Feature

posted 29 Jul 2004 in Volume 9 Issue 5

Modernising the tax system for trusts

Last year, the Chancellor announced plans to change the tax treatment of UK resident trusts with a view to introducing a new regime. ELENA GOGH of Ernst & Young discusses the launch of the consultation process on the modernisation and simplification of the income tax and capital gains tax system for UK resident trusts.

In the 2003 Pre-Budget Report, the Chancellor announced plans to modernise and simplify the tax treatment of UK resident trusts. Following this announcement, on 17 December, the Inland Revenue published the following four discussion papers:

Overview of the proposals;
Capital gains tax issues;
Income tax issues;
Definitions and tests.

The above papers set out a number of wide-ranging proposals for consideration during the consultation period by trust professionals and representative bodies, which ended 18 February and during which various representations were made.

As an aside from the consultation process, the rate applicable to trusts (RAT) increased from 34 per cent to 40 per cent, and the corresponding dividend rate from 25 per cent to 32.5 per cent. The change was implemented with effect from 6 April 2004 and affects trustees receiving income or realising capital gains and personal representatives administering an estate. The RAT is a rate that applies principally to the income and gains of trusts where the trustees can accumulate income and/or pay it out to the beneficiaries at their discretion. Specifically it applies to:

The income of discretionary and accumulation trusts;
The capital gains of all trusts and estates of deceased persons in administration;
Certain amounts received by all trusts, for example gains from offshore funds.

Section 677 of the Income and Corporations Taxes Act 1988, which charges tax on loans or other capital sums made by trustees to the settlor of a trust or their spouse was also amended, with effect 6 April 2004, to ensure that the settlor is not given credit for more tax than the trustees have already paid.

The issues put forward during the consultation period are still under consideration, and the Inland Revenue will consult further over the summer with the aim of publishing draft legislation at the time of the Pre-Budget Report 2004. The new system is expected to come into force on 6 April 2005.

The review

The discussion papers cover UK resident personal trusts, which include the following:

Family trusts;
Employee-benefit trusts;
Trusts that hold life-insurance products;
Service-charge and sinking-fund trusts created under the Landlord and Tenant Act 1987.

This means that offshore trusts and authorised unit trusts are not included in the discussion, although they may be indirectly affected.

The Inland Revenue sums up the aim of the review by saying that it wants a tax system for trusts that does not provide artificial incentives to set up a trust but, equally, avoids artificial obstacles to using trusts where they would bring significant non-tax benefits.

This implies both good news and bad news. The good news is that the Inland Revenue recognises that it will be necessary to ensure that beneficiaries who have a trust imposed on them by statute (such as in a case of intestacy) are not penalised by the new proposals. The potentially bad news is that the proposals build on existing measures rather than starting from scratch.

The concern is that, rather than simplifying the system, this will generate additional complexity.

The proposals for trusts

The Inland Revenue has indicated that common definitions should be developed for the terms settlor, settlement and settlor-interested trust, together with a common residence test for trusts. Currently, there are a number of different definitions of settlement and separate residence tests for trustees for income and capital gains tax purposes. It is also proposed that, for income and capital gains tax purposes, trusts will be divided into the following three categories:

Settlor-interested trusts;
Bare trusts;
General trusts.

The aim is to have standardised definitions for all trusts to make it simpler for trustees to determine their current tax status. Separate rules have also been put forward for specialist trusts.

Settlor-interested trusts

Under the suggestions laid out in the discussion papers, all income arising to a trust in which the settlor retains an interest would be treated as the income of that settlor. This is broadly the same as at the present time. The income would retain its character so that rental income, for example, would be subject to the rules for income from property. The income would be subject to tax at the new RAT and would be paid by the trustees, although the settlor would be entitled to reclaim any tax that has been overpaid.

There may be circumstances where the income is paid to a beneficiary who is not the settlor. In this situation, it is proposed that payment of the income would be regarded as a gift from the settlor to the beneficiary.

Similarly, any gains and losses arising to the trust would be treated as though they belong to the settlor for the purposes of capital gains tax (CGT). This means that the settlor’s own gains and losses may be set against the trust gains and losses, and that transfer into the trust would not be treated as a disposal. All other CGT provisions would therefore need to be reviewed to ensure consistent treatment. This is particularly true for some capital gains tax reliefs, such as business asset taper relief and private residence relief. It is proposed that transfers out of the trust to the settlor would have no effect for CGT purposes but a transfer out to other beneficiaries will be classed as a disposal by the settlor. Gains would be subject to tax at the new RAT, paid by the trustees although, once again, the settlor would be entitled to reclaim any tax that is not due.

Bare trusts

Under the discussion paper suggestions, the rules for bare trusts would remain broadly unchanged. The absolute beneficiary under the trust would be taxed on both income and gains as if the trust did not exist. Trustees would not pay tax on behalf of the beneficiary, although the trust may still choose to complete a self-assessment tax return for compliance purposes, or where there is an administrative benefit from doing so.

General trusts

Discretionary trusts, accumulation trusts and interest in possession trusts would all come under a common regime for general trusts. It is this area where the Inland Revenue sees real potential for simplification.

One issue that is currently up for debate is whether there should be a change in the treatment of income that has been passed to beneficiaries soon after receipt by the trustees. Clearly, this should only apply to discretionary and accumulation trusts since the beneficiary of an interest in possession trust is automatically regarded as having received the income as it arises.

Under the current rules, the trustees are subject to the RAT (broadly, 32.5 per cent for dividends and 40 per cent for other income) on all of the income that they receive. The Inland Revenue is suggesting that if a beneficiary becomes entitled to the income before the end of the year, either by way of a distribution or by right where they hold an interest in possession, the income could be taxed at no more than the basic rate in the hands of the trustees and it would then be treated as the income of the beneficiary and taxed at his or her marginal rate. This flow-through means that the income would be retained when the beneficiary is taxed. For example, interest received by the trust would be taxed as interest in the hands of the beneficiary. Basic rate taxpayers would therefore have no additional tax to pay and tax already paid, would be refunded where the beneficiary would not have been taxable. However, there is concern that the ‘flow-through’ of discretionary payments to underlying beneficiaries would be penal for accumulation trusts for young children who would not be able to claim back tax paid by the trustees when distributions are eventually made.

Consideration is also being given to a policy under which discretionary payments made a short period after the end of the tax year would flow through to the beneficiary as described above. The question would then be whether it would be treated as the income of the beneficiary in the year in which he received it or the year in which the trustees received it. On the whole, such policy should allow a reasonable period to enable professionals preparing trust accounts to make appropriate computations and tax distributions. Generally, taxing income in the year the beneficiary received it, rather than the year it arose to trustees, would allow a later deadline as filing deadlines for the beneficiary would not then be an issue. This has not been resolved by the discussion document.

It is suggested that income received by a discretionary or accumulation trust that has not been paid out by the end of the tax year would be treated as accumulated. Any excess over a ‘basic-rate band’ would be taxed at the rate applicable to trusts. The Inland Revenue have stated that the basic-rate band will be £500 and this will keep small trusts out of the self-assessment process although the associated rules to prevent fragmentation are likely to generate additional complexity. It seems that on the whole the administrative savings would be greater for the Inland Revenue than for trustees, as this would not take away the need for trustees to compile accounts to quantify their income.

Another issue with the introduction of a basic-rate band relates to the tax pool. Beneficiaries of a discretionary trust could receive income that has suffered a mixture of basic and trust-rate tax. To avoid this complexity the Inland Revenue suggests that it would be preferable to keep the tax pool in one non-streamed block. The proposed options for payments out of accumulated income are to either:

Treat them as capital payments;
Treat them as income if made within a specified period of say, three years;
Always treat them as income.

The main issue is that the last two options would require either a tax pool or a mechanism for identifying separate pools of income with similar tax credits. The first option is, therefore, the simplest but will not necessarily be the fairest in practice. Another possible simplification measure would be to use a composite rate for tax entering the pool rather than the rates applicable to different sources of income. The options will be considered further before a decision on whether or not to proceed with the abolition of tax pool is finalised.

An exception to the rule that chargeable gains are taxable at the RAT of 40% is being considered where, during the tax year (or possibly during a short period following the end of the tax year) a beneficiary becomes absolutely entitled to a trust asset or to some or all of the proceeds of a gain. In this case the gain, or the part of it that relates to the beneficiary, would be treated as if it had been made by the beneficiary. It would, therefore, be entered on the beneficiary’s self-assessment tax return and taxed at the beneficiary’s marginal rate. Credit will be given for tax paid by the trustees.

Again, this gives rise to the question of whether the gain would be treated as the gain of the beneficiary in the year in which it arose or the year in which he or she became entitled to the proceeds.

Specialist trusts

The Inland Revenue recognises that some trusts would need to be treated as exceptions from the regime for general trusts. In particular, it suggests that trusts for vulnerable individuals, such as minor orphaned children and disabled people, will be able to elect to be treated as settlor-interested trusts with the beneficiary as the settlor. The theory is that the tax paid on the income or gains of the trust would be at the beneficiary’s marginal rate. The election, once made, would be irrevocable. The Government is considering whether the definition of trusts eligible for this relief should be broadened beyond trusts for the disabled and orphaned minor children.

Other proposals

As from 6 April 2004, personal representatives are liable to CGT at the RAT. As part of the general review of the trusts regime, the Inland Revenue has also indicated that it might be possible to bring estates in the course of administration into the same tax regime as trusts by treating them as general trusts. For example, a capital payment to a beneficiary can be treated as income in the beneficiaries’ hands – up to the level of the estate’s income – if it is distributed prior to an income distribution. The argument in favour of this move is that estates and trusts already use the same self-assessment form and that many estates provide for the creation of trusts.

The disadvantages surrounding treating estates as general trusts are largely due to the way in which estates currently operate. For example, payments to beneficiaries are currently treated as income despite the fact that they may include capital payments. Similarly, there is no limit between the time when income arises in the estate and the time it is paid out to beneficiaries. Other issues are that the entitlement of estates to the annual exempt amount for capital gains tax differs to that of trusts, and all chargeable gains arising in an estate are liable to tax at the trust rate.

The debate continues

The discussion papers recently published by the Inland Revenue take the form of open-ended papers intended to stimulate debate. They, therefore, give no indication of the potential fiscal impact of the changes or indeed whether they are intended to be tax neutral. It is unclear how the Inland Revenue will move forward with the proposals in the discussion papers.

Anti-avoidance measures announced in the Pre-Budget Report to counter tax avoidance using hold-over relief and the PPR exemption in conjunction with settlor-interested trusts suggest that the Inland Revenue is already targeting such trusts in particular. The implication is that the modernisation of the trusts system will be used as a mechanism to negate the use of trusts for tax planning. The danger is that this will be done without full consideration being given to the implications for those who have non-tax reasons for using a trust.

Given the number of matters that have yet to be discussed, such as transitional arrangements for existing tax pools, the wider review which will be carried on by the Inland Revenue over the summer, if properly undertaken, could well take longer than scheduled. If simplification really is one of the main goals of this process, the government should consider putting the brakes on in this instance.

For further information, please contact Elena Gogh at Ernst & Young by telephone on 020 7951 2869 or by e-mail at egogh@uk.ey.com.