UK: Trusts and tax - Government proposals and their implications for trustees

In his pre-Budget report in December 2003, the Chancellor announced that consultations would take place on modernising the tax system for UK trusts. There had been growing concern, both at the Inland Revenue and the Treasury, that trusts were increasingly being used in tax avoidance schemes.

In the March 2005 budget, the Chancellor confirmed two proposed changes (see "changes already underway" section) and at the same time the Revenue published a further discussion paper. As a result, new legislation for the other proposals has already been delayed and is now likely to take effect from 6 April 2006. The proposals represent a fundamental change in the way that UK trusts will be taxed and, as a result, have wide-ranging implications for trustees.

Under the current rules, trustees pay income tax at the rate applicable to trusts (40% from 6 April 2004). This tax is added to a tax pool that is available to frank income distributed to beneficiaries. Any income paid to beneficiaries from 6 April 2004 will have the distribution franked with a 40% tax credit. Under the proposed new rules, the tax pools will be frozen but, for a three-year transitional period, beneficiaries will still be able to receive income out of these pools with a tax credit. After the three-year period, beneficiaries will only be able to use the tax credit to offset any tax payable and tax refunds will therefore not be given.

As a result there are a number of measures trustees may wish to consider prior to 5 April 2006, including:

• utilising tax credits in the pool by making payments of income from accumulated income where a tax credit of 40% will be available, irrespective of the fact that the pool has attracted a lower tax rate in previous years;

• making distributions of income in a way that will allow the trustees to retain some degree of control in order to safeguard the beneficiaries.

From 6 April 2006, the concept of income streaming is likely to be introduced. Under the proposed new rules, trustees will be able to make a payment of income to a beneficiary at any time during the period to 31 December following the end of the previous tax year and that payment will, for tax purposes, be treated as being a payment of income in the previous tax year. As a result, the income paid will not form part of the trustees’ income subject to the rate applicable to trusts. The income payment will be included on the beneficiary’s personal tax return for the year in which it is received, with associated tax credits, as if it had not been received originally by the trustees. An opportunity therefore arises for trustees to consider how payments can be made to beneficiaries in a tax-efficient manner. The proposals on streaming are being further considered in the new discussion document.

From 6 April 2006, parental settlements created for minor children are likely to have the income arising assessed directly on the settlor. At present, income is only assessed on the settlor as and when income payments are made.

However, these aggregation rules are also likely to apply to capital gains tax in that any capital gains made by the trustees, less losses in the year, will be assessed on the settlor, without reference to the trustees’ annual capital gains tax exemption.

From 6 April 2006, parental bare trusts are likely to have their capital gains assessed on the settlor, rather than the child as is the case now. As a result, trustees of such settlements should perhaps consider, with the settlor, realising capital gains and maximising the use of any available losses prior to 5 April 2006.

The consultation period has indicated that principal private residence relief will only be granted to trustees on a sale of property owned by them if the settlor occupies it as his or her principal private residence. As a result, trustees may wish to review property which is occupied by a beneficiary and consider what, if any, action they need to take. It is likely that any new legislation will only be retrospective to the extent that principal private residence exemption will be lost from the date that the rules are changed.

At present, it is possible for a trust to be UK resident for income tax purposes, but non-UK resident for capital gains tax purposes. The proposed new rules are likely to bring in changes which will mean that all such trusts will be either UK or non-UK resident, subject to a 12-month transitional period. Trustees who are currently treated in this manner should review the residence position and consider whether they should appoint non-UK trustees to take the trust offshore or elect to be treated as UK trustees for all taxes. Again, we can review the position with the trustees and advise on the most taxefficient approach. These proposals are being reconsidered in the new discussion document.

Some of the proposed changes took effect from 6 April 2004:

• Certain trusts for the disabled and for minor orphans can now elect irrevocably for the income and gains arising to the trust to be based more closely on the circumstances of the beneficiary. The election enables the trustees’ income to be taxed as if the trust were a bare trust, with the tax arising being determined by the beneficiary’s personal circumstances. For existing trusts, the election must be made by 5 April 2006. For new trusts, the election must be made within two years of the settlement being created.

• The tax rate applicable to trusts rose from 34% to 40% on 6 April 2004 and from 6 April 2005, trustees will have a basic rate band, set at £500. Any income within this band will not be subject to additional income tax.

All in all, there are a number of issues for trustees to understand and address. Deloitte can advise trustees, settlors and beneficiaries on the implications of the proposed legislation and identify areas where tax planning could be implemented prior to publication of the legislation. Our Wealth Advisory group is available to review trusts’ investment policies and make recommendations that take account of the proposed changes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.