Techzone

The Government’s package of measures to help fund social care reform may have a knock on effect for trustees. With the rate of tax on dividend income set to increase by 1.25%, it means  trustees may have important decisions to make on how they deal with trust income and how they invest trust capital.

The additional tax was introduced in conjunction with an equivalent rise to National Insurance so that everyone, regardless of their employment status, was subject to the levy. But the dividend tax rise applies across the board and not just to business owners who pay themselves in dividends.

The trustees of discretionary trusts will see the dividend trust rate increase from 38.1% to 39.35% from April 2022. But the impact of the change may only be felt where the trustees are accumulating rather than distributing the income they receive. So what are the options for trustees?

Paying income to beneficiaries

If trustees receive dividends from investments and are in the habit of paying these out to beneficiaries in full, both trustees and beneficiaries should not really notice any difference following the rate rise.

This is because any income paid to beneficiaries will take form of ‘trust income’. It’s no longer treated as dividend income.

This has two main consequences.

Firstly, when trustees pay out any income to beneficiaries, they must account for tax at 45%. The increase in the dividend rate to 39.35% won’t change this.

So if trustees receive £1,000 of gross dividend and wish to pay this out in full to a beneficiary, the trustees must collect and pay £450 to HMRC. The beneficiary will actually receive ‘trust income’ of £550* with a credit of £450* for the tax deducted. So a beneficiary paying tax at a lower rate than 45% will be able to reclaim some or all of the tax paid. This is doesn’t change from April 2022.    

Secondly, it also means the beneficiaries will miss out on the £2,000 annual dividend allowance. The allowance is not available to trustees and when income is distributed, it loses its source nature and becomes trust income, which means the beneficiaries are unable to claim the allowance too.   

*Assumes that all dividend taxed at trust rate and not the standard rate, and that there is no tax pool available.

The interest in possession solution

Typically a discretionary trust will allow the trustees to appoint the income and capital of the trust as they see fit. If they make an absolute appointment of capital to a beneficiary, this means the beneficiary will be able make use of their own allowances on any future income.

The trustees may not, however, feel it’s appropriate to appoint both income and capital to a beneficiary just to secure the dividend allowance. However, there is an alternative which ensures they retain control and yet still allow the beneficiary to benefit from their dividend allowance (and also any unused personal allowance).

If a beneficiary is not using their dividend allowance, they could appoint just the income of the trust to a beneficiary and create an interest in possession (IIP). This allows the income to be mandated to the beneficiary and they could then use their allowances and not pay any tax on the first £2,000 of dividends received. The IIP doesn't need to be permanent, and it doesn’t have to apply to the whole trust fund - but legal advice must be sought if the trustees wish to take this route.

Creating an IIP won’t make any difference to non-taxpaying beneficiaries. But on a gross dividend of £1,000, a basic rate taxpayer would be £200 better off if they could use their dividend allowance, with the tax savings rising to £400 and £450 for higher and additional rate beneficiaries.

Clearly, adopting this strategy means that beneficiaries will be no worse off if an IIP is created, and in most cases better off. And, of course, an IIP can be given to more than one beneficiary. Each IIP beneficiary could use their own dividend allowance against their share of the mandated dividend income. This could be a useful strategy for trusts receiving large amounts of dividend income that they wish to distribute, as it means there may be multiple dividend allowances to set against the trust income.

But it's important to ensure that the trust’s overall objectives continue to be met before any changes are made to the terms of the trust. Any attempts to reduce tax shouldn’t compromise the trust’s aims.

Accumulating income within the trust 

If the trustees plan to accumulate dividends, there will be an additional drag on returns. Remember that trusts are not entitled to a dividend allowance, so they’ll  pay an extra 1.25% from next year on dividends received whether they fall in the standard rate (8.75%) or the trust rate (39.35%).

So for every £1,000 of gross dividend received and taxable at the trust rate, the amount accumulated will drop from £619 to £606.50 from April. Although this may not seem huge, an extra ‘charge’ of 1.25% on larger portfolios could still be enough to modify trustee behaviour.

The bond alternative 

One solution might be to hold the investments within a bond wrapper. Bonds are non-income producing with income and gains rolled up within the fund. This significantly reduces the administrative burden on the trustees. Investments can be switched/rebalanced within the wrapper without the need to complete tax returns. 

Paying an income to beneficiaries

Of course bonds don't produce a ‘true’ income in the way that deposits, fixed interest and equities do. But if the trustees of a discretionary trust wish to pay a regular ‘income’ to a beneficiary, this could perhaps be mirrored by making withdrawals within the 5% tax deferred allowance.

This would avoid any immediate income tax charge, but it should be remembered that such payments will be regarded as distributions of capital and possibly subject to IHT exit charges. They would also be added back in to the value of the trust when assessing the effective IHT rate for the 10 yearly periodic charge. This is not the case on either count when true income is distributed. 

Paying capital to beneficiaries

If the trustees strategy is to grow the trust fund and accumulate income, when they wish to make a distribution of capital this can be achieved by the assignment of segments to a beneficiary so that when they’re cashed-in, any gains would be assessed on the individual. This is especially appealing if the beneficiary is likely to be able to take gains from an offshore bond while they’re a non-taxpayer - for example, to pay university fees as investment returns would have suffered none of the ‘tax drag’ had they held direct equities.

It should be noted that while the assignment is not subject income tax, it could be subject to an IHT exit charge. This will depend on the value of the trust at outset or at the last 10 yearly anniversary.

Summary

Trustees have a duty of care to keep the investments they hold under regular review. The changes to dividend taxation provide further reason to ensure that the current investments continue to meet both the aims of the trust and that tax is not being paid unnecessarily.