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Discretionary Trusts and The Change Of The Income Tax Rate From 40% To 50% With Effect From 5 April 2010

30 September 2009

Introduction

The change in income tax rates which will be effective in the tax year 2010/2011 make it imperative to consider what steps, if any, should be taken to mitigate the income tax burden on trustees of discretionary trusts.

To appreciate the effect the change rate will have requires an understanding of the way in which trusts, particularly discretionary trusts, are taxed.

Types Of Trust

The taxation treatment of trust income depends on whether the trust concerned is a discretionary trust or an interest in possession trust.  The first step to be taken is to determine which type of trust it is. 

If the trustees either:

  • (a) have the discretion to decide which of the beneficiaries receive the trust income, or
  • (b) have the power to accumulate the trust income,then the trust will be taxed as a discretionary trust.

Alternatively, if, under the terms of the trust, a beneficiary has a right to receive the income, he is treated as having an interest in possession.  An interest in possession trust is sometimes called either a life interest trust or a fixed interest trust.

Discretionary Trusts And The Trust Rate
(formerly known as “the rate applicable to trusts”)

The rate of income tax applicable to discretionary trusts and accumulation trusts is known as “the trust rate”.  Since 2004/2005 the trust rate is intended to match the highest rate of income tax that individual taxpayers have to pay.  Accordingly, since that date the trust rate has been 40%. 

Trustees are not taxed as individuals and so do not qualify of personal allowances.   However, to complicate matters there are a couple of further points for consideration: 

  • since 2005/2006 the is a special trust tax rate equivalent to the basic rate of tax payable by individuals (currently 20%) and that rate is payable on the first £1,000 of trust income; and
  • income covering tax management expenses is taxed at basic rate tax.

For larger trusts, with significant income, these two complications have little impact and so for the purpose of this memorandum are ignored.

Change In The Rate Of Tax From 40% to 50% In The Tax Year 2010/2011

With effect from 5 April 2010 a new top rate of tax of 50% will be introduced for those UK taxpayers with taxable income in excess of £150,000.  Accordingly, also with effect from that date, trustees of discretionary trusts are liable for income tax on all their income at the rate of 50%.  That will be the new trust rate. Until that date trustees of discretionary trusts suffer income tax at the rate of 40%. 

The purpose of this change is to ensure that the rate of tax payable by such trustees matches the rate of income tax payable by those individuals who are required to pay tax at the very highest rate. 

Of course, some income that trustees receive will have had tax deducted at source.  An example of this might be bank interest.  Other income, such as rental income, will be received by the trustees without having had tax first deducted.  Trustees might well receive dividend income.  The taxation of dividend income is more complicated and is the subject of a separate memorandum.

Where trustees receive income  such as bank interest, that has already suffered income tax at source (at 20%), their liability to pay income tax will have already been partly satisfied.  As a result the trustees of discretionary trusts, on receiving such income after 5 April 2010, will be expected to pay a further 30% income tax so that that income will suffer the full 50% tax charge.

Distrubuted Income

Often income is distributed by trustees of a discretionary trust to a one (or more ) of the beneficiaries.  When this happens the trustees issue the beneficiary with a tax deduction certificate.  The certificate shows how much tax has been deducted and paid by, or on behalf of, the trustees.

Suppose that we are considering the position in the current tax year 2009/2010 and that the income of the trust is £1,000.  The trustees currently would be paying £400 income tax.  If they distribute £60 (i.e. one tenth of their net income) to a beneficiary the certificate would show that £40 tax had been paid in respect of that distributed income.

At the end of the tax year, the beneficiary would file his own personal income tax return in the usual way.  The beneficiary would include in his tax return details of the distribution of income that had been made.  He would also send to HMRC the tax deduction certificate that he had received from the trustees.

The beneficiary will be treated as having had his gross income enhanced by £100 by virtue of the trustees’ distribution to him.  This £100 represents the £60 received from the trustees and the £40 income tax borne in respect of that income by the trustees.  If, even disregarding the trustees distribution to him, the beneficiary is a higher rate tax payer (i.e. he pays tax at the rate of 40%) then he will not have to pay any additional tax in respect of the income distribution from the trust.  The £40 income tax paid or suffered by the trustees will have satisfied the beneficiary’s tax liability in full.

If, however, the beneficiary is a non-taxpayer (perhaps he is a student or has a very low income) then he will be able to recover from HMRC all of the £40 income tax paid by the trustees.  This assumes that the income distribution from the trust does not push the beneficiary’s income above his personal allowance threshold.

If the beneficiary, in this example, pays tax at the rate of 20% then since his tax liability in respect of the £100 gross income distribution by the trustees is only £20, he will be able to recover from HMRC £20 (i.e the difference between the £40 income tax paid or suffered by the trustees and the £20 for which the beneficiary is liable .

The Introducion Of The 50% Rate Of Income Tax

It will be apparent from the above that, where beneficiaries are, in any event, paying tax at the very highest rate, it makes very little difference, for income tax purposes, whether or not the trust income is distributed.  Where beneficiaries are non-taxpayers, it can make quite a bit of difference since it will be possible to recover all of the income tax deducted and paid by the trustees in respect of the income that is distributed. 

Where beneficiaries are standard rate taxpayers it may well be worthwhile distributing the income those beneficiaries so that they are able to recover at least some of the tax suffered by the trustees.  This is particularly the case if the trust rate is to be 50% and the amount of income is substantial.

Interest In Possession Trusts

As mentioned above, the position with regard to discretionary trusts and accumulation trusts has to be contrasted with the position of interests in possession trusts.

With the interest in possession trusts the position is, thankfully, a bit simpler.

As mentioned above, if the beneficiary has a right to receive the income (i.e. the trustees have no discretion as to its payment and no power to accumulate it) the beneficiary is said to have an interest in possession.

Sometimes arrangements are made by the trustees of interest in possession trusts(“IIP Trusts”) for the income to be paid direct to that beneficiary who is entitled to the interest in possession (“the IIP”).  Alternatively, the income generated by the investments in the IIP Trust may be received by the trustees and, from time to time, paid to the beneficiary.  This latter arrangement may occur, for example, where the trustees receive rental income from a trust property they have let.

Whichever arrangement is made, the income is not taxed at the trust rate. 

If the income is paid direct to the beneficiary (effectively bypassing the trustees) the beneficiary returns details of that income on his tax return and accounts for any tax due in respect of it by virtue of that beneficiary’s own tax position.  He will get credit for any tax deducted at source (e.g. on bank or building society interest).

If the income is received first by the trustees then, before it is handed over to the beneficiary they would pay tax at the standard rate (currently 20%).  When the beneficiary accounts to HMRC for that income for the tax year in which it is paid to the trustees then the beneficiary will have to account for any tax due in respect of it by virtue of that beneficiary’s own tax position.  Again, he will get credit for any tax deducted paid on his behalf at the basic rate of tax by the trustees.

What Steps Should Be Taken Before The New Tax Rate Is Introduced?

As can be seen above, if, and for so long as, the beneficiary of a discretionary or accumulation trust has taxable income in excess of £150,000 p.a. (and so, with effect from 5 April 2010 will be paying tax at the highest marginal rate of 50%) it makes little difference whether or not the trustees distribute the income.   In this case no particular steps need to be taken to avoid the effects of the change of the trust rate.

In those cases where a beneficiary of a discretionary or accumulation trust has taxable income of less than £150,000 it makes sense to ensure that the trust income is distributed so that the beneficiary is enable to claim a tax refund.

Whilst it is possible for trustees of discretionary or accumulation trusts to make regular distributions to beneficiaries to secure the possibility for the beneficiary to make a tax refund claim,  it might be better for the trust to be converted into an IIP Trust.  This avoids the trustees:

  • (a) having to make periodic distributions on the basis of some quite complex calculations, and
  • (b) having initially to account to HMRC for the tax at the trust rate of 50% rate only for the beneficiary then to have to put to the task of having to apply for a tax refund.  Not only is this administratively burdensome but also results in the cash flow disadvantage of the trustees having to pay the tax only then  for the beneficiary to have to recover it, many months (or years) later.

In Summary

In summary, trustees should take steps now to consider their own and their beneficiaries’ income tax position to ensure that the change of the trust rate will not seriously disadvantage their beneficiaries.

For further information please contact Harvey Barrett, Partner and Head of Private Client, Trusts & Estates.


 

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