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The taxation of trusts is complex. However, Malcolm Finney points out that trusts do offer an attractive vehicle which can be used for family tax planning purposes.

Background

Perhaps one of their main attractions (the Discretionary Trust in particular) is that future unforeseen changes, be they financial or not, can be taken into account at that time by the trustees. For example, a father may create a Discretionary Trust for his four children at a time when they are all minors; it may be that in the future one of the children becomes disabled and as a consequence the trustees can take this matter into account when deciding how the trust assets/income should be allocated amongst the beneficiaries.

Trusts Can Also Serve as Substitute Wills.

The tax treatment discussion below assumes that none of the various anti-avoidance provisions applies (e.g., the ‘settlor interested’ provisions).

Trustee Tax Liability

Trustees of a Discretionary Trust (DT) are subject to Income Tax on trust income at the “trust rate” of 50% (post 6 April 2010; previously 40%); dividend income, however, is subject to the “dividend trust rate” of 42.5% (post 6 April 2010; previously 32.5%).

Example 1

In the tax year 2010/11, a DT receives net rental income of £400 and net dividend income of £90.

The trustees’ liability is 50% on £400 plus 42.5% on £100 (i.e., net dividend of £90 plus tax credit of 1/9th) less the tax credit of £10, i.e., £200 plus £32.50. (To keep the examples simple, we have ignored the special rules for trust expenses and the first £1,000 being taxable at the special "standard rate").

Beneficiaries’ Tax Liability

The beneficiaries of the DT are not entitled to any trust income/capital unless the trustees exercise their discretion in their (i.e., the beneficiaries’) favour. Thus, until this discretion is exercised no Income Tax charge arises on the beneficiaries.

As and when income is distributed to one or more beneficiaries, the amount distributed is treated as if it were made after the deduction of a sum representing Income Tax at the trust rate on the grossed up amount.

Example 2

In the tax year 2010/11, a DT pays out £100 to a beneficiary. The beneficiary is treated as receiving [£100/0.5] i.e., £200 of gross income, less tax of 50% or £100.

It is to be appreciated that the “grossed up” payment to the beneficiary of a discretionary trust is at the trust rate even if the income distributed effectively derives from dividend income which the trustees have received. This is because the source of the income for the beneficiary is the trust and not the underlying income of the trust itself.

Optimal Trust Distribution

From the tax perspective, optimal distribution requires distribution to non-tax-paying beneficiaries in the first instance; then to "basic rate" (20%) beneficiaries; then to "higher rate" (40%) beneficiaries and finally to "additional rate" (50%) beneficiaries. This leads to a refund of Income Tax paid by the trustees for all the above categories of beneficiary other than the additional rate beneficiary.

Example 3

A DT receives rental income of £100 taxed at 50% i.e., £50 net income left.

Net income of £50 distributed to basic rate (20%) taxpayer beneficiary. Beneficiary deemed to have received £100 gross, now taxable at only 20% i.e., £20, thus, £30 of tax reclaimable by the beneficiary.

The trustees may choose to accumulate income of the trust, rather than paying any income to the beneficiaries.

UK Equity Investments

DTs, however, should not be used to hold UK equities as so-called “tax leakage” occurs, i.e., the beneficiary is worse off. The leakage occurs due to the mismatch between the the requirement to gross-up net payments to beneficiaries at the “trust rate”, (i.e., 50% for the tax year 2010/11), and to account for the tax on the distribution at this rate but having only paid tax on the dividend income at the lower rate of 42.5% (for the tax year 2010/11); in effect there is insufficient tax paid by the trust to “frank” the distributions to the beneficiaries.

This therefore requires that the trustees only make distributions of such amount which enables them to discharge their tax liability on the distributions.

Example 4

Option 1: Dividend Routed via Discretionary Trust.

A DT receives dividend income of £90 i.e., £100 gross.

Income Tax liability 42.5% of £100 less notional tax credit of £10 i.e., net liability of £32.50 leaving net cash of £57.50 (i.e., £90 less £32.50).

If the trustees pay out the whole of the £57.50, then the beneficiary would be deemed to have received £115, with a 50% tax credit of £57.50. (Remember that beneficiaries' income from a discretionary trust is always at the 50% rate, regardless of the nature of the income to the trust itself). However, the trustees have only paid tax of £32.50 and thus there is a deficit in tax due, of £57.50 less £32.50 - i.e., £25.

In order to ensure that this deficit does not arise, the trustees must make a distribution of only £45. This requires the trustees to account for tax of £45; given that £32.50 has already been paid the shortfall is £12.50 which the trustees are able to pay as they still have £57.50 less £45 - i.e., £12.50.

So the trustees are obliged to make sure that they pay over enough tax to cover the credit in the hands of the beneficiary. Which of course eats into the amount which can actually be paid over to the beneficiary.

Distribution to a beneficiary of £45 represents £90 gross.

Income Tax liability (assume 50% taxpayer) £45 less £45 tax credit, i.e., nil.

Net cash receipt £45.

Option 2: Dividend Received Directly by Individual

Net dividend received £90 i.e., £100 gross.

Income Tax liability (assume "additional rate" taxpayer) at 42.5% i.e., £42.50 less tax credit of £10 producing net tax liability of £32.50.

Net cash receipt £57.50.

So the beneficiary has effectively lost out by the extra £12.50 which the trustees have to pay in tax - the trust route incurs tax leakage of £12.50, for an individual paying tax at the 50% additional rate.

Practical Advice

It is generally not tax-efficient to invest in UK equities via Discretionary Trusts.