Techzone

The Government's recent 'tax day' may not have been the huge tax event many advisers were expecting. A range of consultations and measures were released by the Treasury on 23 March, but they did not include reforms to CGT, IHT and pension tax relief at this time.

However, it was confirmed that there would not be wholescale changes to the taxation of trusts following an earlier consultation. It was felt that there was insufficient appetite for a comprehensive reform of trusts at this time. However, they have stated that they will keep issues raised under review to ensure that they continue to meet the Governments three key trust taxation principles;

1. Transparency - trusts should not be used to hide the beneficial ownership of assets and overseas trusts should not offer an opportunity to avoid UK tax
2. Fairness and neutrality - the tax treatment of trust should neither encourage or discourage the use of trusts and trusts should not offer tax avoidance opportunities
3. Simplicity - trust taxation should be sufficiently straightforward so that it doesn't discourage the appropriate use of trusts and minimises the chance of errors

So how do the current trust taxation rules stack up against these principles?

Trust taxation is essentially driven by the beneficiary's right to the income and capital of the trust.

Bare trusts

Bare trusts are the simplest form of trust. They have a beneficiary with an immediate right to both the income and capital of the trust. As the beneficial ownership is known and cannot be changed bare trusts are simple and generally offer the most favourable tax treatment.

Income and capital gains will be assessed directly upon the beneficiary with full use of their own allowances and exemptions.

The exception to this is where the trust was established by a parent for their minor child. Parental settlement rules exist which mean income will be taxed upon the parent if income exceeds £100 per year.

Bare trusts also enjoy privileged IHT treatment. Gifts into a bare trust will be potential exempt transfers and no IHT will be due provided the settlor survives for seven years from the date of the gift. Also, the trustees are not subject to the relevant property regime meaning there are no periodic or exit charges.

Interest in possession trusts

An interest in possession is where a beneficiary has a right to the income but not the capital of the trust. They include life interest trusts which typically occur in wills, for example where the surviving spouse may be entitled to income (or a right to reside in the family home) from the trust, but following their death the capital passes to the children.

Because a beneficiary has a right to income, the trust rate of 45% (38.1% for dividends) does not apply. Instead, income received by the trustees is taxed at basic rate and is then paid to the beneficiary with a credit for the tax deducted. Alternatively, the income can be mandated directly to the beneficiary and they simply include the income on their own tax returns.

As no one has an immediate right to the capital then capital gains are assessed against the trust at the trust rate of 20%. The trustees are only entitled to half the individual annual CGT exempt amount. However, this exemption is shared equally between all trusts created by the same settlor, subject to a minimum of one fifth of the trust exemption.

The IHT treatment of interest in possession trusts was impacted by the 2006 trust tax changes.

Any new trusts created during the settlor's lifetime will be subject to the relevant property regime. This means that gifts into the trusts are chargeable lifetime transfers (CLT). If these, when added to the cumulative value of CLTs in previous seven years, exceed the nil rate band there will be a 20% tax charge on the excess. It also means the trust is subject to IHT periodic and exit charges.

Trusts created on death are classed as immediate post death interests (IPDI) and follow the pre 2006 rules. This means the trust isn't deemed to be relevant property and therefore periodic and exit charges will not apply. The downside is that the value the trust assets are included in the beneficiary's estate for IHT.

Discretionary trusts

Discretionary trusts are the most flexible type of trust in that payments of both income and capital are at the discretion of the trustees. The tax treatment of discretionary trusts is therefore different from other trusts because there is no certainty as to who will benefit in the future.

Income in excess of the £1,000 standard rate amount will be taxed at the trust rate of 45% (38.1% dividends). The trustees will keep a record of the tax paid by the trust and this will be a credit in the 'tax pool'.

The tax pool is used to provide credit to a beneficiary when trust income is distributed to them. Beneficiaries will receive income with a 45% tax credit. To ensure fairness and neutrality the beneficiary can reclaim the difference between the tax credit and their own marginal rate of tax.

It should be noted that income payments to a beneficiary must be accompanied with a tax credit of 45% irrespective of the source of the income. This can be problematic if there are insufficient credits in the tax pool because income received by trustees is mainly in the form of dividends taxed at 38.1%. A shortfall in the tax pool may mean a reduction in the amount of income distributed to the beneficiary.

The rules for CGT follow those for post 2006 interest in possession trusts. Gains are assessed on the trustees at 20% (28% for residential property) and they are subject IHT periodic charges.

Tax on investment bonds in trust

Investment bonds held in trust don't follow the usual trust taxation rules. The chargeable event rules determine who is assessable on any gains. This will typically be the settlor of the trust during their lifetime and the tax year of their death. However, the trustees may be liable if the settlor is deceased or is not UK resident in the year of assessment.

These special rules don't apply to absolute trusts where the trust is generally looked through and the gains assessed on the beneficiaries.

Of course, trusts may have the option of assigning the bond or segments of it to a beneficiary rather than pay cash to them. This doesn't create a chargeable event. And all future gains will be taxed upon the beneficiary.

Summary

It has been recognised that there are many non-tax related uses of trusts and that they play a crucial role in getting money into the right hands at the right time. And while it may be possible to say that the trust taxation is broadly fair and neutral it is far from simple. So it is important that advisers have a good understanding of the taxation of the different types trusts and that they can help settlors, trustees and beneficiaries when investing and managing trust assets.