The taxation of trust income and gains (Part 3)

Introduction

In this third article in a series of four, we review the tax treatment of capital gains arising in connection with UK-resident trusts. The trustees of a UK-resident trust may be liable to pay UK capital gains tax (CGT) on the trust’s worldwide assets. The rules for CGT for non-UK resident trusts are complicated and beyond the scope of this series of articles. 

CGT is broadly relevant when a person disposes of a chargeable asset.  Where a profit (or gain) arises, a capital gain arises.  If the asset has reduced in value a loss arises. 

In this article we consider the CGT implications for trusts in the following circumstances:

i)   The transfer of assets into a trust on its creation or when additional assets are transferred into an existing trust.

ii)  The management of trustee investments by the trustees whilst the trust subsists.

The liability to CGT falls on trustees of a settlement.  For CGT the word ‘settlement’ refers to the situation where property is held in trust except where it is an absolute (bare) trust. In this article therefore the term ‘settlements’ means discretionary trusts, interest in possession trusts and A&M trusts but not absolute (bare) trusts.

 

CGT and the transfer of assets into trust 

On the transfer of assets into trust, gifts of chargeable assets (ie. excluding any exempt property, such as cash and gilts) will normally constitute disposals for CGT purposes as well as being transfers of value for inheritance tax (IHT) purposes.  For these purposes, because the settlor and the trustees will be connected, any capital gain arising will be based on the market value of the asset less the base cost.  Any capital gains tax liability will fall on the settlor.  In a number of cases, it may be possible to claim “hold-over” relief.  This effectively defers the taxation of the gain that arises at that time until subsequent disposal by the trustees. 

Subject to certain restrictions, this hold-over relief can apply to all gifts (PETs or chargeable transfers for IHT) of qualifying business and agricultural property under section 165 Taxation of Chargeable Gains Act (TCGA) 1992; and to transfers of any assets which are otherwise immediately chargeable for inheritance tax purposes (e.g. transfers to all trusts other than absolute trusts and trusts for the disabled) – under section 260 TCGA 1992 – except where the transfer is into a trust under which the settlor, the settlor’s spouse/civil partner or minor unmarried children not in a civil partnership can benefit.  

The hold-over relief is given, in effect, by deducting the held-over gain from both the gain otherwise accruing to the transferor (settlor) and from the consideration regarded as having been given by the transferee (trustees) - section 260 TCGA 1992.  The effect is that if the whole of a gain is held-over the settlor pays no CGT and the CGT base cost for calculation of the gain on a later disposal by the trustees is reduced by the gain.

In determining whether to make any gift (even where hold-over relief is available) it is, of course, essential to weigh up the competing merits of future IHT and (possibly) CGT savings against the loss of the benefit of the current capital gains tax-free uplift in the value of the assets in question following the death of the disposer. The age and health of the disposer would need to be carefully taken into account as well as a consideration of the likely future rates of tax applying to capital gains.

The ability to hold over or (defer) capital gains in respect of a transfer into a trust that constitutes a chargeable transfer can yield some valuable benefits.  However, the value of those benefits has diminished following the introduction of certain provisions to restrict the availability of hold-over relief in certain circumstances. For example, provisions exist to:-

i)   Prevent a claim for hold-over relief on the transfer of a private residence into a trust and a claim for principal private residence relief at a later date on the held-over gain

ii)  Prevent a claim for hold-over relief when an asset is transferred into a trust under which the settlor, settlor’s spouse/civil partner or minor unmarried children not in a civil partnership can benefit

Trusts that are eligible for hold-over relief

For hold-over relief to be available on the gift of an asset to a trust the gift must be a chargeable lifetime transfer.  The IHT changes to the tax treatment of trusts introduced in March 2006, (with the result that, basically,  all trusts created during lifetime, other than absolute trusts and trusts for the disabled, are now taxed for IHT purposes in the same way as discretionary trusts), means that hold-over relief is available to all such trusts under section 260 TCGA (except for transfers into an excluded property trust when hold-over relief will not be available). 

However, hold-over relief is not available on transfers into a trust under which the settlor, the settlor’s spouse/civil partner or settlor’s minor unmarried children not in a civil partnership can benefit. 

It should be noted that hold-over relief is widely available when assets are transferred out of a trust and the transfer is immediately chargeable to IHT including trusts under which the settlor, settlor’s spouse/civil partner and minor children not in a civil partnership can benefit. 

CGT and the management of trustee investments whilst the trust subsists

We now consider the sale or transfer of assets by the trustees giving rise to capital gains during the administration of the trust.

In this section, a distinction is drawn between

A)   Settlements, which have all the features of a trust. These include discretionary trusts, interest in possession trusts and A&M trust

B)  Absolute (bare) trusts.

C)   Special trusts such as trusts for the disabled – this subject will be covered in the next article.

 

3A.    Settlements

i)   The liability to CGT

Trustees of a settlement will be liable for CGT on the disposal of chargeable trust assets. A disposal generally takes place when trustees dispose of chargeable trust assets by way of sale of trust assets, for example stocks and shares.

ii)  The rates of CGT

Most settlements are eligible for an annual exemption equal to one-half of that available to an individual (ie. £6,150 for tax year 2020/21). The annual exemption can be reduced when the settlor has created more than one settlement – see section (iii) below.

Chargeable capital gains that exceed a settlement’s annual exempt amount will, in general, suffer tax at 20%. However, gains on the disposal of residential property that is not the main private residence of a beneficiary, and on carried interest, suffer tax at 28%.

iii) The annual exemption

Settlements created before 7 June 1978

For each settlement an outright exemption of one-half of the full annual exemption for an individual - £6,150 for tax year 2020/21.

Settlements created after 6 June 1978 (single settlor)

Paragraph 2 of Schedule 1 Taxation of Chargeable Gains Act (TCGA) 1992 provides that the annual CGT exemption available to trustees of a settlement is one-half of that available for individuals. The trustees’ annual exemption for tax year 2020/21 is therefore £6,150.

However, under the anti-fragmentation rules, where a settlor has made more than one current “qualifying” settlement the exemption is split proportionately between all of the settlements with the proviso that the exemption for anyone settlement is a minimum of one-tenth of the full annual exemption, that is currently £1,230. 

A “qualifying” settlement is one made after 6 June 1978.  Such settlements include settlements arising under a Will or an intestacy.  Trusts of life policies also count as “qualifying” settlements even though a life policy is generally not subject to CGT.

A settlement for the disabled which satisfies certain rules is not a “qualifying” settlement for this purpose and the trustees of such a settlement enjoy a full annual exemption.  However, the annual exemption (subject to a minimum of £1,230 per settlement) is reduced proportionately where more than one such disabled settlement has been made after 9 March 1981.

“Excluded” settlements are also not treated as “qualifying” settlements.  Such excluded settlements cover any settlements where:

• the trustees are not resident in the UK for the whole or any part of the tax year;
• the trust property is held solely for charitable purposes;
• the property is held for the purposes of certain pension schemes and funds which are exempt from a charge on capital gains.

When calculating the CGT annual exemption available to a UK-resident trust, any trusts created by the same settlor which are non-UK resident trusts are ignored.

Settlements created after 6 June 1978 (multiple settlors)

The position where there are multiple settlors is dealt with in paragraph 6 of Schedule 2 TCGA 1992. Where a settlement is comprised in two or more groups (because it has two or more settlors), and the groups themselves are comprised of different numbers of settlements, the annual exempt amount is divided by the number of settlements in the largest group.

For example, three settlors create a trust (trust A). Trust A, assuming it is a qualifying settlement, is comprised in three groups because there are three settlors.  However, there is only one settlement in each group (assuming none of the settlors has created other trusts).  Therefore, the annual exemption in this case would be £6,150 as the greatest number of settlements in a group is one. 

If one of the settlors creates another trust (trust B) the standard rule will apply so that the new trust (B) would have an annual exemption of £3,075 because this is the second trust created by the same settlor.  The annual exemption for the old trust (A) would be reduced under the multiple settlors rule because the largest group now has two settlements in it.  The annual exemption for this trust would therefore reduce to £3,075.

  

3B.  Absolute (Bare) Trust

i)   The liability to CGT

The beneficiary under an absolute trust is absolutely entitled to capital of the trust which means that any capital gain that arises in connection with a trust asset is assessed to tax on the beneficiary in his or her personal capacity.  Therefore, the beneficiary is liable for payment of the tax on any capital gain.

ii)  The rates of CGT

Any chargeable capital gain is treated as the most highly taxed part of the beneficiary’s income for the tax year of disposal.  Any gain falling within the basic rate tax band suffers tax at 10% and other gains at 18%.  Gains on residential property and carried interest suffer tax at 18% or 28% as appropriate.    

iii)  The annual exemption

Each individual beneficiary is entitled to a full individual’s annual exemption, which for tax year 2020/21 is £12,300.  Unlike the rule for settlements there is no reduction in the annual exemption when a settlor creates more than one absolute trust, nor is an absolute trust taken into account as a qualifying trust in determining whether the annual exemption for a settlement is reduced.

 

 

In the next article, we will continue with a review of special trusts, other reliefs available, the reporting of capital gains, the tax treatment on the termination of a trust and the tax treatment when beneficiaries become entitled to benefits under a trust.