A (net) £
X	Dividends (gross)	X	X
X	Interest (gross)	X		X
X	Rents	X			X
X		X
(x)	Less: Annuity	(x)			(x)
Y		X	X	X	X
	Less: Tax	(Y)
	Trust Expenses	(x)	(x)	(x)

Income available for distribution x Nil x x

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The trustees are required to issue beneficiaries with a tax certificate (form R185 (non-discretionary trust)) showing the beneficiary's share of income, which is grossed-up at tax rates attributable to the particular category of income. These income sources are separately identified on the R185 form, together with the relevant tax credits at the appropriate rate(s).

Trusts without an 'interest in possession'

The trust deed may confer powers on the trustees to pay income at their discretion, or to accumulate it. Unlike an interest in possession settlement, the beneficiaries have no absolute right to receive the trust income. Income which is accumulated or payable at the trustees' discretion (whether the trustees have power to accumulate or not) generally falls within the tax regime applicable to accumulation and discretionary trusts outlined below.

Accumulation and discretionary trusts

Such trusts are liable to tax under section 686 at 'the rate applicable to trusts' currently of 34 per cent, and (with effect from 1999-2000) 'the Schedule F trust rate' of 25 per cent in respect of UK dividends and certain other income falling within Schedule F.

As mentioned, trust management expenses are not deductible for purposes of computing the amount of income liable to tax at 10, 20 or 23 per cent. However, to the extent that those expenses are 'applied in defraying the expenses of the trustees in that year which are properly chargeable to income (or would be so chargeable but for any express provisions of the trust)', they may be deducted in arriving at the amount of income liable at the additional rate(s) in (a) above (s. 686 (2AA)). The order of set-off for trust management expenses is the same for non-interest in possession trusts as it is for those with an interest in possession (TM3260). Charges on income such as annuities to beneficiaries are included as a deduction for additional rate tax purposes.

Because the trust's tax liability is computed on the basis of gross income, those expenses paid out of trust income must also be grossed up for tax purposes, at the rate appropriate to the income from which they are treated as paid (see Example 2).

The charging of expenses against trust income is therefore potentially attractive from the trustees' viewpoint. Not surprisingly, case law has arisen on the issue of whether expenses are properly chargeable against income. In Carver v Duncan (Insp of Taxes); Bosanquet v Allen (Insp of Taxes) [1985] STC 356, the trustees incurred life assurance premiums out of trust income, pursuant to powers contained in the trust deeds. The House of Lords (hearing both cases simultaneously) held that the expenses were applications of income, not expenses chargeable to income under general law. Expenses connected with the trust fund as a whole are generally chargeable to capital, thereby precluding deductions, inter alia, for the cost of appointing new trustees and making or changing investments.

Example 2 - set-off of trustees' management expenses

	Total £	Dividends (10% tax) £	Interest (20% tax) £	Sch A (net) (23% tax) £
Trust income (gross)	X	X	X	X
	---	---	---	---
Trust Expenses: (a) Set-off order		1	2	3
(b) Grossing rate Additional rate of tax		100/90 15%	100/80 14%	100/77 11%

When the trustees make a discretionary payment of income to a beneficiary, the net distribution is grossed-up for tax, at a current rate of 34 per cent (ie 100/66). A payment of £66 is therefore equivalent to gross income of £100, with a £34 tax credit. The beneficiary will receive a form R185 evidencing the associated tax credit, and the gross distribution forms part of the beneficiary's income for the tax year of payment. The tax credit is available against the beneficiary's income tax liability, and may possibly be repayable in whole or part, subject to his or her personal tax position.

However, the trustees must have paid sufficient tax on trust income overall to cover the beneficiary's tax credit. Since there will invariably be a mismatch between trust income and distributions to the beneficiary for any given year, a cumulative record is required in order to compare the total tax paid on trust income with the total tax deducted from distributions to beneficiaries. This is generally referred to as the 'tax pool'. Whereas a surplus of tax credits on trust income can be carried forward to the following year(s), any shortfall of tax following an income distribution gives rise to an additional tax liability on the trustees, by virtue of section 687(2)(b).

Prior to 6 April 1999, the dividend income of accumulation and discretionary trusts was taxable at 'the rate applicable to trusts' (34 per cent in 1998-99). The introduction of the 'Schedule F trust rate' of 25 per cent from 6 April 1999 was designed to ensure that the trustees' s. 686 liability was broadly the same under both tax systems (see Example 3).

However, the tax credit on dividends paid from 6 April 1999 is reduced to 10 per cent and is non-payable, and following the changes introduced by F(No 2)A 1997 ss 32 and 34 and Para 15 Sch 4, the tax credit does not enter the trust's s 687 tax pool. No credit is therefore given for that tax within the pool, when comparing the tax paid by the trustees with the tax deducted from income distributions to the beneficiaries. This means that, all things being equal, where the trust's dividend income is distributed to the beneficiaries in full, there will be insufficient tax in the tax pool to cover the 34 per cent tax credit on those distributions. A further tax liability will therefore arise on the trustees under s. 687(2)(b).

Example 3 - net UK dividend income £500

	1998-99 £	1999-00 £
Dividend (net)	500.00	500.00
Tax credit 20% / 10%	125.00	55.55
Gross dividend	625.00	555.55
Tax at 34% / 25%	(212.50)	(138.88)
Net income	412.50	416.67
Tax paid by trustees	212.50	138.88
Less: Tax credit	(125.00)	(55.55)

Additional tax due (s. 686) £87.50 £83.33

----------------------

In 1998-99, tax at 34 per cent (£212.50) would enter the s. 687 tax pool. However, in 1999-2000, only the additional tax due under s. 686 (£83.33 in the above example) enters the tax pool. If the trustees subsequently distribute the £500 net dividend income, the tax credit available to the beneficiary amounts to £257.57 (ie £500 x 34/66). After deducting the tax of £83.33 entering the s. 687 tax pool, the trustees will be faced with a s. 687(2)(b) tax charge for 1999-00 of £174.24 (ie £257.57 less £83.33).

In order to avoid the additional tax liability under s. 687(2)(b), the trustees may only distribute 66 per cent of the £500 net dividend income, ie £330. The combined s. 686 and s. 687 liabilities account for the remaining 34 per cent, ie £170.

In the above example, the dividend received in 1998-99 could perhaps be distributed to beneficiaries after 5 April 1999. In those circumstances, the Revenue have confirmed that the tax pool restriction would not apply. Tax at 34 per cent would enter the s. 687 pool for matching against distributions to beneficiaries, despite the change in legislation from 1999-2000.

Practical points

The trustees are required to state on the self-assessment return whether they are liable to tax at the rate applicable to trusts. Until recently, the form 41G (Trust), which provides notification of a new trust, enquired whether the trustees may pay income at their discretion, have the power to accumulate, or whether the settlor has retained an interest. These questions have now been omitted from the 41G (Trust), and are included as part of the trustees' self-assessment.

Different R185 certificates require completion in respect of income distributions to beneficiaries, depending on whether the trust income is discretionary or non-discretionary (and a further form R185 deals with estate income).