The UK government is currently considering major reform of the taxation of trusts.
In November 2018, it launched a public consultation to that end, inviting views on the principles that, in the government’s view, should form the basis of the taxation of trusts: transparency, fairness/neutrality, and simplicity.
The consultation document set out examples of where the government felt these principles were not met, and sought views for and against reform.
The consultation closed at the end of February 2019, and practitioners and clients with any involvement with trusts now await the government’s resulting policy proposals.
It therefore seems an appropriate time to consider the purpose of trusts, their current tax treatment and the ways in which this might be reformed.
The focus of the government’s consultation is primarily the tax treatment – in particular, inheritance tax – of private trusts for individuals.Key Points:
- The UK government launched a consultation last November into the taxation of trusts
- Many trusts are taxed unfairly and defeat the object of using them
- Most people use trusts for legitimate reasons, not tax avoidance or evasion
Accordingly, this article focuses on the tax treatment of life interest trusts, discretionary trusts, and vulnerable beneficiary trusts.
Transparency, fairness and neutrality, and simplicity constitute a reasonable approach to ensure an effective trust taxation system.
Tax neutrality is one of the government’s key aims in assessing the tax treatment of trusts. Neutrality is taken to mean ensuring that tax considerations neither incentivise nor disincentivise the use of trusts.
There are many examples where the use of trusts is clearly disincentivised by the existing tax regime, where the aims of fairness and neutrality are not met, and where reform would be desirable.
The current landscape
Trusts are sometimes viewed as morally questionable and inherently obfuscatory mechanisms, used primarily to hide wealth and avoid or evade tax.
The consultation document suggests that the government believes some trusts may still be used for tax avoidance or evasion.
In reality, the taxation of trusts in the UK has in some areas become so unduly onerous and complex that it can disincentivise the use of trusts: a result contrary to the aims of the consultation.
Most clients create trusts not for the purpose of saving tax, but for a number of wholly legitimate reasons: asset protection (for example, to avoid assets being at risk in divorce financial proceedings); preserving major assets such as farmland and heritage property; providing for intergenerational family planning or to ensure a long-term family legacy; or providing for vulnerable people.
Tax avoidance is no longer a significant motivator.
Two particularly common types of trust are lifetime interest-in-possession trusts – trusts created during a settlor’s lifetime that give the beneficiary the right to benefit from the trust income/property during their life, but no right to the underlying capital – and discretionary trusts.
Lifetime IIP trusts can be a particularly useful way of providing for family members, vulnerable people, or indeed settlors themselves.
Discretionary trusts are invaluable where it is desirable for the trustees to use their judgment as to who should benefit and to what extent (if at all) from a trust, depending on the beneficiaries’ circumstances.