AF1/J02 Part 4: Taxation of Trusts (1)

AF1/J02 Part 4: Taxation of Trusts (1) The next three parts will cover the taxation of trusts. Since it is a complex subject each tax, income, capital gains and inheritance tax will be dealt with separately. This first part will take an overview of the tax regime and then focus on income and capital gains tax. The milestones are to understand: The way tax impacts on trusts. How income received by the three main types of trusts is taxed. How beneficiaries are taxed on income received from a trust How capital gains tax impacts on trusts. Overview Tax can impact on the three parties to a trust in different ways. Settlor When the settlor makes a lifetime gift into the trust this will be subject to IHT being either an exempt, potentially exempt or a chargeable lifetime transfer. Further gifts into the trust will also come under the scope of IHT. Making a gift into a trust may also give the Settlor a Capital Gains Tax liability if he or she transfers assets that have a higher value at time of transfer than when they were acquired. Trustees Trustees have a duty to invest the assets and any income or gains will be subject to tax. Except for a Bare/Absolute trust, the trustees are responsible for declaring and paying this. The trust is a legal entity so the trustees liability is separate from their own tax position. However, should the trust owe tax and there was insufficient money in the trust to pay it, the trustees would have to pay this from their own pockets. Beneficiaries When money or assets are distributed from the trust, the beneficiary may have a tax liability. The general rule is that beneficiaries will always be liable to income tax on any income they receive from the trust but can offset tax paid by the trustees. Beneficiaries are not normally liable for any Capital Gains Tax when they are given an asset by the trust. The trustees are usually responsible for paying any tax before the asset is transferred. The beneficiary is then deemed to acquire the asset at the price on the day it is 1

transferred and this then becomes the starting point for calculating any CGT they may have to pay in the future. Income tax and trusts The way the income of a trust is taxed will depend on whether it is: Bare/Absolute Trusts Trusts which must pay out income (IIP trusts) Trusts that can accumulate income (Discretionary Trusts) Bare/absolute trusts In this type of trust, the beneficiaries have the right to demand the trust property is given to them at any time. Consequently they are personally liable for tax on any income produced by the trust and can use their personal allowance, personal savings allowance together with their dividend allowance. Income from a bare trust is subject to the parental income rule in that if the trust property was a gift from the parents any income of more than 100 is deemed to be the parents rather than the child s. If the trust was set up by anyone else, e.g. the grandparents, all the income is deemed to be the child s who can use his or her personal allowance. Trusts that must pay out any income to beneficiaries (IIP) The trustees will initially be liable for income tax on all income. The basic rules are: The trustees are liable for the tax. The trust has no personal allowance and is liable for tax on every of income it receives. The trust cannot use the Personal Savings Allowance nor the 2,000 dividend allowance. Savings income is taxed at 20% Dividend Income is taxed at 7.5% The trust has no liability for higher or additional rate tax This regime is described as basic rate taxation. Since April 2016 interest from deposit accounts are paid gross so the trustees should pay tax at 20%. Dividends are also paid gross so the trustees are liable for tax at 7.5%. These changes mean that trustees must pay tax on interest and dividends whereas before 16/17 basic tax was deducted at source which satisfied the trustees liability. Alternatively, 2

trustees can mandate income, that is pay the gross income directly to the beneficiary so passing the responsibility for the taxation to them. Tax on income received by beneficiaries The basic rule is that beneficiaries are liable to tax on the income from an IIP trust but can offset tax already paid by trustees. The trustees will prepare HMRC form R185 which gives details of the gross income and any tax deducted. If trustees pay the tax the form would look like this Form R185 Gross Net Tax Interest 2,000 1,600 400 Dividends 1,000 925 75 Beneficiaries will use this form to declare their income to HMRC. The beneficiary should enter the gross income in the relevant column of their tax calculation as income from an IIP trust retains its status, that is savings income remains savings income and dividend income remains dividend income. Put another way the income the beneficiaries receive will be taxed as if they owned the asset. They can use their Personal Savings Allowance, the 5,000 0% band and the 2,000 Dividend Allowance. Assuming this person had a salary of 20,000 this is how it should be shown in a calculation. Non-Savings Savings Dividend Salary 20,000 2,000 1,000 Less PA 11,850 8,150 2,000 1,000 8,150 @ 20% 1,630 Savings 1,000 @ 0% 0 1,000 @20% 200 Dividend 1,000 @ 0% 0 Total 1,830 Less savings tax ( 400) Less dividend tax ( 75) Liability 1,355 3

Discretionary Trusts As with an IIP trust the trustees are responsible for paying any income tax and there is no personal allowance. The first 1,000 of income is taxed at 7.5%, or 20% depending on its source. This is known as the Basic Rate. If the trust has both different sources of income the basic rate must be applied in this priority order, first non-savings (rent), next savings (interest) and finally dividends. If the settlor sets up more than one trust this 1,000 band is shared to a minimum of 200 a trust. All income above 1,000 is taxed at one of two rates: Non-Dividend Income 45% Dividend Income 38.1% These are known as the Rate applicable to Trusts (RAT) The Widmerpool trust receives 10,000 in gross interest Tax due is 1,000 @ 20% = 200 plus 9,000 @ 45% = 4,050 so the trustees must pay 4,250 The trust now has 5,750 The same trust receives a share dividend of 1,000. Tax is charged at 38.1% on this giving a liability of 381. The Trust has 691 Tax on income distributed to beneficiaries Unlike an IIP trust a Discretionary Trust does not need to distribute income. If it chooses to accumulate this then no further tax is payable by the trustees. The fundamental point about distributing income is that the trustees must pay this with a tax credit of 45%. This tax credit represents the tax already paid by the trustees. For non-dividend income the position of the trustees is straightforward. If the basic rate is ignored the trust will have already paid 45% tax. A trust has received 1,000 gross interest and paid 450 in tax. It pays 550 to the beneficiary with 450 tax credit. The situation where dividend income is distributed, as in the second example, is more complex. The trustees will have paid tax at 38.1% but if they want to distribute it they have to provide a 45% tax credit. A trust has received 1,000 gross dividend and paid 381 in tax. It now wishes to pay this to a beneficiary so must pay another 69 in tax. It can now pay the beneficiary 550 with a tax credit of 450 4

Tax on the beneficiary When the beneficiary receives trust income they must declare it on their tax assessment. In all cases it is treated as non-savings income regardless of its original source. grossed up by multiplying the net amount by 100/55 Once the tax liability is established the 45% tax credit can be deducted The effect is that: a nil rate tax payer can claim back 45% tax. a basic rate tax payer can claim back 25% tax a higher rate tax payer can claim back 5% tax an additional rate tax payer has no further tax liability This is how you should show it in a calculation. Mary has a salary of 50,000 and receives an income distribution from her family s discretionary trust of 8,250. Non-Savings Salary 50,000 Trust income 8,250 x 100/55 15,000 65,000 Less PA 11,850 53,150 34,500 @ 20% 6,900 18,650 @ 40% 7,460 14,630 Less tax credit (!5,000 @ 5%) 750 Liability 13,880 If Mary had received the 15,000 dividend from her own share-holding or from an IIP trust, she could offset the 2,000 dividend allowance. The remaining 13,000 would be taxed at 32.5% giving her a liability of 4,225. Her total tax liability would be: Non- Savings 34,500 @ 20% = 6,900 3,650 @ 40% = 1,460 Dividend 13,000 @ 32.5%= 4,225 12,585 5

In summary: Any trust other than a bare trust which has to pay out income to the beneficiaries and cannot accumulate income will be taxed at basic rate. Any trust that can accumulate income rather than pay it to the beneficiaries will be subject to tax at the rate applicable to trusts. Tax on trustees Tax on beneficiary Bare None Liable for all tax Can use PA, PSA, 0% savings rate and Dividend Allowance Interest Possession in Liable to tax on all income Cannot use PA, PSA, 0% savings rate or Dividend Allowance All income taxed at basic rate Income is paid to beneficiary either gross or with tax credit if trustees paid tax. Income retains its type, savings income stays savings income, dividend income remains dividend. Taxed on beneficiary s situation and can use all allowances Discretionary First 1,000 of income taxed at basic rate. All other non-dividend income taxed at 45% Dividend income taxed at 38.1% All income taxed as non-savings income regardless of its origin. Income is paid with 45% tax credit How trustees pay tax A trust is a legal entity and trustees are jointly and separately liable for paying income and CGT. This is separate from their own tax affairs. The trustees must register for self-assessment and complete a tax return each year Interim payments on account based on last tax year s income must be made by 31 January in the year of assessment and by the following 31 July. The balancing payment must be made by 31 January following the end of the tax year. Any CGT liability must be paid by the 31 st January following the end of the tax year The trustees of a discretionary trust operate a tax pool. When income is received, the tax paid by the trustees enters the pool. When they pay out an income to beneficiaries, this must be paid with a 45% tax credit and this reduces the amount in the pool. 6

At the end of each tax year if the tax paid is higher than the tax credits this will roll over to the previous year (the pool is in credit) If the tax paid is lower than the tax credits, the trustees make a payment to HMRC to cover the difference. A trust receives 50,000 of interest. The trustees are liable for 1,000 @ 20% and 49,000 @ 45%, a total of 24,050. This enters the tax pool. In the same year they pay out 20,000 to a beneficiary so there must be a tax credit of 9,000. There is now 15,050 in the tax pool and if there is no further income in or out of the trust this would be rolled over to the next tax year. A trust receives 60,000 of dividend income. The trustees are liable for 1,000 @ 7.5% and 59,000 @ 38.1%, a total of 22,554. This enters the pool. They decide to pay all the 60,000 to a beneficiary so must give this with a tax credit of 27,000. If there is no further income received or paid out the trustees must pay HMRC 4,446 ( 27,000 less 22,554) Trust Management Expenses These are expenses incurred by trustees. The most common example would be money used to pay the costs of financial advice. They do not include, for example, the expenses incurred in running a property such as management agent s fees or costs of insurance. These would be deducted as a normal business expense before arriving at the net income due to the trust. TMEs are treated differently and the rules depend on the type of trust. Bare trusts and settlor interested trusts Here the income belongs to the beneficiary so the trustees must pay the gross income (less any tax deducted at source) without any deduction for TME. A bare trust is not allowed to offset any TMEs. Interest in Possession Trusts TME reduce the income a beneficiary receives and will therefore reduce the tax that is payable by the beneficiary. They cannot be used to reduce the tax payable by the trustees. Any TME must first be set against dividend income, then savings income and finally non savings income. TME are deducted from net income 7

In the following example the details are as follows: Gross Interest 1,500 Dividends 1,000 TME 400 The TME cannot be used to reduce the tax payable by the trustees so their liability is: Interest 1,500 @ 20% = 300.00 Dividends 1,000 @ 7.5% = 75.00 Total 375.00 Turning now to the beneficiary, as there is dividend income, expenses are first set against this. Dividend Income 1,000 Less tax 75 925 Less TME 400 525 This must be grossed up to show the correct figure in R185. Grossed up amount 525 x 100/92.5 = 567 (rounded down) They would give the beneficiary form R185 completed as follows: Gross Net Tax Interest 1,500 1,200 300 Dividend 567 42 525 If there were no TME (and assuming the trustees paid the tax) the beneficiary would have received 925 of dividend with a tax credit of 75 Discretionary trusts Here TME reduce the amount of tax payable at the rate applicable to trusts. TME are deducted from firstly dividend income, then savings income, and finally nonsavings income. The TME are grossed up at the appropriate rate (100/92.5 for dividends 100/80 for savings and non savings) They are offset against the appropriate source of income The grossed up expenses are taxed at either 7.5% or 20% The total income less grossed up expenses is taxed at either 38.1% of 45% 8

A Discretionary trust has income and TME as follows Interest 20,000 Dividends 10,000 TME 2,000 Tax calculation Interest 1,000 @ 20% 200 19,000 @ 45% 8,550 Dividends 10,000 Less Grossed up expenses 2,174 7,826 2,174 @ 7.5% 163 7,826 @ 38.1% 2,982 3,145 3,145 11,895 Capital Gains Tax CGT could impact on both the settlor and the trustees. If the settlor makes a lifetime gift into a trust it will be a disposal for CGT. When the trustees dispose of an asset within the trust it could be subject to CGT CGT on lifetime gifts An important point in assessing any tax on a lifetime gift is whether the receiving trust is a Relevant Property Trust. This has a major impact on the IHT treatment which will be covered in the part 3 but it is also significant for CGT. A discretionary trust is always relevant property. All trusts created since 27 March 2006 are Relevant Property except for: Bare Trusts Immediate Post Death Interest Trusts Bereaved Minor Trusts In addition, all IIP trusts set up before 22 March 2006 where there hasn t been change of beneficiary since October 6 2008 will be classed as non-relevant property trusts. 9

The significance of this as regards CGT is that if a settlor makes a gift into a relevant property trust holdover relief is available. This is not available if it is not a relevant property trust. Ben gifts shares with a value of 50,000 that he acquired for 10,000 into a bare trust. He will be liable for CGT on the gain of 40,000. The trust will have acquired them at a value of 50,000. If he had gifted the shares to a discretionary trust he could have asked the trustees to use holdover relief. If they agreed, he would not be liable for any CGT but the trust would have deemed to have acquired them at 10,000. CGT does not arise when assets are transferred on death since any individual CGT liability is wiped out on death. CGT on trustees A distinction needs to be made between a bare trust and all other trusts. The beneficiary of a bare trust is personally liable to pay CGT on gains made within the trust. They can use their full annual exemption ( 11,700) and will pay at either 10% or 20% depending on their own tax position. With all other trusts when the trustees dispose of an asset, the gain is calculated in the normal way but the trust s CGT allowance is ½ of the normal allowance, i.e. 5,850. The rate is 20% for non-residential property and 28% for residential property. If the settlor sets up more than one trust the CGT exemption is shared between them subject to a minimum allowance of 1,170. A liability could also arise if assets were transferred from the trust to a beneficiary. The trustees are then liable to the gain made between acquisition and disposal. However, if it is a relevant property trust holdover relief can be used if both trustees and beneficiary agree to this. The trustees will not have a tax liability and the beneficiary is deemed to have acquired the assets at the price at which the trustees acquired them rather than the price at transfer. This can be advantageous since the beneficiary would have the full annual exemption and may only be liable to tax at 10% The trustees of an IIP trust decide to pass unit trusts showing a gain of 20,000 to Sam, a beneficiary of the trust who is a basic rate tax payer. If the trustees pay the tax they would be liable to ( 20,000-5,850) @ 20% = 2,830. I 10

If holdover relief were claimed and Sam were immediately to sell the unit trusts, his liability would be ( 20,000-11,700) x 10% = 830 Sam could also decide to dispose of just enough to use his annual exemption and avoid tax completely If the beneficiary of an IIP dies and the trust winds up, the assets within the trust are valued at date of death but there is no CGT liability on the trustees or deceased beneficiary. That concludes this part so you should now understand: The way tax impacts on trusts. How income received in the three main types of trusts is taxed. How beneficiaries are taxed on income received from a trust How capital gains tax impacts on trusts. 11