Tax legislation has developed over the years in a piecemeal way, particularly with regards to the thwarting of tax avoidance routes. As a result a tax liability in connection with a trust can arise on several different occasions, not just on settling the trust. Each of the parties to the trust – the settlor, the trustees and the beneficiaries – may be liable to tax.
Trust income tax
Taxation of trust income covers two separate areas: the taxation of trustees receiving income and the taxation of a beneficiary who receives income from the trust. Trustees in their capacity as trustees are not treated as individuals and accordingly are not entitled to the same personal allowances.
For income tax purposes a trust is UK-resident if all the trustees are UK-resident, or if at least one trustee is UK-resident and the settlor was UK-resident, ordinarily resident or domiciled at the relevant time.
Discretionary trusts
The rate applicable to trusts is 45 per cent and the trust rate applicable to dividends is 37.5 per cent.
As no one is entitled to income under a discretionary trust, the trustees themselves are taxed on any income arising from the funds at their own rates. Any income appointment made by the trustees is treated as trust income regardless of its origins. The beneficiary must include the grossed-up amount of income in his total income computation. The trust income is then taxed at the marginal rate of the taxpayer and credit is given for tax paid by the trustees.
• Standard-rate band
A standard-rate band (basic-rate income tax) for discretionary trusts was introduced in 2005/2006 and this now stands at £1,000. Within the standard-rate band the trustees will have no further tax liabilities if total income falls within this band and they do not distribute it.
The standard-rate income-tax band is shared between all discretionary trusts made by the settlor, to a minimum of one-fifth of the full band, or £200.
Where a discretionary trust distributes its income to the beneficiaries, this must be franked by a 45 per cent tax credit. As such, if income is distributed there will be little benefit from the standard-rate band as additional tax will have to be paid to total 45 per cent.
• Interest income
For income originating from interest, the 20 per cent credit is reclaimable and therefore can be used by the trust to reduce its outstanding tax liability. The beneficiary can reclaim the difference between the 50 per cent and their own marginal income-tax rate. An illustration of this is provided in Box 1.
• Dividend income
However, with an equity fund, the 10 per cent dividend credit is not reclaimable so when dividend income is distributed, the trust cannot offset it against its 45 per cent liability.
These two examples both start with £100 gross income and demonstrate that the beneficiary is 10 per cent worse off in net terms when receiving income that has originated from dividends rather than from interest.
Absolute entitlements
Where a beneficiary has a vested right to income, he is assessed directly on any income received by the trustees. This means that if the trustees have received dividend income, the beneficiary is assessed as having received dividend income.
Life interest trusts
Trustees of life interest trusts who receive trust income are liable to income tax at the basic rate. In most cases, income received has already borne tax at source and therefore the trustees do not have a further liability. If the beneficiary receives income direct from the provider, then the trustees are exempt from tax.
The life tenant (beneficiary with a vested right to income) will be assessed for income tax whether they actually receive that income or not. They will have a basic-rate tax credit due to the tax borne by the trustees.
Bare/absolute trusts
The absolute entitlement means that the trust is transparent for the taxation of unit trust investments, unless the parental settlement rules apply.
Trust capital gains tax
The capital gains tax (CGT) rate for trusts is 28 per cent and is charged on any gains made when shares and unit trusts are disposed. If the total of any gains realised in the year, minus any losses, exceeds the available CGT annual exemption the excess is liable to CGT.
The annual CGT exemption for trustees of a settlement (ie non-bare trusts) is one half of the normal exemption. However, where a settlor has made more than one qualifying settlement, the exemption is split proportionately between all of the settlements with the proviso that the exemption for any one settlement is a minimum of one-fifth of this half exemption – eg £1,090 in tax years 2013/14. Qualifying settlements are most settlements made after 6 June 1978.
Danny Cox is head of financial planning at Hargreaves Lansdown
