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Matthew Hutton MA, CTA (fellow), AIIT, TEP, author and presenter of Monthly Tax Review (MTR), highlights a potentially unpleasant tax trap for trust settlors, and its application in relation to trust dividends. 

Matthew Hutton

Context

 A potentially nasty anti-avoidance provision deriving from TA 1988, ss 677-678 is to be found in ITTOIA 2005, ss 633-643.  In broad terms, if the trustees of a discretionary or accumulation trust pay a ‘capital sum’ to the settlor or his spouse and there is undistributed income in the structure, whether in or up to that year or in any of the ten succeeding years, the settlor is assessed to higher rate tax on that undistributed income up to the amount of the capital payment.  We are of course envisaging a trust which is non-settlor interested, as otherwise the income would already have been assessed on the settlor.

The problem is the definition of ‘capital sum’ in ITTOIA 2005, s 634, as meaning:

(a) any sum paid by way of loan or repayment of a loan, and

(b)  any other sum which (i) is paid otherwise than as income, and (ii) is not paid for full consideration in money or money's worth.

So if the settlor makes a loan to the trustees (whether on preferential terms or on fully commercial terms, it matters not), repayment of that loan may trigger the provisions.

Where the rule might apply: sales by settlor to trustees at an undervalue

If employing such an arrangement so as to avoid triggering a positive charge to IHT on settling assets worth more than the nil-rate band, the need to avoid these provisions would suggest an interest in possession structure.

As has been pointed out to me, however, this is not necessarily the case, in view of ITTOIA 2005, s 640.  This provision works as follows:

(1) Gross up any capital sum treated as income of the settlor by reference to the rate applicable to trusts for that year.
 
(2) Set off against the tax charged on any deemed income of the settlor the ‘deductible amount’.

(3) The deductible amount is equal to the least of:

(a) tax at the rate applicable to trusts on the amount treated as the settlor’s income;

(b) so much of the amount of tax at that rate as is equal to the tax charged; and

(c) the amount of tax paid by the trustees on the grossed-up amount of so much of the income available up to the end of the year in relation to the capital sum, as is taken into account under s633 in relation to that sum in that year.

(4) For purposes of s 640(3)(c), reductions are to be made in an earlier before a later tax year.

(5) For purposes of s 640(3)(c) the grossed-up amount is a reference to the ‘appropriate rate’ for each part of the sum, which is given by s 640(6)(b) as 34% for tax years up to and including 2003/04 and 40% for 2004/05 and subsequent years.  The tax paid by the trustees on that grossed-up amount is the difference between the grossed-up amount and the sum in question.

(Point put to me by Jane Penny of Freeman & Co)

Application: an example

Assume that in 2007/08 the trustees repay  to the settlor a loan of £100,000 which he had made to them five years earlier.  This is grossed up at 40% to £166,667.  Assume that within the settlement there is £50,000 of undistributed income, itself grossed up to £83,333.  Applying s 640(3): para (a) produces £33,000 and so does apparently (b).  Para (c) is also going to be £33,000 – except apparently in relation to dividend income.

Suppose the whole of the income of the trust is dividends.  Presumably the 10% irrecoverable tax credit can be said to be ‘tax paid by the trustees’.  But they have a further liability of just 22.5% producing a total of 32.5%.  And grossing up £50,000 at this rate produces just £74,074, tax of £24,074.  So should not the settlor have to pay a further £9,259? 

HMRC have in correspondence stated that even with dividend income there is a credit at a 40% grossing up, though this does not appear to be substantiated by the legislation.

The upshot?

It does seem that, subject to the doubt about dividend income, the ITTOIA 2005 s 633-643 fear  is a non-point.  Of course, by using a life interest structure one does avoid the hassle of the trustees having to pay tax at the ‘special rate’ and, with distributions to beneficiaries, going through the rigmarole of forms R185 and possible reclaims of tax. 

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