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New tax year for trusts, trustees and beneficiaries

Although the March 2016 Budget did not include any specific  announcements in relation to trusts, the announced  changes to the capital gains tax (CGT) rates, with effect from 6 April 2016, do of course affect trustees as much as any other taxpayer. In addition to the CGT changes, the key tax changes taking effect from 6 April 2016 are those announced in 2015 and which relate to income tax, namely the introduction of the personal savings allowance (PSA) and dividend allowance, as well as gross payments of interest from banks and building societies and the new dividend tax rates coupled with the abolition of the dividend tax credits. This month we will review all of these changes and consider how they may affect trustees' decisions, in particular in relation to the investment of trust funds. 

First a brief refresher of some basic rules, then the details. As always tax considerations depend on the type of trust under consideration.

The Basics 

Bare trusts

For income tax and CGT bare trusts are generally ignored unless (for income tax purposes only) the parental settlor provisions apply. This means that under a non-parental bare trust all income and, under any bare trust, all capital gains are assessed on the beneficiary at the beneficiary's tax rate(s). The PSA and the dividend allowance are available as well as the full annual CGT exemption.

Discretionary trusts

Trustees of discretionary trusts have a standard rate tax band (SRB) of £1,000. Income within the SRB is taxed at basic rate only. The SRB is divided by the number of trusts created by the same settlor but does not go below £200 for each trust. 

Any income in excess of the SRB is taxed at the trust rates. 

For CGT trustees have their own annual exemption (normally equal to one half of the personal exemption but reduced in cases where the settlor has created more than one trust), after which they pay CGT at the trust rates.

Interest in possession trusts (other than bare trusts)

Under interest in possession (IIP) trusts - i.e. where a beneficiary is entitled to trust income as it arises, e.g. in life interest trusts - the income is taxed on the beneficiary entitled to income and so, in these cases, the trust tax rates do not apply.

The exception to this is a trust for the settlor's own minor unmarried child where income is taxed on the settlor, and settlor-interested trusts - see immediately below.

Settlor-interested trusts

A trust will be a settlor-interested trust if either the settlor or the settlor's spouse can benefit under it. This includes trusts under which the settlor may be entitled to loan repayments even if he is not a beneficiary under the trust as such.  In such cases all trust income will be treated as income of the settlor. However, if the trust is discretionary, the trustees will still be liable to income tax at the trust rates. Currently there are no equivalent rules for CGT purposes, except that hold-over relief is not available on transfers of assets to these trusts.

Let's now have a look at the details which apply from 6 April 2016.

Income tax rules from 6 April 2016

IIP trusts

As mentioned above, if there is a beneficiary entitled to the income from a trust (and the income is not assessed on the settlor), the beneficiary will be assessed to tax on trust income at their marginal rate(s) of tax i.e. as if that income were directly theirs and not payable under a trust.

Up until 5 April 2016 trustees of such trusts were only taxed at the basic rate on any income they actually received without a tax credit and the beneficiary then received an equivalent tax credit. From 6 April 2016 individuals (who of course include trust beneficiaries) are entitled to a personal savings allowance (PSA) and dividend allowance.

Until 5 April 2016 interest paid to trustees would normally be paid net of basic rate tax with an equivalent 20% tax credit; and dividends were paid with a tax credit of 10% so that the trustees would have no tax to pay at basic rate. From 6 April 2016 bank and building society interest is paid gross as are dividends. Therefore, trustees will now have to pay basic rate tax (20%) on interest and 7.5 % (the dividend rate for basic rate taxpayers) on dividends unless the income is paid directly to the beneficiary.

If the income isn't paid directly to the beneficiary entitled to it and the trustees pay the basic rate tax then the beneficiary will be entitled to an equivalent tax credit. 

Whether the income is paid direct to the beneficiary or via the trustees, that income retains its nature (i.e. interest or dividends) and so the beneficiary can offset the income against their PSA or the dividend allowance as appropriate.

As  a concession, for tax year 2016/17 HMRC has  announced that trustees will not need to notify it of savings interest income if the trust has no other income and the tax liability on the savings interest income is under £100.

Discretionary trusts

If no beneficiary is entitled to income, then the trustees are taxed at the special trust rates of 38.1% (37.5% until 5 April 2016) on dividend income and 45% on other income above the SRB. Income within the SRB is taxed at the basic rates, i.e. 7.5% on dividends and 20% on interest. 

Until 5 April 2016 interest would normally be paid net of basic rate tax with an equivalent tax credit, and dividends were paid with a tax credit of 10%. From 6 April 2016 bank and building society interest is paid gross, as are dividends. Therefore, trustees will have to pay basic rate tax on the interest and 7.5% on the dividends received within the SRB.

Trustees are not entitled to the PSA nor the dividend allowance.

If the trustees accumulate any dividend income in the trust, as stated above they pay tax at the appropriate rates of 7.5% within the SRB and 38.1% on the rest. However, if they want to distribute that income to a beneficiary, they have to account for tax at 45% which means they will have some additional tax to pay. For example, if the trustees have paid tax at 38.1% on dividends of £1,000, i.e.  £381.00, they will have to pay an extra 6.9%, i.e. £69.00. The beneficiary will then receive the trust income of £550 with a credit of £450 (45%). As this income will be classified as "trust income", neither the PSA nor the dividend allowance will be available to offset against it.  

Settlor-interested trusts

Special rules apply to these trusts as explained earlier. If the settlor-interested trust is a discretionary trust and the trustees have paid the tax at the trust rates (see above), effectively on behalf of the settlor, the settlor receives an equivalent tax credit and, in such cases, the settlor will also be entitled to use their PSA and/or dividend allowance.

Capital gains tax from 6 April 2016

Trustees are now liable to a single CGT rate of 20% on realised gains in excess of their annual exempt amount (regardless of trust type or whether or not the settlor has an interest in the settlement) unless the asset in question is residential property that is not the principal private residence of a beneficiary in which case the rate is 28%.  A 28% rate applied to all trust gains until 5 April 2016.  The exception is a bare trust which is ignored for CGT purposes - see earlier.  

Next month we will look at trustee investments in the light of the above changes, in particular the usual choice of bonds or collectives for trustees. Meanwhile here is a taster of some planning ideas to take on board.

Some planning points

  • If there is a beneficiary entitled to income under a trust (i.e. an IIP trust) the trustees of such a trust should generally not  invest in non-income producing investments, such as insurance bonds or in accumulation units/shares (i.e. where the accumulation of dividends is reflected in the unit/share price). In some cases insurance bonds may be suitable as part of a portfolio to deliver the capital appreciation that the trustees may be seeking to achieve in addition to income.
  • Where the trustees invest in collectives, any dividends declared in relation to those investments, even if reinvested (e.g. in accumulation units/shares), are fully taxable. However, any reinvested dividends can be added to the base cost of the shares for CGT purposes reducing any taxable profit that arises on any future realisation of the units/shares.
  • When investing for growth then, in relation to equity-based investments, the choice will often be between capital investment bonds and collectives.  The pros and cons of each should be considered in every case.
  • For IIP trusts it is important to ensure that any trust income is mandated directly to the beneficiary entitled to the income ( i.e. not via the trustees) if the trustees want to avoid having to make trust tax returns and pay tax at the basic rates.

Conclusions

The changes in the tax rates and the beginning of the new tax year should provide a good opportunity to contact all "trustee clients" with a view to reviewing trust investments. This cannot be done without a full understanding of the tax and legal fundamentals.

The next step for each "trustee client" will be a proper trust fact find and then a review of the investments in the light of the current trustees' and beneficiaries' objectives and the standard investment criteria. As indicated earlier, next month we will look in more detail at some specific investment strategies for trustees.

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