The taxation of trusts can be a complex area. We have looked through previous articles at the different types of trusts that can be used. Following is an introduction into the taxation of a trust.
The first step when working out how a trust is to be taxed is to consider the trust instrument to assess what type of trust you are dealing with. Trusts are subject to the same taxes as individuals, that is, income tax, inheritance tax and capital gains tax.
Trust property is held by trustees for the benefit of the beneficiaries. The trust deed will, in most cases, set out who are the trustees and who are the beneficiaries. A trust fund will often consist of the following:
a) Capital – this will likely be the original property transferred into the trust, any replacements of that property and any additions
b) Income – income earned on the capital held by the trust
The income tax treatment of trusts falls into two categories:
• standard rate tax (bare trusts and all interests in possession)
• trust rate tax (discretionary and accumulation trusts)
The income of trusts in the first category is initially taxable at the basic rate of 20 per cent, or the dividend rate according to the type of income. Since the beneficiary has a right to the income, it is ultimately taxed at his or her personal rates.
Income that may be accumulated or applied at the trustees’ discretion is taxed within the trust at the trust rate of 45 per cent (50 per cent before 6 April 2013) or the dividend trust rate. When a beneficiary receives trust income, it carries a tax credit of 55 per cent (previously 50 per cent), regardless of the origin of the income. This may result in a refund for the beneficiary or a tax charge on the trust.
Capital gains tax
Capital gains tax applies to actual disposals of assets within the trust. In addition, certain occasions are deemed disposals for CGT purposes. In both situations, the capital gain is calculated using the standard principles, but the computation of tax may differ with regard to the amount of annual exemption and the rate of tax. Another distinction is the availability of holdover relief.
Annual exemption
The annual exemption will be either:
• full annual exemption (bare trusts and trusts for disabled persons)
• half annual exemption (all other trusts). The trust annual exemption is shared between all trusts created by the same settlor, subject to a minimum for each trust of one 10th of the full annual exemption.
The current rate of capital gains tax applied to trustees is 28 per cent.
Inheritance tax
The inheritance tax treatment of trusts falls into two broad categories:
• beneficial entitlement (bare trusts and qualifying interests in possession)
• relevant property (non-qualifying interests in possession and discretionary trusts)
In the beneficial entitlement category, trust property is subject to inheritance tax as if it belonged outright to the beneficiary. It is deemed to be his or hers and treated as part of his or her estate.
In the relevant property category, trust property is subject to a special regime for inheritance tax. Tax is charged when property enters the trust, when it leaves the trust and at 10-year intervals within the trust. The regime is intended to compensate for the fact that the trust property does not belong in any individual’s estate.
Ben Chapin is managing director of Taxwise
