I understand that the 2004 and 2005 Finance Acts have brought about major changes to the taxation of trusts. What has changed and is there likely to be more change?

The whole field of the taxation of trusts has undergone enormous changes in recent years and more reforms are anticipated in next year’s Finance Act. The significant changes that will affect trusts that have been announced are as follows:-

Finance Act 2004

There were several significant changes introduced in the Finance Act 2004, mostly designed to block what were perceived by the Government to be loopholes allowing tax avoidance opportunities.

One of these was the introduction of a 40% income tax rate for all accumulation and discretionary trusts, in place of the previous rate which was 34%. This means that these types of trust became liable to the top rate of income tax on all their income. This was undoubtedly a very harsh change, particularly for children’s trusts, where the beneficiary would often need the trust funds as his or her only available capital to make a start in life upon becoming entitled to the trust funds.

A further change was that the rate of Capital Gains Tax on all trusts, except bare trusts, was also increased from 34% to 40% with effect from 6 April 2004.

The net result of these two changes is that many of the tax advantages of making trusts have been swept away, and in fact it is quite possible for it to be disadvantageous to put money into trust. For example, the Settlor’s Capital Gains Tax rate could never be more than 40%, but in some years it might be less. Fixing the trust rate at 40% means that the tax bill on gains realised on assets within a trust might well be greater than if the Settlor had retained the assets in his or her estate.

One of the few remaining tax advantages in making a trust is therefore the removal of assets from the Settlor’s estate. So long as this is carried out more than seven years prior to the Settlor’s death, a saving in inheritance tax should be achieved.

It is often possible to reorganise the terms of a trust in order to mitigate these increased tax liabilities. As regards income tax, depending on the type of trust concerned, the funds could be appointed on interest in possession trusts for a beneficiary, so that the income would then belong to that person and be taxed at the beneficiary’s tax rate. In the case of children’s trusts, the funds could be appointed on bare trust for a beneficiary which would mean that capital gains would be taxed on the beneficiary rather than the trustees. The income tax position of bare trusts depends on whether the funds were derived from a parent and whether the beneficiary is still under the age of 18. For bare trusts set up by a grandparent, the income is that of the beneficiary for tax purposes, which will often enable repayment claims to be made.

Capital Gains Tax Holdover Relief

Two other important changes to the Capital Gains Tax regime in relation to trusts were also introduced in the Finance Act 2004.

The first related to gifts to settlor-interested trusts.

The gift of an asset into trust is a disposal for Capital Gains Tax purposes, but for gifts of business assets or gifts into a discretionary trust it is possible to make a claim for the trustees to take over the settlor’s indexed base cost, thus deferring any tax charge until the trustees sell the asset. This is known as holdover relief and was commonly used to “restart” the taper relief clock where assets were owned which only partly qualified for the more generous taper relief on business assets.

Previously holdover could be claimed even if the Settlor was the principal beneficiary under the trust. However, following the Finance Act 2004, holdover cannot be claimed if the Settlor has any interest, actual or potential, under the trust.

The other change to holdover relief concerned its interaction with private residence relief for Capital Gains Tax purposes. If the base cost for a property is affected by a holdover claim, main residence relief will no longer be available for disposals of the property after 10 December 2003.

Thus if a property is transferred to a trust, and the Settlor makes a claim for holdover relief, main residence relief will not be available on a subsequent disposal by the trustees of the property, even if the property has been occupied by a beneficiary of the trust as his or her own residence.

Similarly, if a property is transferred out of a trust to a beneficiary who then uses it as his or her main residence, the beneficiary will not be able to claim main residence relief if the transfer out of the trust is the subject of a claim to holdover relief.

Again, the purpose of this further legislation is to prevent taxpayers from “washing out” capital gains by transferring a property to a beneficiary who uses it as his or her residence so that the entire gain becomes exempt even though the property was only used as such for part of the period of total ownership.

Finance Act 2005

When the income tax changes to trusts were announced in 2004, it was suggested that further reforms might follow in order to assist trusts with low levels of income and also trusts with ‘vulnerable beneficiaries’, the latter being disabled persons and certain infants.

These two reforms have surfaced in the Finance Act 2005. In essence, a trust with a vulnerable beneficiary can, by means of an election, claim to have its income tax liability reduced to that which would be payable if the income were returned on the beneficiary’s tax form. An election is irrevocable once it has been made.

The definition of ‘vulnerable beneficiary’ is very tightly drawn. In a case of disabled persons, it means a person who is incapable of administering his affairs by reason of mental disorder or alternatively is in receipt of an attendance allowance or disability living allowance with a care component at the highest or middle rate. Those not in receipt of attendance allowance, but with entitlement to it if a claim were made, may also qualify.

A ‘vulnerable beneficiary’ may also be a person under the age of 18. Qualifying trusts for minors must give absolute entitlement to the funds at the age of 18 and they must have been established either under the laws of intestacy, or under the will of a deceased parent, or under the criminal injuries compensation scheme.

In all cases, it is a requirement that the income of the trust is not caught by the settlements legislation as being taxable on the settlor. Thus it will not be possible to set up a qualifying trust for a disabled person, if the trust property may revert to the settlor at some future time.

Apart from the income tax benefits of making the election under these provisions, there will also be Capital Gains Tax benefits. So long as the vulnerable beneficiary is United Kingdom resident, gains will be taxable at the rate which would be applicable to gains in his or her hands, and not at the 40% trust rate.

The second reform in the Finance Act 2005 introduced a reduction in the 40% rate applicable to trusts for the first £500 of income arising to accumulating and discretionary trusts. This relief is available to all such trusts, and is not dependent on any election. The income within the £500 band is chargeable at either the basic rate, the lower rate or the ordinary dividend rate, depending on the nature of the income. Amounts of tax paid at the basic rate or the lower rate on this band of income then go into the trustees’ tax pool. However, payments to beneficiaries continue to be certified net of 40% tax so that the new £500 band will effectively be withdrawn if the trust income is fully distributed.

Further reforms to come

A consultation exercise is still being conducted by the Revenue as regards other aspects of the taxation of trusts. One of these relates to the residence of trustees and, in particular, cases where there are some non-resident trustees and some resident ones. This will be mainly of relevance to those who have set up offshore trusts where there is one professional trustee acting who is resident in the United Kingdom. The position of these trusts could be affected under possible changes to be made next year.

Another possible reform would affect discretionary trusts. At present these pay income tax at the effective rate of 25% on the amounts of dividends received, and at the rate of 40% on all other sources of income. Payments to beneficiaries are certified as having been made after deduction of tax at 40% and these notional tax deductions have to be matched with a pool of the tax actually paid by the trustees. If there is a shortfall in the pool of actual tax payments as compared with the certified deductions, that shortfall has to be paid over to the Revenue.

This system may change under some proposals under discussion. A possible reform would allow trustees a period of time after the end of each fiscal year (possibly 9 months) in which to make distributions of that year’s income, and to the extent that they do this the trust rate of 40% will not be due on the payments made. Under this new system, the trustees’ pool of tax payments made to the Revenue would be phased out and so those who have set up discretionary trusts should seek further advice in the spring of 2006 as to the best way forward. It may be advisable to make distributions of accumulated income to beneficiaries, so that the 40% tax paid by the trust can be certified out to them and potentially recovered by them, depending on the tax position of the beneficiaries concerned.

Another change under consideration relates to trusts with sub-funds. For example, children’s trusts have been very popular tax planning tools for many years and in some cases it has been appropriate to set up individual funds for each child. However, the tax legislation does not recognise the existence of separate funds and this can give rise to various problems; for example capital gains tax losses of one fund may be automatically set against gains of another fund. The Revenue is considering whether to introduce new legislation enabling trustees to elect to have the different funds treated as separate entities for tax purposes. At present it appears that this idea will be mainly of interest to newly formed trusts, as the Revenue is reluctant to allow any concessions where an election is made in an existing trust; the election will mean funds passing from one entity for tax purposes (the existing trust) into a new entity (the new sub-fund) and this will result in a Capital Gains Tax disposal without any holdover relief. It remains to be seen whether the Revenue will change its mind and offer any reliefs in this area.

You will already have gathered that the reforms that have been introduced and those that are expected to be announced provide a number of questions over the benefit or using a trust. We are experienced in helping clients to make decisions over types of trust and the running of them and we shall be pleased to assist you. Please do not hesitate to contact us to discuss your particular situation.

FOR GENERAL INFORMATION ONLY

Please note that this answer is not intended to give specific technical advice and it should not be construed as doing so. It is designed to merely alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.

© 2006 - Gordon Leighton.

Gordon Leighton is registered to carry on audit work by the Institute of Chartered Accountants in England and Wales