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Discretionary Will Trusts
Many financial advisers I have worked with really want to know the tax benefits of the different types of trusts. I have therefore started with an explanation in relation to Discretionary Will Trusts which must be differentiated from Lifetime Discretionary Trusts set up during a person’s lifetime, outside of their Will.
Wherever there is a separation of legal title and beneficial ownership, a trust arrangement will exist. In this relationship, the Trustees actually own the assets. However, the Trustees must not benefit from those assets themselves. Instead, the Trustees have a duty to use the income and capital of the trust for the benefit of the beneficiaries, as instructed by the Trust Deed.
Family trusts set up by Will are not contentious or controversial and are not black listed by HMRC and do not fall foul of recent anti-avoidance legislation.
In a trust set up by a Will, the trust is created on the date of death of the testator. Trustees are a separate legal person. Trustees as a legal body will themselves have income tax, capital gains tax and inheritance tax liabilities and will have to file self-assessment tax returns. The same self-assessment rules apply to Trustees as they do for individuals. No personal allowances are available to reduce trust income. When calculating the income tax liability of the trust, the same rates of tax usually apply regardless of the levels of trust income. The various rate bands, which apply for individuals, do not apply for trusts. A trust cannot be an employee; therefore, trusts will never receive employment income. The sources of income in a trust tax computation are normally restricted to rent, interest and dividends.
The beneficiaries of the trust are the only persons who are entitled to use or enjoy the income or assets of the trust.
If a Trustee appoints an asset to a beneficiary (they are deemed to have disposed of the asset at market value) or sells a trust asset at market value, this is a disposal by the Trustees for capital gains tax purposes and capital gains could arise. Trustees receive an annual capital gains tax annual exempt amount, which is equal to half of an individual’s annual exempt amount (currently £12,300, so £6,150 for a trust). The Trustees annual exempt amount is divided by the number of UK trusts settled by the same settlor/testator (the person who set up the trusts) after the 6th June 1978. Overseas trusts and trusts no longer in existence are ignored for this purpose..
If either Trustees distribute income to a beneficiary, at their discretion or in accordance with the beneficiaries entitlement e.g. Life Tenant (who has the right to income - see below), that income is charged to income tax in the hands of the beneficiary.
Any trust, which is liable to UK income tax or capital gains tax, must register with HMRC using their online trust registration service.
There are various different types of trusts and the three that we will be primarily looking at from the perspective of your Will are Discretionary Trusts, Life-interest Trusts (sometimes called Interest in Possession Trust) and Protective Trusts.
Discretionary Will Trust
A discretionary trust is the most flexible form of trust as it enables the Trustees to use and distribute the income and capital of the trust entirely at their discretion. They have the power to either retain or distribute income as they see fit.
A. Inheritance Tax position for Discretionary Will Trusts
If an individual leaves his entire estate to a discretionary trust, this is a chargeable transfer for inheritance tax purposes on death. This will be the case even if the spouse is a beneficiary of the discretionary trust. As the whole of the estate has been left to a chargeable beneficiary, inheritance tax is payable in full.
A distribution by a discretionary trust, will normally give rise to an exit charge. However, any distributions from a discretionary will trust within two years of death are deemed to have been made by the deceased in the will. This means that no exit charge arises and if the Trustees make a distribution to an exempt beneficiary such as a spouse or charity, this is treated as having been made by the deceased in his will and is therefore an exempt transfer. As inheritance tax would already have been paid by the executors on the basis that the whole of the estate is chargeable because it went to a discretionary trust, a distribution to an exempt beneficiary, for example to a spouse, will lead to an inheritance tax repayment.
Once two years have elapsed, the normal rules for discretionary trusts apply i.e. exit charges and principal charges (see below).
If a beneficiary of a discretionary trust dies, no part of the discretionary trust will fall within the beneficiary’s estate.
Because, under normal circumstances, HMRC cannot levy an inheritance charge on a discretionary trust beneficiary, any inheritance tax charges will arise on the trustees instead.
There are two types of inheritance tax charge on the Trustees of a Discretionary Will Trust. The first is the principal charge that arises on each 10th anniversary from the creation of the trust (which is the date of death). This is at most a 6% charge on the revaluation of the trust fund less the available nil rate band (currently £325,000).The second is the exit charge when the discretionary trust distributes cash or capital assets to a beneficiary.
No exit charge will be levied where income is distributed.
To calculate the actual rate of tax, you have to look at the inheritance tax history of the creator of the trust because it is affected by their cumulative chargeable transfers (i.e. the number of other trusts they’ve set up) in the 7 years before the creation of the current trust and by any other trusts set up by them on the same day (i.e. where they have set up two different trusts in their will). The calculations are quite complex and I do not intend to explain them here.
B. Income Tax on Discretionary Will Trusts
Discretionary trusts are particularly useful when the trust is established for minor beneficiaries because the terms of the trust will enable trust income to be accumulated during periods when the beneficiaries are too young to receive the money. It is therefore the preferred vehicle to a life interest trust where the beneficiary has an entitlement to the net trust income, irrespective of their age.
From an income tax perspective, trust income that is distributed to the beneficiary belongs to the beneficiary. This effectively means that the income tax, which was paid by the Trustees via the self-assessment process, will come back to the beneficiary if their marginal tax rate is lower than that of the trusts.
The Trustees pay tax as follows:
Non-savings income is charged to income tax at a flat rate of 45%. Interest is also charged at 45%. Dividends are charged at 38.1%. To arrive at income, which is chargeable, some relief is available for trust management expenses; the 45% only applies to income, which is available for distribution. If the Trustees have received some income and that income has been used to meet expenses of the trust, such income is not available for distribution and is not chargeable at 45% or 38.1%. Only expenses, which are properly deductible against the income of the trust, may be relieved. This means that any expenses, which should be charged against the capital of the trust, for example, legal fees associated with capital items, cannot be deducted for income tax purposes. Trust management expenses are set against dividend income in priority to other income. Next they are set against interest and finally against non-savings income. The expenses are grossed up before deduction to reflect the type of income it’s being deducted from, for example, if a trust expense of £925 has been incurred, the Trustees must have earned a dividend of £1000 to meet that expense.
The first £1000 of income is taxed at 20% or 7.5%. This rate applies to non-savings income in priority to interest and in priority to dividends.
C. Capital Gains Tax on Discretionary Will Trusts
There is no similar, two-year rule, for capital gains. Instead, for capital gains tax purposes where assets are distributed from the discretionary will trust before the end of the executor’s administration period, these are treated as having been made on death at probate value. No capital gains tax liability will therefore arise in the discretionary trust on asset appointments out of the trust to discretionary beneficiaries until the administration period has been completed.
Once the administration period has been completed, any disposal or deemed disposal, by the Trustees, of an asset will be subject to capital gains tax. For example, on the appointment out of the asset to a discretionary beneficiary. The disposal takes place at market value.
Business Asset Disposal Relief – This would be relevant if the trust owned a business and is a capital gains tax relief available to tax payers who sell or give away their businesses. It reduces the rate of capital gains tax on disposals that qualify for Business Asset Disposal Relief to 10%. It is not available for purely discretionary trusts. It is necessary for the discretionary trust first to create an interest in possession (a right to income), which can be revocable or irrevocable. Please see section on Life Interest Will Trusts for further details.
Investors Relief – This again is not available to a purely discretionary trust. The Trustees will need to seek advice and consider the implications of meeting the criteria of creating a life interest in order to obtain the relief. The relief enables individuals to claim relief on a disposal of shares in an unlisted trading company in which they do not work. Please see section on Life Interest Will Trusts for further details.
Principal Private Residence Relief – if the Trustees own a Trust property and they permit one or more beneficiaries to occupy that property as their only or main residence, Principal Private Residence Relief is available on the subsequent disposal of the property. The following periods are exempt for Principal Private Residence Relief: (i) the period during which the property was occupied by the beneficiary; (ii) the last 9 months of ownership; (iii) deemed occupation period which include periods of absence up to 3 years, periods of absence during which the beneficiary was abroad by reason of his or her employment and periods of absence up to 4 years where the beneficiary was required to work elsewhere. The seemed occupation periods can only apply to trust gains where the same beneficiary occupied the trust property, both before and after the period of absence.
Principal Private Residence Relief is restricted where at the time the property was transferred to the trust, gift relief was claimed to roll the settlors gain against the Trustees base cost. Clearly, this would only be necessary on a lifetime gift into trust and not when the trust is set up on death, since the value of the property would be subject to inheritance tax and not capital gains tax on death. However, it is relevant where the Trustees of the Discretionary Will Trust appoint a property to a beneficiary and gift relief is claimed on that deemed disposal to the beneficiary. If the beneficiary then occupies the property as his only or main residence, Principal Private Residence Relief will not be given to that individual when they sell the property. It may therefore be preferable to NOT make a Gift Relief claim on appointment of the property out of the trust to the beneficiary absolutely and instead, for the Trustees to pay the capital gains tax liability on appointment of the property out of the trust. This will enable the beneficiary to claim full Principal Private Residence Relief on a later disposal by them.
Discretionary trusts pay exit charges when assets are appointed out to a discretionary beneficiary absolutely. If it is an asset subject to capital gains tax, then there may also be a chargeable gain upon which capital gains tax is due. In such cases, the inheritance tax paid on the transfer to the discretionary beneficiary is an allowable deduction for the beneficiary for capital gains tax purposes. It can be treated as an additional cost incurred by the beneficiary in acquiring the shares, in the event of a future disposal.
D. Tax position of the beneficiaries of Discretionary Will Trust
Any income distributed to a beneficiary of a discretionary trust is deemed to have been paid net of a 45% tax credit. This 45% rate applies irrespective of the type of income actually received by the Trustees. For example, if the Trustee’s only source of income is UK dividends, on which tax is paid at 38.1%, if that income is subsequently distributed to a beneficiary, it will still carry a 45% tax credit. The beneficiary may then be able to claim a repayment of tax if they are a basic rate or higher rate taxpayer.
As the beneficiaries in receipt of income distributions can always claim a tax credit of 45%, HMRC must have a method of making sure that any tax reclaimed by beneficiaries does not exceed the tax originally paid by the Trustees. They do this by asking the Trustees to maintain a tax pool. The tax pool is a running total of tax paid by the Trustees, less any tax credits, which have been taken out of the pool by the beneficiaries. Tax on income used to pay trust management expenses does not enter the pool. Receipts of a capital nature that are charged to income tax e.g. gains on life assurance policies are entered into the pool, but the tax stated is restricted to 25% of the chargeable income. Whenever beneficiaries claim tax credits on distributions, the balance in the pool will go down. Where a tax pool becomes negative, the Trustees must make up the difference and pay it under self-assessment. This usually happens when some of the trust income received is from dividends. Therefore, Trustees with an asset base consisting mainly of shares need to be careful when deciding how much income to pay out. The tax pool will close when the trust is wound up i.e. when Trustees make a decision to distribute all remaining funds to the beneficiaries. Any tax credits within the tax pool at that point will not be repaid by HMRC. They will then be lost, so it is common planning for Trustees to make sufficient income distributions just before the trust is finally wound up to enable the beneficiaries to take advantage of the 45% tax credit, which often leads to tax repayments to the beneficiaries.
There are interest restrictions for property income. No interest costs are deductible from rental income. Instead, discretionary trusts receive tax relief for the disallowed interest as a tax reducer. The tax reducer is the lower of (i) the interest costs disallowed; and (ii) the taxable profits of the rental business x 20%. The tax credit is therefore 45% of the property business profits after the disallowance of interest.
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