Any trust income must be included on the beneficiary s self-assessment return.

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1 9.2.1 Bare trust The beneficiary is normally liable for income tax on income received by the trust and will have a full personal allowance (unless individual annual income is over 100,000). Effectively, it is treated as though the beneficiary is receiving the income directly. Although the liability falls on the beneficiary, the tax may be paid by the trustees (from the trust fund) on behalf of the beneficiary. If the beneficiaries are non-taxpayers, then the trustees can complete a form R85 in order for interest to be received gross. If interest (e.g. from bank accounts, corporate bonds, fixed interest unit trusts/oeics) is received net of 20% the tax can be reclaimed if the beneficiary is a non-rate taxpayer. The 10% tax credits on dividends is not reclaimable. Any trust income must be included on the beneficiary s self-assessment return. Note: there is an exception to the above tax treatment: As we saw in an earlier section, where bare trusts are funded by a parent for a child (under 18 and unmarried) investment income is generally taxed on the parent(s). However, if the annual income from all the investments set up for the child by its parent(s) is 100 or less, it will be taxed on the child. If the income is more than 100, all of it not just the excess over 100 will be taxed on the parent(s). This only applies to arrangements funded by a parent; if a bare trust has been genuinely settled by a different party e.g. grandparents, then investment income will be taxed on the child Trust for a vulnerable beneficiary The trustees will be liable for income tax on income generated by the trust but an election can be made for favourable tax treatment. A joint election for the trust to be treated as a trust for a vulnerable person must be made by the individual and the trustees. Once made, the election is irrevocable. The result of the election is that tax will effectively be calculated as though the beneficiary had received the income directly. The beneficiary will therefore have a full personal allowance (unless annual income is over 100,000). The actual calculation is: (a) calculate the tax on the trust (at normal trust rates, described in 8.2.4, with no personal allowance) (b) calculate tax payable if income was received directly by the beneficiary deduct the difference as a relief from (a). As we saw in section 3.5.2, if a trust is to be split (used in part for a vulnerable beneficiary and partly for a non-vulnerable beneficiary) then the assets to be used for the vulnerable beneficiary must be: identified and kept separate used only for the vulnerable beneficiary and

2 Only that part of the trust will receive special tax treatment interest in possession trusts The trustees are liable for basic rate tax on the income, 10% on dividends (covered by the tax credit) and 20% on non-dividend income. The trustees will deduct basic rate tax on any income that has not been taxed at source e.g. gilt interest, and account to HMRC for the tax deducted. There is no starting rate band. The trustees do not have a personal allowance. The income, net of expenses, is then paid to the income beneficiary who will be assessed for income tax (and can use a personal allowance). If the income beneficiary is a basic rate taxpayer (when the grossed up trust income has been added to their other taxable income) then there is no further liability. If the income beneficiary is higher rate or additional rate taxpayer, then they will have a further tax liability (20% or 25% on grossed up interest, 22.5% or 27.5% on grossed up dividends). If the income beneficiary is a non taxpayer or starting rate taxpayer, then they may be able to claim back tax (although not the 10% tax credit on dividends). Where an interest in possession trust has been established by a parent where the income beneficiary is a child (under 18 and unmarried) investment income is generally taxed on the parent(s). However, as before, if the annual income from all the investments set up for the child by its parent(s) is 100 or less, it will be taxed on the child Note: With a flexible interest in possession trust where the settlor (or their spouse/ civil partner) is a potential beneficiary, trust income will be taxed on the settlor not the beneficiaries Discretionary trusts and accumulation trusts The trustees do not have a personal allowance. They have a standard rate band of 1,000 (2015/16) which is subject to basic rate tax i.e. 10% on dividends (covered by the tax credit) and 20% on other income. There is no starting rate of tax available. The standard rate band may be divided between trusts if created by the same settlor. For example, if a settlor sets up two trusts, they will each have a 500 starting rate band. However, the standard rate band for a trust will never fall below 200. The standard rate will be applied firstly to non-dividend income, then to dividends. Any income in excess of the standard band is taxed (at trust rates which are the same as for an additional rate taxpayer i.e. 37.5% on dividends and 45% on non

3 dividends, calculated on the on the grossed up amounts. Tax paid at source will be deducted from this liability. Example Malcolm set up a discretionary trust, the only trust he has settled, in In 2015/16 the trust receives 1,200 net bank interest and 810 net dividend income. The trust s income tax liability will be Calculated as: Interest: 1,200 divided by 0.8 = 1,500 gross 1,000 x 20% = x 45% = 225 Dividends: 810 divided by 0.9 = 900 gross 900 x 37.5% = = tax liability 390 taxed at source ( 300 on interest and 90 on dividends) so further tax payable is Decisions regarding accumulation and distributions must be documented, accounts must be kept and any tax must be deducted before a distribution is made. If income is distributed to a beneficiary, it carries a 45% tax credit (regardless of the underlying source of the income). If the beneficiary is not an additional rate taxpayer, they will be able to reclaim some of the tax paid, based on their own tax position and using a personal allowance. A non taxpayer can reclaim 45% A basic rate taxpayer can reclaim 25% A higher rate taxpayer can reclaim 5% The beneficiary can only reclaim tax actually paid by the trustees. As part or all of the 45% may be reclaimed by a beneficiary, the trustees may have to pay more tax to cover the beneficiary s tax credit. If the trustees make a payment to a beneficiary, they need to ensure therefore that they have paid sufficient income tax (in the current year or in previous years) to cover the 45% tax credit. The discretionary trust tax pool records all income tax paid by the trust and if the income payment is made to a beneficiary, the trustees will need to ensure that the 45% credit attached to the payment is covered by the tax pool.

4 9.3 Capital gains tax treatment of trusts Bare trust Beneficiaries are liable for CGT on gains made by the trust (even if created by parents) and each has an annual exemption ( 11,100 in 2015/16). It is treated as though the beneficiary has made the gain personally. Although the beneficiary is liable, the tax may be paid by the trustees (from the trust fund) on behalf of a beneficiary. If for example, there are three beneficiaries (who have no gains outside the trust) the trust can make chargeable gains of up to 33,300 in 2015/16 before any CGT is incurred Trust for a vulnerable beneficiary The trustees will be liable for CGT on any gains within the trust fund. However, the tax may be calculated as though the beneficiary had made the gains personally. The beneficiary will therefore have a full annual exemption of 11,100 and the rate of CGT will depend on their individual position. The actual calculations is: (a) calculate the tax on the trust (b) calculate tax payable if the gain had been made directly by the beneficiary and deduct the difference from (a) Interest in possession trust/ Discretionary trust/ Accumulation trust The trust has half the individual annual CGT exemption (therefore 5,550 for 2015/16). If a settlor has set up more than one trust, the exemption is divided between the trusts but will never fall below 1,110 (2015/16) per trust. A trust set up for a beneficiary who is disabled (where the trust doesn t qualify as a trust for a vulnerable beneficiary) will have an annual exemption of 11,100. On any gains above the annual exemption, the rate of CGT is 28% (If a disposal by the trust qualifies for entrepreneurs relief, then the rate of CGT will be 10%). A principal private residence held in an interest in possession trust will normally be exempt. For a transfer into a relevant property trust (discretionary/accumulation trusts and most interest in possession trusts created on or after 22 March 2006) holdover relief can be claimed so that no CGT is payable at the time of the transfer but a

5 subsequent chargeable gain will be based on the settlor s acquisition value. The election for holdover relief must be made jointly by settlor and trustees. For relevant property trusts, holdover relief can also be claimed when assets are transferred to a beneficiary. The election for holdover must be made jointly by trustees and beneficiary. Holdover relief is not available for a transfer to a trust in which the settlor has an interest (or will later have an interest) for example, if the settlor or their spouse/civil partner or minor children are beneficiaries. If a UK domiciled settlor transfers assets into an offshore trust in which they have an interest (e.g. the beneficiaries are grandchildren) then they will be liable for CGT on any gains made by the trust in any tax year that the settlor is UK resident or temporary non-resident. With an interest in possession trust, there is normally no CGT liability upon the death of an income beneficiary. The exception is where the settlor claimed holdover relief on the transfer into the trust, in which case held-over gains are assessed for CGT upon the death of the income beneficiary Charitable trust A transfer to a charitable trust is exempt from CGT. Care: In the AF1 exam, if investments in a trust fund are exempt from CGT (e.g. the trust disposes of gilts or qualifying corporate bonds) then, of course there is no CGT. It is very easy under exam conditions to focus on the trust aspects and overlook the basics of CGT