The first article in this series concerning Trusts described the two different types of Trust; two different types of trust potentially means two different sets of tax rules. This article details the current rules for the charge to income tax only for both types of trust, and ends with some ideas as to how to use trusts to reduce tax.
As a reminder, the two types of trusts are:
1. Qualifying Interest in Possession (IIP) Trust - under which the beneficiary has the right to receive the income and
2. Discretionary (‘Mainstream’) Trust - the income is only distributed if the trustees direct; it is not the beneficiaries’ by right.
Qualifying Interest in Possession
The percentage tax charge on income received into an IIP trust is the same as the charge used if the income is received by an individual taxpayer - namely 10% of the grossed-up amount on share dividends and unit trust dividend distributions received (designated the ‘dividend rate’); 20% of the gross amount of bank interest received (the ‘savings’ rate) and for other types of income (for example rents) the basic rate (the ‘standard rate’) is used, which is currently also 20% for the tax year 2011/12.
As the income is the beneficiary’s by right he/she accounts for the income received from the trust on his/her annual tax return declaring the amount of income received net of the tax deducted by the trustees.
Against the annual tax liability the beneficiary is allowed credit for any such tax paid.
Therefore if the beneficiary is a non or lower rate taxpayer he will be entitled to receive a tax refund; the actual amount being dependent upon the type of income, as income taxed at the ‘dividend rate’ cannot be repaid.
If the beneficiary is a higher rate tax payer additional tax will be due on the trust income being the difference between the 50% higher rate of tax less the amount of tax credit on the trust income received.
The rules for the income tax charge on ‘Mainstream trusts’ were revised as from the year 2010/11 such that the tax rate charged on income received by IIP trusts is at a much lower rate than for ‘Mainstream’ trusts.
The tax charge for a ‘Mainstream’ trust is at the ‘trust rate’ which is always levied at the same rate as the top rate of tax charged on individuals. Therefore with effect from 5 April 2010 the tax rate for ‘Mainstream’ trusts on all types of income is 50% (or 42.5% if the income is solely from dividends (called the ‘dividend trust rate’).
Similarly, as for income received by an IIP trust, some income received into the trust will have had tax deducted at source (for example bank interest - 20%) but other income (for example rental income) will have been received gross with no tax credit. Where the trust has received income that has already had tax deducted at source the trustees’ liability to pay income tax will have already been at least partly satisfied.
As a result, on receiving such income after 5 April 2010 the trustees are required to pay a further 30% income tax (e.g. on bank interest) such that the final tax liability will be satisfied at the full 50% rate.
Trustees’ expenses are allowed to be deducted from income being first set against the dividend income received into the trust, if any, followed by any savings income and then finally against any other income; the expenses being grossed up at the relevant ‘trust rate’.
Should the trustees decide to make a payment to a beneficiary, that payment is required to be grossed up at the ‘trust rate’ thereby allowing tax credit at that rate for the beneficiary concerned. If the beneficiary is a non or basic rate tax payer, a tax refund can be claimed.
It can therefore be seen that it is more beneficial from an income tax and practical viewpoint for the trust to be an IIP should the beneficiaries not be higher rate taxpayers although the IIP trust vehicle might not be the best for other reasons (for example should the trust have been created to protect property for a beneficiary who is mentally incapable or who cannot deal or manage property themselves).
How to Reduce the Tax Bill
Income tax planning for trusts is best via use of the ‘Mainstream’ trust; the income tax treatment of IIP trusts cannot really be bettered as the income must be distributed to the beneficiary; the trustees have no choice in the matter. In addition, should either the settlor or their spouse be able to benefit in any way from the assets that are held in an IIP trust, then any income generated will be treated as if it were the settlor's for tax purposes. As a result, there may well be no change in the settlor's situation with regard to income tax.
‘Mainstream’ Plan 1 - Discretion in Distribution
Where a beneficiary either pays no tax or is a basic rate taxpayer the trust income should be distributed to that particular beneficiary as this will enable a refund to be claimed; this is preferential to payment being made to a beneficiary who is a higher rate taxpayer as although entitled to a tax credit they will be unable to claim refund of the tax deducted.
‘Mainstream’ Plan 2 - Conversion of the Trust
Trustees are allowed to make regular distributions to beneficiaries, however, it might be preferable for the trust to be converted into an IIP Trust which gives one or more beneficiaries entitlement to the income; this is done via use of what is termed a ‘Deed of Revocable Appointment’ which is produced by a solicitor. The benefits of conversion are:
1. The trust income is taxed on the beneficiary and not on the trustees and as such this will allow the beneficiaries lower rates of tax to be utilised and in the case of dividends the 10% tax credit will be used.
2. Cash flow benefit for the beneficiary - enabling the full amount of income to be received.
3. Income can be mandated to the beneficiary directly - simplifying the preparation of trust returns and hence reducing costs.
4. Reduction in cost (and time); the trustees will no longer be required to:
a) make periodic distributions possibly on the basis of complex calculations, and
b) account to HMRC for the tax at the ‘trust rate’ only for the beneficiary to have to submit an annual R40 tax repayment claim form possibly many months (or years) later.
The downside of the conversion is less flexibility as the income now must be paid to particular beneficiaries and this might not be what was wanted when the trust was set up - the settlor might have specifically wanted the trust to be a Discretionary Trust.
However, the trustees do have the power to cancel the income entitlement and create new ones as the circumstances of beneficiaries change.
Finally, (although not strictly an ‘income plan’) investments can be rearranged to produce capital growth rather than income or sold such that the profit made is to the trust’s annual exempt amount. The money made can be distributed, and being a capital payment there will be no income tax implications.