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Making the Most of Income Tax and Discretionary Trusts

Making the Most of Income Tax and Discretionary Trusts
The taxation of trusts is complex. However, trusts do offer an attractive vehicle which can be used for family tax planning purposes.


Background

Perhaps one of their main attractions (of the Discretionary Trust in particular) is that future unforeseen changes, be they financial or not, can be taken into account at that time by the trustees. For example, a father may create a Discretionary Trust for his four children at a time when they are all minors; it may be that in the future one of the children becomes disabled and as a consequence the trustees can take this matter into account when deciding how the trust assets/income should be allocated amongst the beneficiaries.


Trusts can also serve as substitute wills.

The tax treatment discussion below assumes that none of the various anti-avoidance provisions apply (e.g. the ‘settlor interested’ provisions).


Trustee Tax Liability


Trustees of a Discretionary Trust (DT) are subject to Income Tax on trust income at the “trust rate” of 50% (post 6th April 2010; previously 40%); dividend income, however, is subject to the “dividend trust rate” of 42.5% (post 6th April 2010; previously 32.5%).


Example 1

In the tax year 2010/11, a DT receives net rental income of £400 and net dividend income of £90.

The trustees’ liability is 50% on £400 plus 42.5% on £100 (i.e. net dividend of £90 plus tax credit of 1/9th) less the tax credit of £10, i.e. £200 plus £32.50.

Beneficiaries’ Tax Liability

The beneficiaries of the DT are not entitled to any trust income/capital unless the trustees exercise their discretion in their (i.e. the beneficiaries’) favour. Thus, until this discretion is exercised no Income Tax charge arises on the beneficiaries.

As and when income is distributed to one or more beneficiaries, the amount distributed is treated as if it was made after the deduction of a sum representing Income Tax at the trust rate on the grossed up amount.

Example 2

In the tax year 2010/11, a DT pays out £100 to a beneficiary. The beneficiary is treated as receiving [£100/0.5] i.e. £200 of gross income.


It is to be appreciated that the “grossed up” payment to the beneficiary is at the trust rate even if the income distributed originally constitutes dividend income which the trustees have received. This is because the source of the income for the beneficiary is the trust and not the underlying income of the trust itself.

 

Optimal Trust Distribution

From the tax perspective, optimal distribution requires distribution to non-tax paying beneficiaries in the first instance; then to basic rate (20%) beneficiaries; then to higher rate (40%) beneficiaries and finally to additional rate (50%) beneficiaries. This leads to a refund of income tax paid by the trustees for all the above categories of beneficiary other than the additional rate beneficiary.

Example 3

A DT receives rental income of 100 taxed at 50% i.e. 50 net income left.

Net income of 50 distributed to basic rate (20%) taxpayer beneficiary. Beneficiary deemed to have received 100 gross taxed at 20% i.e. 20, thus, 30 of tax reclaimable by the beneficiary.

The trustees may choose to accumulate income of the trust rather than paying any income to the beneficiaries.

UK Equity Investments

DTs, however, should not be used to hold UK equities as so-called “tax leakage” occurs i.e. beneficiary is worse off.


Example 4

Dividend routed via Discretionary Trust.


A DT receives dividend income of 90 i.e. 100 gross.

Income Tax liability 42.5% of 100 less tax credit of 10 i.e. net liability of 32.5 leaving net cash of 57.5 (i.e. 90 less 32.5).

Distribution to a beneficiary of 45 represents 90 gross.

Income tax liability (assume 50% taxpayer) 45 less 45 tax credit i.e. nil.

Net cash receipt 45.

Dividend received directly

Net dividend received 90 i.e. 100 gross.


Income Tax liability (assume 50% taxpayer) at 42.5% i.e. 42.5 less tax credit of 10 producing net tax liability of 32.5.

Net cash receipt 57.5.

 

Practical Tip

Do not invest in UK equities via Discretionary Trusts.