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Reviewing trust investments in April 2013

As announced in the Budget 2012, the additional rate of income tax paid by individuals has come down from 50% to 45% from 6 April 2013.  In line with this the rates of income tax paid by trustees of discretionary trusts have also reduced from 42.5% to 37.5% for dividend income that is accumulated and from 50% to 45% for all other income.

The CGT rate paid by trustees remains at 28% but the annual exempt amount has gone up to £5,450 from £5,300.

Any changes in taxation should be a trigger to review investments held by trustees. This month we will have a brief reminder of the legal and tax fundamentals. Next month we will look at some specific investment strategies for trustees.

A. The trustees' duty to review investments

The key principles of trustee investment and the duties imposed on trustees are governed inEnglandandWalesby the Trustee Act 2000 (TA).  Of these the most important are:

(i) Duty to have regard to the need for diversification and suitability of investments to the trust- these are known as the "standard investment criteria" (Section 4 TA).


The requirement is to consider/have regard to the need for diversification - there is no actual duty to diversify all trust funds. Where it is appropriate, to diversify the trust fund means that the trustees should use a spread of investments.


"Suitability" relates both to the kind of investment proposed and to the particular investment as an investment of that kind.  It includes considerations as to the size and risk of the investments and the need to strike an appropriate balance between income and capital growth to meet the needs of the trust. It also includes any relevant ethical considerations as to the kind of investment that is appropriate for the trust.

Most importantly there is a further requirement for the trustees to keep the investments of the trust under review  and to consider whether, in light of the "standard investment criteria", they should be varied.

(ii) Duty to obtain and consider proper advice 

The following provisions in the TA govern the need for trustees to obtain advice (Section 5 TA):- 

  • before exercising any power of investment, the trustees must obtain and consider proper advice about the way in which that power should be exercised, having regard to the need for diversification of investments of the trust and the suitability to the trust of the proposed investment;
  • when reviewing the investments of the trust, the trustees must obtain and consider proper advice about whether, having regard to the "standard investment criteria", the investments should be varied. 

The requirement to obtain advicedoes not apply if the trustees reasonably conclude that in all the circumstances it is unnecessary or inappropriate to do so.  This may cover a case where, for example, the trust fund is small and the cost of advice would outweigh the benefit of it; or if the trustees are suitably qualified and can provide this advice at reasonable cost.

For these purposes proper advice would be the advice of a person who the trustees reasonably believe to be qualified to give it by his ability in, and practical experience of, financial and other matters relating to the proposed investment.

It should be noted that the duties to take advice in making/retaining investments and in relation to the standard investment criteria apply to all trusts (i.e. not just those where the statutory power of investment under the TA applies) and are non-excludable, that is, they cannot be excluded by an express provision in a trust document.

B. The taxation of trust investments - key rules

As far as trust investments are concerned, of key importance are income tax and capital gains tax (CGT). We will therefore concentrate on these two taxes to the exclusion of inheritance tax.

(i) Income tax

Discretionary trusts

  • Standard rate tax band

Trustees of discretionary trusts have a standard rate tax band of £1,000. The first £1,000 of income they receive is not taxed at the higher trust rates.  As the income would normally have been received with a tax credit equal to the lower  (20%) rate or a 10% dividend tax credit this means that no further tax will be payable.  The standard rate band is divided by the number of trusts created by the same settlor but does not go below £200 for each trust. 

Clearly, the existence of the standard rate band will be useful for a number of "smaller" trusts. Given an average gross yield of, say, 2%, a trust fund of £50,000 would receive all its income within the standard rate income tax band with no further tax due.

It may be that trustees will wish to maximise the amount of income that falls within the standard rate band even if they would not otherwise necessarily invest for income.  Whilst most trusts created for children would generally be investing for growth, it is often desirable to keep a certain amount in income-producing assets to provide for occasional payments to beneficiaries.  Within the current level of the standard rate band, £1,000 of gross income can be produced tax efficiently. 

In most cases, the trustees will be able to either accumulate the income within the trust and add it to capital, or distribute it as income.  Given the potential IHT exit charges on distributions of capital, some trustees may consider distributing income, as and when required, as income rather than capital.  Much will depend on the tax position of the beneficiary (and whether the settlor-interested trust rules apply - see below).

  • Trust tax rates

From 6 April 2013 income received by trustees in excess of the standard rate band is taxed at 37.5% if dividend income and 45% if other income. Previously the trust rates were 42.5% and 50% respectively, i.e. the equivalent of the rates which applied to additional rate taxpaying individuals.

Where income is to be distributed to a beneficiary, the trustees must first have paid 45% income tax on the income they have actually received regardless of its source. For these purposes tax already actually paid by the trustees on "received" income and the tax credit on savings income will count but the 10% tax credit on dividend income cannot be taken into account for this purpose.  Before distributing dividend income to a beneficiary, a further income tax liability will therefore arise on the trustees. 

The beneficiary will then be taxed on the income received from the trust grossed-up to take account of the tax credit in respect of the tax paid by the trustees.  Where the beneficiary is not an additional rate (45%) rate taxpayer, a tax reclaim may be made.

Interest in possession trusts (including bare trusts)

Interest in possession trusts - where a beneficiary is entitled to trust income as it arises, e.g. in life interest trusts - are subject to different rules. Here 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 where the beneficiary is a minor and unmarried (and not in a civil partnership) child of the settlor/donor. In such case the assessment will be on the parental settlor/donor if the income exceeds £100 gross in a tax year (when added to income from all other gifts made by that parent to that child).  There is also a special rule in respect of gross income received by the trustees - see below in connection with offshore funds.

One important point to remember about investments for interest in possession trusts which are not bare trusts (e.g. flexible power of appointment trusts), is that any income that arises needs to be either paid over to the beneficiary immediately ( a preferred route)  or at least identified and kept for the absolute benefit of the beneficiary entitled to it. For this reason investments in accumulation funds will never be appropriate for such trusts. This, of course, is not relevant to bare trusts where the same beneficiary is entitled to both the income and capital of the trust.

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 (37.5% and 45% as appropriate) on income in excess of the standard rate band. The trustees will therefore effectively pay tax on behalf of the settlor. If the settlor pays a lower amount of tax on the income than that paid by the trustees, the tax overpaid by the trustees can be reclaimed from HMRC. Any such reclaimed tax must be paid back to the trust. 

Generally, the above rule means that for those settlors who are not additional rate taxpayers (i.e. those whose taxable income does not exceed £150,000) the inclusion of the settlor's spouse may result in a reduced overall income tax liability. However, it will not reduce the amount of administrative work for the trustees.  For those still contemplating the appropriate trust for their circumstances this point is therefore something to carefully consider. One would generally not recommend the inclusion of the settlor themselves as a beneficiary as such a trust will be ineffective for IHT purposes.

Bonds as trustee investments

The above rules apply where "real" income is received by the trustees. Different rules apply where the investment is a single premium (life assurance or capital redemption) policy - here called  a "bond".

When a bond held subject to trust is encashed (fully or partially), a chargeable event gain can arise that will be subject to income tax.  Who that gain is taxed on depends on the type of trust, and whether the settlor is alive or not and whether they areUKresident.

Bare trusts

With a bare trust, the chargeable event gains will normally be assessed on the beneficiary, even if the beneficiary is a minor (i.e. under age 18) .  The exception to this applies during the minority of a beneficiary (who is unmarried and not in a civil partnership) in cases where the trust funds were provided by the parent of the beneficiary and the gains exceed £100 in a tax year (when added to income from all other gifts made by that parent to that child).  In those cases chargeable event gains will be assessed on the parent.

A 20% tax credit will apply if the bond is aUKbond which means that a liability will only arise if the beneficiary (or the parental donor) is a higher rate (40%) or additional rate (45%) taxpayer.  This credit will not be available for gains made under offshore bonds.

Trusts other than bare trusts

 (i) During the settlor's lifetime and in the tax year in which the settlor's death occurs 

For income tax purposes, any chargeable event gains arising under the bond will be assessed on the settlor provided the settlor is alive andUKtax resident.  If there are joint settlors, each will be assessed on one half of the gain. A 20% tax credit will apply if the bond is aUKbond which means that a liability will only arise if the settlor is a higher rate (40%) or additional rate (45%) taxpayer.  This credit will not be available for gains made under offshore bonds.

(ii) After the end of the tax year in which the settlor's death occurs or in a tax year in which the settlor is non-UK resident.

Any chargeable event gains arising in a tax year after that in which the settlor died (or in a tax year in which the settlor is non-UK resident) will be assessed on the trustees if they areUKresident. The first £1,000 of gain (assuming the settlor has not made other trusts) is taxed at the "standard rate", which is 20%, and the rest at the special rate of 45%.  A 20% tax credit will be available forUKbonds as noted above. 

Offshore funds as trustee investments

Special rules apply to some investments held offshore. Offshore bonds have been dealt with above.

Offshore collectives offer the choice of reporting funds (prior to 2009 these were known as "distributor" funds) and non-reporting funds (previously known as "non-distributor" or "roll up" funds).

Reporting funds are taxed in the same way asUKcollectives except, of course, the income will be received gross.  An investment in a reporting fund can therefore be used as a means of generating income to utilise a beneficiary's personal income tax allowance. Obviously, this will be most useful where a beneficiary is entitled to income under a trust.  Not only will the income arising generally be tax free in the jurisdiction in which it arises but enhanced returns may be available and the payment will be made gross so no reclaims are required - as long as the income is paid directly to the beneficiary. If the gross income is paid via the trustees of an interest in possession trust, the trustees will have to account for tax at basic rate and pass the income on to the beneficiary with an equivalent tax credit. This is the exception to the rule that under an interest in possession trust only the beneficiary is taxed on trust income - see above.

Non-reporting funds continue to offer tax deferment as, generally¸there will be no tax to pay until the shares/units are encashed or otherwise disposed of (as defined for CGT purposes).  Consequently, any income entitlements will roll up within the fund free of any immediate liability toUKtax. However, the offshore income gain that will arise on a "disposal" will be subject to income tax, with no CGT annual exemption available

(ii) Capital gains tax

Here the rules also depend on whether the trust is a bare trust or another type of trust.

Under a bare trust, all gains are assessed on the beneficiary at the beneficiary's rate, regardless of who provided the funds. The beneficiary is entitled to an annual exemption of £10,900 from 6 April 2013. Clearly, bare trusts are the most efficient from a CGT standpoint.

For all other trusts, since June 2010 the CGT rate paid by trustees is 28 % - regardless of the level of other income or gains. By comparison, in the case of individual taxpayers, the 28% CGT rate only applies to gains which, when added to other income subject to tax, exceed the higher rate threshold (£41,450 for 2013/14). Gains made by individuals that exceed their annual exemption but fall below this threshold are only subject to CGT at 18%.

Trustees are entitled to their own annual CGT exemption which is equal to one half of the exemption for an individual, ie £5,450 from 6 April 2013.   If the settlor has created more than one trust (ignoring bare trusts) since June 1978 the annual exemption is divided between such trusts, but will not fall below one tenth of the full exemption available to individuals, i.e. £1,090 for each trust. For this purpose it does not matter whether the investments held in the trust are subject to CGT; so, for example, any life assurance trusts (other than bare trusts) must also be taken into account for this purpose.

It should be noted that the settlor-interested trust rule (under which capital gains of the trust used to be taxed on the settlor) no longer applies, except in relation to a claim for "hold-over" relief. Notably, no such relief is available when assets are transferred to a settlor-interested trust (for this purpose a settlor-interested trust includes one under which a settlor's minor unmarried child, who is not in a civil partnership, is a beneficiary. However, the same restriction does not apply on transfers out of trusts - obviously this is only relevant to trusts which are relevant property trusts for IHT purposes.


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 outlined above. Next month we will look in more detail at some specific investment strategies for trustees.