Taxation of trusts. Delegates notes John Thurston 20/01/15

Transcription

1 Taxation of trusts. Delegates notes John Thurston 20/01/15 1 1

2 All rights reserved. No part of these notes may be reproduced in any material from (including photocopying or storing it in any medium by electronic means and whether or not transiently or incidentally to some other use of these notes) without the written permission of the copyright owner except in accordance with the provisions of the Copyright, Designs and Patents Act The doing of an unauthorised act in relation to a copyright work may result in both a civil claim for damages and criminal prosecution. Whilst every care has been taken to ensure the accuracy of the contents of this work, no responsibility for loss occasioned to any person acting or refraining from action as a result of the contents of these notes can be accepted by the author of these notes or the course organiser. 2 2

3 Index Finance Act Finance Act The relevant property regime IHT on the lifetime creation of trusts apart from trusts for disabled persons after 22 March The relevant property regime IHT on trusts apart from immediate post death interests, trusts for disabled persons and trusts for bereaved minor ten yearly or principal charges and exit or proportionate charges Pilot settlements IHT on immediate post death interests and trusts for disabled persons CGT on settlements Income tax Income tax Where there is a beneficiary entitled to the income Accumulation and discretionary trusts First slice of trust income Trust management expense and the special rate applicable to trusts Income/capital The tax pool Income becoming capital The 50/42.5% problem Trusts for vulnerable persons Case studies

4 Finance Act IHT. All trusts are taxed for IHT purposes as if they were trusts without an interest in possession the relevant property regime. Three exemptions: 1. Trusts created on death for the benefit of one life tenant - an immediate post death interest". 2. Trusts created either in the settlor s lifetime of or on death for a disabled person as defined in s 89 IHTA. 3. Trusts created on death by a parent for a minor child who will be fully entitled to the assets in the trust at age Immediate post death interest. In order for a settlement to qualify as an immediate post death interest, the following conditions must be satisfied: 1. The settlement must be effected by will or under the law relating to intestacy. The life tenant must have become beneficially entitled to the interest in possession on the death of the testator or intestate. 3. S 71A does not apply to the property in which the interest subsists or the interest is not a disabled person s interest. 4. Condition 3 has been satisfied at all times since the life tenant became beneficially entitled to the interest in possession. 2. Trusts for disabled persons. 2. Trusts for disabled persons. Section 89(1) of the Inheritance Tax Act 1984 applies to settled property transferred into a settlement after the 9 th March 1981 and held on trusts: a) under which, during the life of a disabled person, no interest in possession in the settled property subsists and b) which secure that, if any of the settled property or income arising from it is applied during the disabled person's life for the benefit of a beneficiary, it is applied for the benefit of the disabled person. 4 4

5 Section 89(4) defines a disabled person as a person who, when the property was transferred into the settlement, was: a) incapable by reason of mental disorder within the meaning of the Mental Health Act 1983, of administering his property or managing his own affairs; or b) in receipt of an attendance allowance or disability living allowance by virtue of entitlement to the care component at the highest or middle rate. c) in receipt of personal independence payment by virtue of entitlement to the daily living component. d) in receipt of an increased disablement allowance. e) in receipt of constant attendance allowance. f) in receipt of armed forces independence payment. Under section 89(2) the disabled person is treated as beneficially entitled to an interest in possession of the settled property. A life interest trust will also come within the definition of a trust for a disabled person. Self settlement will also be permitted provided that the property is held on trusts: 1. Under which during the life of the disabled person no interest in possession in the settled property subsists; 2. If any of the trust property is applied during the life of the disabled person then it must be applied for the benefit of the disabled person; 3. If there is any power to bring the trusts to an end during the life of the disabled person, if such power is exercised: (i) the disabled person or another person will, on the trusts being brought to an end, be absolutely entitled to the settled property, or (ii) on the trusts being brought to an end a disabled person s interest within section 89B(1)((a) or (c) will subsist in the settled property. A trust can still be a disabled persons' trust even if the trustees have the power of advancement conferred by s32 Trustee Act However, the trustees must not be able to apply capital or income otherwise than for the benefit of the bereaved minor amounting to more than the lower of 3,000 or 3% of the amount that is the maximum value of the settled property during the period in question. 3. Trusts for bereaved minors. 5 5

6 In order for a trust to be treated as a trust for bereaved minors, the following conditions must be satisfied: 1. The property must be held on the statutory trusts for the benefit of a bereaved minors under sections 46 and 47 (1) of the Administration of Estates Act 1925; or 2. Held on trusts of the benefit of a bereaved minor, and the following conditions are satisfied: (A) the trust must be established under the will of the deceased parent of the bereaved minor; (B) the trust must provide that the bereaved minor, it he has not done so before attaining the age of 18, will on attaining that age become absolutely entitled to the settled property, any income arising from it, and any income that has arisen from the property held in the trust for his benefit which has been accumulated before that time; (C) the trust must also provide that so long as bereaved minor is living and under the age of 18, if any of the income arising from the settled property is applied for the benefit of a beneficiary, it is applied for the benefit of the bereaved minor, and (D) the trust must also provide that so long as bereaved minor is living and under the age of 18 either the bereaved minor is entitled to all of the income (if there is any) arising from any of the settled property or if any of the income arising from the settled property is applied for the benefit of a beneficiary it is applied for the benefit of the bereaved minor. A bereaved minor is defined as a person who has not yet attained the age of 18 and at least one of whose parents has died. A stepparent and someone with parental responsibility for a child can also create such a settlement. A trust can still be a bereaved minors' trust even if the trustees have the power of advancement conferred by s32 Trustee Act However, the trustees must not be able to apply capital or income otherwise than for the benefit of the bereaved minor amounting to more than the lower of 3,000 or 3% of the amount that is the maximum value of the settled property during the period in question. It is possible to have a trust for a bereaved minor contingent on them attaining the age of 25 or any age between 18 and 25, but there will be a charge to IHT when the child satisfies the contingency. 6 6

7 Summary. All settlements created during lifetime will be taxed as if they were trusts without an interest in possession unless they are a trust for a disabled person within section 89 of the Inheritance Tax Act All settlements in wills will be taxed as if they were a trust without an interest in possession unless they come within the three exemptions. CGT. Hold over relief will be available for all transfers into and out of trusts which do not come within the three exemptions provided it is not a settlor interested trust a trust where the beneficiaries include the settlor, or the settlor s spouse or civil partner or the infant children of the settlor who are not married or in a civil partnership. Income tax. No change. 7 7

8 IHT Finance Act The relevant property regime. All settlements apart from immediate post death interests, trusts for disabled persons, and trusts for bereaved minors. Inter vivos payable on creation rate 20% if in excess of NRB or NRB exhausted by other settlements On death payable if estate large enough Ten yearly or principal charge - 6% Exit or proportionate charge. CGT Inter vivos creation deemed disposal by settlor On death no CGT Disposals by trustees chargeable Deemed disposal if beneficiary becomes absolutely entitled Hold over relief available whatever the nature of the assets unless it is a settlor interested trust Income Tax If no interest in possession Rate applicable to trusts If income applied for benefit of beneficiary, beneficiary gets credit for tax paid by trustees Might be a trust for a vulnerable person If interest in possession Trustees pay basic rate tax Beneficiary gets credit for whatever tax has been paid by the trustees. 8 8

9 Immediate post death interests, trusts for disabled persons, and trusts for bereaved minors. IHT Trust for disabled person created inter vivos PET On death, IHT may be payable Life tenant deemed to own underlying trust assets Surrender of life interest by life tenant PET Death of life tenant deemed disposal of trust assets CGT Inter vivos deemed disposal by settlor On death no CGT Chargeable on disposal by trustees Deemed disposal at MV when beneficiary becomes absolutely entitled otherwise than on death of life tenant Income Tax If no interest in possession Rate applicable to trusts If income applied for benefit of beneficiary, beneficiary gets credit for tax paid by trustees Might be a trust for a vulnerable person If interest in possession Trustees pay basic rate tax Beneficiary gets credit for whatever tax has been paid by the trustees. 9 9

10 Finance Act Transitional serial interests. Transitional serial interest arise where there is an interest in possession trust which was created before the 22nd of March 2006 and where there are successive life interests. The first life interest is subject to the old interest in possession rules. However, any subsequent life interest is subject to the relevant property regime unless it is a transitional serial interest. Under the Finance Act 2006, if the first life interest terminated before the fifth of April 2008, a transitional serial interest came into existence, and it did not matter who the next life tenant was. However, if the first life interest terminated after the fifth of April 2008, then the next life tenant had to be the spouse or civil partner of the previous life tenant before it became a transitional serial interest. The Finance Act 2008 extended the transitional period to fifth of October

11 The relevant property regime. IHT on the lifetime creation of trusts apart from trusts for disabled persons after 22 March IHT is payable on the lifetime creation of this type of trust. In order to determine the rate of tax, any other trusts apart from trusts for disabled persons created within the previous seven years must be added together. If the settlor dies within seven years of the creation of this type of trust, the IHT must be recalculated using death rates. Taper relief may reduce the amount of tax payable

12 1. If a settlor creates a trust apart from a trust for a disabled person, then IHT is payable at 20% in so far as it exceeds the NRB. 2. If the settlor dies within seven years of the creation of the trust, then the IHT must be recalculated using the death rates. Taper relief may reduce the amount of tax payable. 3. If a settlor creates a trust apart from a trust for a disabled person, then in order to determine the rate of tax it must be cumulated with all other trusts apart from trusts for disabled persons created in the previous seven years and after 22 March If a settlor has created several trusts apart from trusts for disabled persons, whilst it is only necessary to recalculate the IHT on those within seven years of death, in determining the rate of tax, you must bring into account all the trusts apart from trusts for disabled persons created within seven years of the one you are dealing with. If the previous trust was created before 22 March 2006, then it is only discretionary trusts, which have to be cumulated. 5. In recalculating the IHT, if a settlor has made PETs and created trusts apart from trusts for disabled persons within seven years of death, the PETs within seven years of death and prior to the trust you are dealing with must be taken into account in determining the rate of tax has the NRB been exhausted? Note that trusts for disabled persons are treated as PETs, and prior to 22 March 2006 many other trusts were also PETs. 6. Note that it is necessary to do a separate calculation for each lifetime gift and each settlement. Each one has its own cumulative total

13 The relevant property regime. IHT on trusts apart from immediate post death interests, trusts for disabled persons and trusts for bereaved minor ten yearly or principal charges and exit or proportionate charges. Charge to IHT every ten years. Charge to IHT when capital leaves the trust. 10 yearly charge. Section 64 imposes a charge on relevant property. Relevant property is settled property in which no qualifying interest in possession subsists. The value charged is the value of the relevant property comprised in the settlement less agricultural property relief and business property relief. The settlement has its own cumulative total. This is the aggregate of: a) the values transferred by any chargeable transfers made by the settlor in the period of seven years ending with the day on which the settlement commenced; and b) the amounts on which any charges to tax are imposed under section 65 in respect of the settlement in the 10 years before the anniversary concerned. c) the value immediately after it became comprised in the settlement of any property which was not their relevant property and has not subsequently become relevant property while remaining comprised in the settlement and d) the value, immediately after a related settlement commenced, of the property in comprised in it. Section 65 imposes a charge to IHT when property leaves the settlement. The rate of tax is 30% of the rate, which would be charged on a lifetime transfer. If property has been added to the settlement, then the cumulative total is the higher of: 1. the chargeable transfers made by the settlor in the seven years before the settlement and the transfers made by the trustees before the addition, and 13 13

14 2. the aggregate of the values transferred by any chargeable transfers made by the settlor in the period of seven years ending with the day on which the property was added to the settlement but excluding the transfer made on the creation of the settlement and any transfer to a related settlement. In addition the rate of tax on the added property is reduced by one fortieth for each quarter before the property was added to the settlement. Example. Assume average rate is 2%. Capital is added to the settlement five years after commencement or last ten year anniversary charge. Rate of tax applying will be 2% x 20/40 = 1%

15 Exit charges. These arise: a) where property comprised in the settlement ceases to be relevant property; and b) if (a) does not apply, where the trustees of the settlement make a disposition as a result of which the value of relevant property comprised in the settlement is less than it would be but for the disposition. There is no charge if the event in question occurs in the quarter beginning with the day in which the settlement commenced or with a 10-year anniversary. The amount chargeable is the amount by which the value of the relevant property in the settlement is less immediately after the event in question then it would be but for the event. The rate of tax is a proportion of the rate charged on the last 10-year anniversary. The proportion is so many fortieths as there are complete successive quarters in the period beginning with the most recent anniversary and ending with the day before the occasion of the charge. Grossing up. If the trustees pay the IHT, then they have to gross up the amount they are handing out

16 Exit charges before ten year anniversary. 1. Calculate hypothetical transfer s 68(5). (i) (ii) (iii) the value of the property in the settlement immediately after it commenced plus the value at the date of addition of any added property the value of property in a related settlement (value immediately after it commenced) 2. Add all chargeable transfers made by the settlor in seven years before date of settlement. Transfers on same day are ignored. If settlement created in will, other gifts ignored. 3. Deduct 2 from NRB. 4. Deduct balance of NRB, if any, from Calculate tax at 20%. 6. Convert into average rate for the settlement. 7. Calculate 30% of Calculate fall in value of fund 9. Calculate the number of quarters, which have elapsed 10. Multiply 8 x 7 x

17 Pilot settlements. Pilot settlements are where the settlor creates settlements on different days, and transfers 10 to each settlement. Assets are then added to the settlements by the settlor's will. The advantage of this was that when calculating 10 yearly charges it was only the 10 transferred to the previous settlements which was brought into account in determining if there was anything left of the nil rate band. For all relevant property trusts ten yearly and exit charges arising after 6 April 2015 and 18/25 trusts created after 10 December 2014 all added property must be brought into account when calcualting the charge. It also applies to trusts created before that date when capital is added after 10 December

18 IHT on immediate post death interests and trusts for disabled persons. No IHT on lifetime creation of a trust for disabled persons PET. If by will, IHT payable if the estate is large enough. Life tenant or disabled person is deemed to own all the trust assets. On death IHT payable on all the trust assets. Lifetime termination by life tenant is a PET if remainderman absolutely entitled. Reversionary interests are not subject to IHT

19 1. If a trust for a disabled person is created during the lifetime of the settlor, the settlor will be deemed to have made a PET. Taper relief will apply if the settlor survives for three years after making the settlement. 2. If the settlement is created by will, then IHT will be payable if the estate is in excess of the nil rate band, or if the nil rate band has been absorbed by inter vivos gifts in the seven years up to the date of death. 3. There is a fiction for IHT purposes that the life tenant under an immediate post death interest owns all the trust assets. This fiction does not operate for other purposes. The trust assets will be aggregated with the life tenant s personal estate, and any IHT will be apportioned between them. 4. The fiction that the life tenant owns all the underlying trust assets also applies to lifetime terminations. If the life tenant surrenders or assigns all or part of his interest, then the life tenant will be deemed to make a PET if the remaindermam is absolutely entitled. 5. The fiction that the life tenant owns all the underlying trust assets means that the remainderman owns nothing for IHT purposes. 6. If it is a trust for a disabled person, the disabled person is deemed to have an interest in possession in all the assets the subject of the trust whether or not it is a discretionary trust or a life interest trust

20 CGT on settlements. Creation of inter vivos settlement is a disposal for CGT purposes. No CGT is payable if the settlement is created in a will. Trustees liable for CGT on disposals of trust assets. Charge to CGT when a beneficiary becomes absolutely entitled. No charge when the life tenant dies under an immediate post death interest or on the death of a disabled person under a trust for a disabled person where the disabled person has a life interest. Usually no CGT when a beneficiary disposes of his/her beneficial interest. Hold over relief available whatever the nature of the assets unless it is an immediate post death interest or a trust for a disabled person or a settlor interested trust

21 1. The creation of a settlement during the lifetime of the settlor is a chargeable disposal for capital gains tax purposes. A settlor could make a declaration of trust constituting himself the trustee. This will still be construed as a disposal of the whole property subject to the trust. 2. If the settlement is created by will, then the normal rule that CGT is not payable on death applies. Instead, the trustees will be deemed to acquire the assets at market value as at the date of death. 3. Disposals by trustees are chargeable in accordance with normal principles. 4. Section 71(1) provides that when a person becomes absolutely entitled to any settled property as against the trustee, all the assets forming part of the settled property to which he becomes entitled shall be deemed to have been disposed of by the trustees, and immediately reacquired by him in his capacity as a trustee for a consideration equal to their market value. Under s 60(1) the deemed reacquisition by the trustees is deemed to be by the beneficiary. Note that this does not apply on the death of a life tenant under an immediate post death interest or pre 22 March 2006 life interest trust or on the death of a disabled person under a trust for a disabled person. 5. In the case of an immediate post death interest, or a trust for a disabled person where the disabled person has a life interest, there is a deemed disposal and reacquisition by the trustees on the death of a beneficiary, but no chargeable gain or allowable loss accrues (s 72(1)). 6. Normally there will not be a charge to CGT on the disposal by a beneficiary of his interest in a settlement. 7. Any loss made on the creation of the settlement can only be offset against gains made on another disposal to the trustees. 8. Any loss on a deemed disposal by the trustees must be offset against gains made by the trustees in the same assessment year and prior to the disposal or on the disposal. If there are no such gains the loss can be offset against any gain made on a disposal of the trust assets, but not other assets. 9. Where property is held on trusts for a disabled person which secure that that, during the lifetime of the disabled person (a) if any of the property which is applied is applied for the benefit of a beneficiary is applied for the benefit of that person, and (b) either (I) the disabled person is entitled to all the income arising from the property, or 21 21

22 (ii) if any such income is applied for the benefit of a beneficiary, it is applied for that person's benefit. the trustees are entitled to the full annual exemption available to an individual

23 Hold over relief on creation of a trust. Hold over relief is available whatever the nature of the assets transferred to a trust unless it is a trust for a disabled person or a settlor interested trust. Hold over relief when a beneficiary becomes absolutely entitled to trust assets under all trusts apart from trusts for disabled persons and immediate post death interests. Hold over relief is available whatever the nature of the assets when a beneficiary becomes absolutely entitled to the trust assets unless it is an immediate post death interest or a trust for a disabled person. Professional trustees should not agree to any gain being held over unless the beneficiary gives them an indemnity for the CGT. Hold over relief on trusts for bereaved minors. Hold over relief is available whatever the nature of the assets when a minor attains 18 or 25. If more than one minor is entitled, and the assets cannot be easily divided, there will not be any deemed disposal until the youngest minor satisfies the contingency. This will mean that hold over relief will be limited to business assets. Settlor interested trusts. Note that hold over relief is not available on creation if it is a settlor interested trust one where the settlor, settlor's spouse, settlor's civil partner or infant children who are not married or in a civil partnership are beneficiaries or within the class of beneficiaries. A trust which is not settlor interested trust at inception may later become one. If that happens within six years of the creation of the trust, then if any hold over relief has been claimed, the Revenue will claim it back. A settlor who creates a settlement for the benefit of his children who are all adults could fall foul of this rule if the settlor later has further children

24 Relationship between hold over relief and inheritance tax. 1. If hold over relief is claimed, and then any inheritance tax payable in respect of that transaction can be offset against the gain. However, it is the amount of IHT payable if the transferee had paid it, and it is not possible to create a loss [s260(7) and (8) TCGA 1992]. 2. If hold over relief is not claimed, then the value transferred is not increased by the amount of CGT

25 Trusts - Income tax. Where there is a beneficiary entitled to the income. If there is an interest in possession, then trustees only pay basic rate tax. The beneficiary receives a credit for whatever tax has been paid by the trustees. Frequently the income will be mandated directly to the life tenant. The expenses incurred in running the trust cannot be deducted from this income. If the income is not mandated directly to the life tenant, then the trustees will pay basic rate tax or lower rate tax on the income

26 Trustees income Net Tax Gross Tax credit UK dividends BS interest NS&I interest Rental income Total tax credit 600 Trustees' tax liability UK dividends 10% BS interest 20% NS&I interest 20% Rental income 20% Total tax liability Less tax credits 600 Trustees pay 1320 Liability of beneficiary who is 40% higher rate taxpayer UK dividends 32.5% BS interest 40% NS&I interest 40% Rental income 40% Total tax liability of beneficiary who is higher rate taxpayer Less tax credits 1920 Beneficiary pays 2420 The expenses of the trustees have to be paid out of the net income

27 S 500 ITA 2007 provides that the expenses of the trustees can be used to reduce the beneficiary s income for income tax purposes only so far as: the expenses are incurred by the trustees in the current tax year or an earlier year, and as a result of the expenses being properly chargeable to income, the beneficiary s entitlement to income is reduced by reference to the expenses. An expense is properly chargeable to income if: it is chargeable to income by the trustees under a term of the settlement, or it is not chargeable to income under a term of the settlement, but is chargeable to income in accordance with any law. Expenses are offset against the income in the following order: UK dividends; savings income; other income

28 Trustees income Net Tax Gross Tax credit UK dividends BS interest NS&I interest Rental income Total tax credit 600 Trustees' tax liability UK dividends 10% BS interest 20% NS&I interest 20% Rental income 20% Total tax liability Less tax credits 600 Trustees pay Income of beneficiary when TME are 10,000 UK dividends 10% Net Tax Gross Income after deducting TME BS interest 20% NS&I interest 20% Rental income 20% Income of beneficiary of expenses left ( grossed up at 20%) 28 28

29 If the beneficiary is entitled to a refund of income tax, it is desirable to give the trustees power to charge the expenses to capital as otherwise the beneficiary will not be able to obtain a complete refund of the income tax paid by the trustees. Alternatively, the trustees could obtain an undertaking from the beneficiary to pay the management expenses. On the other hand, if the beneficiary is a higher rate taxpayer, it will be best if the expenses are paid out of income. Example (using tax rates for 2010/2011) Expenses deducted from income A trust has rental income 3,000. The life tenant, B, has no other income. The management expenses are 500. If the management expenses are paid out of income, B will receive 3,000 income tax of 600 and the expenses of 500 = 1,900. The gross income of the beneficiary will be 1,900 x 100/80 = 2,375. B will be able to recover the income tax of 475 ( 2,375 1,900), so he will receive net 2,375. If the expenses were paid out of capital, B would receive 2,400, and will be able to obtain a refund of the income tax of 600, and so will receive 3,000. If B was a 40% higher rate taxpayer, and the expenses are paid out of income, he will receive 2,375 gross. He will then have to pay an extra 20% = 475, and will not be able to recover the 475, leaving a net income of 1,425. B s total income tax liability would be 950. If the expenses were paid out of capital, he would receive 2,400. He will then have to pay income tax at 40% on the 3,000 = 1,200 less the 600 already paid leaving him with a net amount of 1,800. B s total income tax liability would be Expenses refunded by the beneficiary If the whole of the income is paid to B with no other income after the deduction of tax but without the deduction of management expenses, he will be able to recover 600. If he then refunds the management expenses to the trustees, he will be left with 2,500. If B was a higher rate taxpayer, he will have to pay income tax at 40% on 3,000 = 1,200, plus the management expenses of 500, leaving a net income of 1,300. Capital payments taxed as income. Normally income tax is not payable on payments to beneficiaries from capital, but according to Revenue Law: Principles and Practice (25th edn, 2007, Tottel Publishing), para it will be in the following situations: (a) (b) if they are designed to augment income; the trust deed authorises the trustees to apply the capital to maintain a beneficiary in the same degree of comfort as in the past; 29 29

30 (c) the payments from capital amount to an annuity

31 Accumulation and discretionary trusts. S 480 ITA 2007 defines an accumulation and discretionary trust as one where the income must be accumulated or is payable at the discretion of the trustees or any other person. If there is no interest in possession, then the trustees pay 40%/50%45% [32.5%/42.5%/37.5% in the case of dividends] with a credit for any tax deducted at source. If the trustees pay the income to a beneficiary, then it must be grossed up at 40/50/45%, and the beneficiary gets a credit for the 40/50/45%. First slice of trust income. The first slice of trust income up to 1000 will be taxed at basic or lower rate. Example. Trust Y receives income of 1200, made up of the following: A income from property. B savings income from building society account. C dividend income. A taxed at basic rate (20%) = 120. B taxed at basic rate (20%) = 60. C taxed at dividend ordinary rate (10%) = 10. C taxed at trust rate (37.5%) = 75. Total tax due

32 Rule 1. Assuming tax rates are the same for all income apart from dividend income, add all the non dividend income. Trustees pay lower or basic rate tax on the first 1,000, but then 45% tax with a credit for any tax deducted at source. Rule 2. Add all the dividend income. If there is any of the 1000 band left, trustees pay 10%. On all income above 1000, trustees pay 37.5% with a credit for any tax deducted at source. Rule 3. If the trustees distribute any income, then then they must gross it up at 45% and account to HMRC for 45% tax. Rule 4. The beneficiary gets a tax credit for the 45% tax

33 Income of trustees of a discretionary trust. Net Tax Gross Tax credit Dividends Interest Rental income less rental expenses Tax at 20% on first 1000 of rental income at 45% 4050 Tax at 45% on interest Tax at 37.5% on dividends Total tax 5900 Less tax credits 600 Due 5300 Trustees distribute 1000 income x 100/55 = 1,

34 Example. Trustees of a discretionary trust receive a net dividend of 1,800. Tax of 10% has been deducted from the gross dividend of 2,000. This is irrecoverable. Trustees will have to pay tax at 37.5% on the gross dividend already paid = 550. Trustees distribute the net sum; it will have to be grossed up at 45%. 1,250 x 100 = 2, Trustees will have to account to the Revenue for tax at 45% on 2, = =

35 Trust management expense and the special rate applicable to trusts. Trust management expenses so far as they relate to income can be set against income. However, they must be grossed up at the appropriate rate for the income against which they are going to be offset. The expenses must be offset against the income in the following order: UK dividends; savings income; other income. Note that it is only expenses with regard to income which are deductible

36 Rule 1. Assuming tax rates are the same for all income apart from dividend income, add all the non dividend income. Trustees pay lower or basic rate tax on the first 1,000, but then 45% tax with a credit for any tax deducted at source. Rule 2. Add all the dividend income. If there is any of the 1000 band left, trustees pay 10%. On all income above 1000, trustees pay 37.5% with a credit for any tax deducted at source. Rule 3. If the trustees distribute any income, then then they must gross it up at 45% and account to HMRC for 45% tax. Rule 4. The beneficiary gets a tax credit for the 45% tax. Rule 5. When calculating the special rate applicable to trusts, trust management expenses applicable to income can be offset against firstly dividend income, then savings income and then other income. They must be grossed up at the appropriate rate for the income against which they will be offset

37 Income of trustees of a discretionary trust. Expenses 6000 Net Tax Gross Expenses grossed up Dividends x 100/90 = 2000 Interest x 100/80 = 2000 Rental income less rental expenses Calculation of RAT Net rental income of trustees after deduction of expenses x 100/80 = = 6750 Tax credit Tax at 20% on first 1000 of rental income. Tax at 20% on grossed up rental income offset against expenses Tax on remaining rental income at 45% Interest tax deducted at source Dividends tax deducted at source 0 absorbed by expenses 0 absorbed by expenses Basic rate tax 200 Lower rate tax 0 absorbed by expenses 0 absorbed by expenses 37 37

38 Total tax Less tax credits 600 Due THE TRUSTEES OF THE PETER CLAY DISCRETIONARY TRUST Appellant - and - THE COMMISSIONERS FOR HER MAJESTY'S REVENUE AND CUSTOMS Respondents This case concerned a large discretionary trust where most if not all of the income was accumulated. In calculating the special rate applicable to trusts, the expenses attributable to income are deductible. The dispute between the trustees and the Revenue was about what expenses were properly attributable to income. There was also a dispute as to whether the net income should be calculated on an accruals basis or a cash basis. On the facts of this case, it was held that the accrual basis was the correct basis, but the Special Commissioners accepted that the cash basis might be appropriate. The Special Commissioners summarised their decision as follows: 23. In summary, our decision in principle is that: (1) In accordance with the requirement to achieve a fair balance between income and capital beneficiaries, a proportion of all the expenses in issue, with the exception of the investment management fees, is attributable to income and is properly chargeable to income for the purposes of s 686(2AA). (3) The accruals basis adopted here is a proper way of allocating expenses to a particular year of assessment. COMMISSIONERS FOR HER MAJESTY'S REVENUE AND CUSTOMS v. THE TRUSTEES OF THE PETER CLAY DISCRETIONARY TRUST [2007] EWHC 2661 (Ch). In calculating the special rate applicable to trusts, it is permissible to deduct the expenses attributable to income. It was held that if the expenses incurred were for the benefit of the trust estate as a whole, then they were of a capital nature. It was also held that the deductible expenses could be calculated on an accrual basis

39 COMMISSIONERS FOR H M REVENUE & CUSTOMS v. TRUSTEES OF THE PETER CLAY DISCRETIONARY TRUST [2008] EWCA Civ The issue in this case was what expenses were attributable to income and what to capital. The Court of Appeal held that if the expenses were incurred for the benefit of the whole of the trust, then they were capital expenses. The Revenue accepted that some expenses might be attributable to income, and that it was possible to apportion expenses between income and capital. The Revenue also argued that if a trustee was paid a fixed fee, it was not possible to apportion that between income and capital. The Court rejected that argument. It was also held that until trustees decided to accumulate income, then an apportionment was possible. However, once they decided to accumulate income, then the expenses were all capital expenses. The will or settlement may give the trustees a discretion as to whether expenses are paid from income or capital. If the trustees do have a discretion, and they pay all expenses from income, and there is a beneficiary entitled to the income, then the Revenue would accept the decision of the trustees. The beneficiary entitled to the income will only be taxed on income actually received. If there is no one entitled to the income, a distinction has to be made between trust management expenses and the liability of a beneficiary to whom income is paid. In calculating the special rate applicable to trust, trustees can only deduct expenses which are properly attributable to income. A beneficiary to whom income is paid is not concerned about expenses, and only needs to include the income actually paid to them in his or her tax return. If the settlor or spouse or civil partner of the settlor or infant children of the settlor who are not married or in a civil partnership are beneficiaries or within the class of beneficiaries, then the income of the trust is taxed as if it was the top slice of the income of the settlor

40 Income/capital. The trustees do not have to distribute the income; it can be accumulated subject to the rule against accumulations. If it is accumulated, then it will become capital. When does income become capital? It is probably best if the trustees resolve at least once a year what income has become capital. Income which has been accumlated for five years will now be treated as capital as far as IHT is concerned. There will be no reduction in the rate of charge to IHT because it has not been capital for ten years. If the income is paid out as capital, this may give rise to an exit charge. Payments from capital can also become income in the hands of the beneficiary. The test is whether they are income in the hands of the beneficiary. If there is a clause in the settlement authorising trustees to top up income from capital, then the payments of capital will be income. In Stevenson v. Wishart [1987] STC 266 the trustees of a discretionary trust spent 109,000 on medical expenses and nursing home fees. It was held that this was capital expenditure

41 The tax pool. Trustees of a discretionary trust will usually have more than one source of income. They may also have unspent income from previous years. All this income will contribute to the tax pool which can be offset against their liability if they distribute any income

42 Example. Trustees of a discretionary trust have the following income: Dividends from various companies: Gross 5000; net Interest from various banks: Gross 10,000; net Management expenses pa: 900; grossed up 1,000. Trustees pay: Dividends: Tax at 37.5% on = 1,500. Interest: Tax at 45% on 10,000 = Total tax = % of 1000 = Less already paid or credited Due from trustees Tax pool for dividends: 1100 ( ). Trustees decide to distribute dividends amounting to 400 to one beneficiary. Gross the dividend up at 45% = 400 x 100 = % = The trustees will not have to pay any more tax as it can be offset against the pool. Tax pool for interest: Trustees decide to distribute interest amounting to 2000 to one beneficiary. Gross the interest up at 45% = 2000 x 100 = % = The trustees will not have to pay any more tax as it can be offset against the pool. Rule 1. Assuming tax rates are the same for all income apart from dividend income, add all the non dividend income. Trustees pay lower or basic rate tax on the first 1,000, but then 45% tax with a credit for any tax deducted at source. Rule 2. Add all the dividend income. If there is any of the 1000 band left, trustees pay 10%. On all income above 1000, trustees pay 37.5% with a credit for any tax deducted at source

43 Rule 3. If the trustees distribute any income, then then they must gross it up at 45% and account to HMRC for 45% tax. Rule 4. The beneficiary gets a tax credit for the 45% tax. Rule 5. When calculating the special rate applicable to trusts, trust management expenses applicable to income can be offset against firstly dividend income, then savings income and then other income. They must be grossed up at the appropriate rate for the income against which they will be offset. Rule 6. The trustees have a pool of all the tax paid or deducted at source apart from the tax deducted by a company when paying a dividend. Rule 7. If the trustees pay any income to a beneficiary, they must gross it up at 45%. If there is any tax in the tax pool, the trustees can offset that against what is due to HMRC. If the grossed up tax exceeds the tax in the pool, then the surplus will have to be paid from income/capital. Rule 8. Even if expenses eliminate or reduce a source of income, do not forget to include the tax deducted at source in the tax pool. This does not apply to dividend income

44 Income of trustees of a discretionary trust. Expenses 6000 Net Tax Gross Expenses grossed up Dividends x 100/90 = 2000 Interest x 100/80 = 2000 Rental income less rental expenses Calculation of RAT Net rental income of trustees after deduction of expenses x 100/80 = = 6750 Tax credit Tax at 20% on first 1000 of rental income. Tax at 20% on grossed up rental income offset against expenses Tax on remaining rental income of 5750 at 45% Interest tax deducted at source Dividends tax deducted at source 0 absorbed by expenses 0 absorbed by expenses absorbed by expenses absorbed by expenses 44 44

45 Total tax Less tax credits 600 Due Tax pool (total tax less 10% deducted from dividends by paying company Trustees pay 1000 to member of class of beneficiaries Tax at 45% can be offset against tax in pool 1000 x100/55 = 1, =

46 The 45/37.5% problem. Possible solutions: 1. Appoint revocable life interests. 2. Change investment policy. 3. Capital rather than income distribution. 4. Appoint assets on bare trusts. 5. Make it a settlor interested trust

47 Income of trustees of a discretionary trust. Expenses 6000 Net Tax Gross Expenses grossed up Dividends x 100/90 = 6666 Net dividend 3334 Interest Rental income less rental expenses Total non dividend income Tax at 20% on first at 45% at 37.5% (Dividend income expenses grossed up) Tax at 10% on grossed up income offset against expenses (6666) Total tax Less tax credits 1200 Due Tax pool (total tax less 10% on dividends) Trustees pay 2000 to 2000 x100/55 = Tax credit

48 member of class of beneficiaries Tax at 45% can be offset against tax in pool =

49 Income tax and capital gains tax. Trusts for vulnerable persons. A vulnerable person is a disabled person or any relevant minor. A disabled person is defined in section 38(1) of the Finance act 2005 as: (a) a person who by reason of mental disorder within the meaning of the Mental Health Act 1983 is incapable of administering his property or managing his affairs, or (b) a person in receipt of attendance allowance or of disability living allowance by virtue of entitlement to the care component at the highest middle rate. S 39 defines a person as a relevant minor if - (a) he has not yet attained the age of 18,and (b) at least one of his parents has died. S 34(2) provides that the qualifying conditions for a trust for a disabled person are- (a) that if any of the property is applied for the benefit of a beneficiary, it is applied for the benefit of the disabled person, and (b) either that the disabled person is entitled to all the income (if there is any) arising from any of the property or that no such income may be applied for the benefit of any other person. S 35 provides that where property is held on trusts for the benefit of a relevant minor those trusts are qualifying trusts if they are- (a) statutory trusts for the relevant minor under sections 46 and 47(1) of the Administration of Estates Act 1925 (succession on intestacy and statutory trusts in favour of relatives of the intestate; (b) trusts established under the will of a deceased parent of the relevant minor where: (i) the relevant minor will, on attaining the age of eighteen, become absolutely entitled to the property, any income arising from it and any income that has arisen from property held on the trusts for his benefit and been accumulated before that time, (ii) that, until that time, for so long as the relevant minor is living, if any of the property is applied for the benefit of a beneficiary, it is applied for the benefit of the relevant minor, and 49 49

50 Income tax. (iii) that until that time, for so long as the relevant minor is living, either- (a) the relevant minor is entitled to all the income (if there is any) arising from any of the property, or (b) no such income may be applied for the benefit of any other person. Section 26 provides that the trustees liability to income-tax for the tax year is to be reduced by an amount equal to -- TQT I - VTQI Section 27 provides that the purpose of section 26 TQTI is the amount of income-tax to which the trustees would be liable for the tax year in respect of the qualifying trust income were it not for the Act. VTQI is an amount equal to TLV1 TLV2. TLV2 is the total amount of income-tax and capital gains tax to which the vulnerable person would be liable for the tax year if his income-tax liability were computed. TLV1 is what it would be if the qualifying trust income arising or treated as arising to the trustees in the tax year in respect of which the trustees are liable to income-tax were income of the vulnerable person for the tax year. Income tax liability of trustees calculated in accordance with normal principles Less Income tax liability of beneficiary on the assumption that all the income of the trust was paid to the vulnerable person income tax liability of the beneficiary on the assumption that no trust income has been paid to the beneficiary. Capital gains tax. The gains are treated as being the gains of the vulnerable person. Income tax parental settlements. Settlements by parents on infant children can fall foul of anti avoidance rules with the result that the income of the settlement is taxed as the parents

51 Case studies. Case study 1. What are the IHT, CGT and income tax consequences of the following transactions? 1. T makes a will transferring assets to A for life then to B. IHT. CGT. Income tax. 2. T transfers assets to trustees during his life to hold on trust for A for life then to B. IHT. CGT. Income tax

52 3. T creates a discretionary trust either during T s lifetime or in a will. The terms of the trust would have to require the trustees to apply one half of the income and capital for the benefit of the disabled person, and there must be no interest in possession. IHT. CGT. Income tax. T makes a will containing a gift to all my children contingent on them attaining the age of 18. IHT. CGT. Income tax

53 T makes a lifetime settlement containing a gift to all my children contingent on them attaining the age of 18. IHT. CGT. Income tax. 6. T makes a will containing a gift to all my grandchildren contingent on them attaining the age of 18. IHT. CGT. Income tax. 7. T makes a will containing a gift to all my children contingent on them attaining the age of 25. IHT. CGT. Income tax

54 Assume no lifetime exemptions or reliefs apply and that NRB is 300,000 unless otherwise stated. Case study 2. What IHT will be payable on the following transactions? 1. E transfers 800,000 to the trustees of a discretionary trust. He dies two years later. 2. F transfers 800,000 to the trustees of a trust with an interest in possession. F dies four and a half years later. 3. C transfers 300,000 to the trustees of a discretionary trust. Six years before C had transferred 500,000 to the trustees of another discretionary trust. 4. D transfers the following amounts to the trustees of a discretionary trust: 10 years before death 400, years before death 200,