All change for discretionary trusts

Financial advisers have some interesting, but far from insurmountable, challenges ahead with respect to the use of trusts in financial planning reports Senior Solicitor Carla Brown from the Wealth Management department at Moore Blatch.

At the outset, it is important to stress that trusts continue to be an invaluable tool for managing estates, but their traditional use for tax avoidance has, and will continue to wane; that said, there are still invaluable financial advantages to be had.

Currently, trustees of discretionary trusts, which receive over £1,000 in income, pay income tax at a rate of 40% or dividend income which is taxed at 32.5%.
 
However, as from 6 April 2010, the trustees of discretionary trusts will pay 50% income tax and 42.5% on dividend income. This represents an effective 25% increase over the current income rates, and over 30% on dividend income. It is, therefore, likely that such trusts will pay a higher rate of income tax than the individual would. 

Anti-tax avoidance legislation has been introduced over the years in an attempt to prevent individuals obtaining income tax benefits from the use of trusts.  Tax law has consequently developed to treat all income as belonging to the person who established the trust (the settlor), unless that person derives no benefit from it.  The settlor is, generally speaking, caught by the rules not only if they benefit but also if their spouse (or civil partner) or unmarried children under the age of 18 receive any benefit from the settlement. 
The measures were intended to stop higher rate tax payers passing assets into trust for the benefit of themselves or close family members while paying trust rates of tax which until 2004/05 were 34% (25% on dividends); i.e. significantly lower than higher rate personal tax.

In 2004 the rate was raised to 40% (32.5% dividends) to bring them into line with personal income tax. 

The new regime which comes into force in a few months therefore represents a radical departure insofar as personal rates for all but the highest earners will be at a lower level than those of discretionary trustees.  This is almost counter intuitive and loses sight of the real motivation behind years of anti-avoidance legislation.

In light of the forthcoming changes, advisers have a number of options worth consideration.
 
1.Pay out income

Trustees could ensure that any income arising in a discretionary trust is paid to any beneficiaries who are non-tax payers or basic rate tax payers, so that the difference between the trust rate of tax and the beneficiaries may be reclaimed.  However, the trustees must of course consider whether it is appropriate to be paying out all the income simply to save tax. Furthermore, the trustees need to have paid enough tax to be able to vouch such distributions with a 40% tax credit.
 
2.Restructure to Create Revocable Life Interests

Trustees of well-drawn discretionary trusts will usually have powers to declare different trusts.  If appropriate, perhaps in the case of a widow or widower of a deceased, the trustees might declare that instead of discretionary trusts they hold the trust fund to pay the income to a particular person for their lifetime.  These are normally revocable so that if it is appropriate in the future to provide an income to somebody else, or pay out lump sums to anybody they still have the flexibility to do so.

There are many advantages of this type of arrangement: Firstly, the income is taxed on the beneficiaries at their personal rate, rather than on the trustees at trust rates. Secondly, enabling the beneficiary to take income in this way effectively ends the anomaly of the high discretionary trust dividend rate since the dividends will be treated as if they arose directly to the individual and are then taxed at that individual’s highest marginal rate of tax.  Unless the beneficiary falls into the 50% tax band, the resulting tax treatment will be more benign. Thirdly, there is no need for beneficiaries to reclaim tax where their personal income is under £150,000 post 5 April 2010, as under option 1. Thirdly, there’s no capital gains tax downside provided the beneficiary does not become absolutely entitled to the underlying trust assets. And, finally, there is no inheritance tax downside since, post 22 March 2006 and providing the new trust is declared more than 2 years from the death if it’s a will trust;  these life interests are relevant property trusts and so the trust is assessed to inheritance tax every 10 years and on capital distributions, rather than on any individual.

3. Review investment strategy to suppress Income

As professional advisers, you can work with the trustees to harmonise investment strategies with tax considerations. As lawyers, we would not wish to claim investment management expertise, but here are some of the strategies that we are seeing adopted: Using investment bonds, where up to 5% of the original capital can be drawn down each year without any tax liability.  Investing in Zero dividend preference shares, which return a defined capital sum which is taxed at 18%, rather than at higher rates of income tax.  It goes without saying that tax mitigation must be tempered by broader investment considerations.

4.Invest for Capital Growth

Capital Gains Tax is levied at 18%; for the time being at least. Whilst a candidate for future increases, in the meantime the arbitrage between income tax rates and the flat rate of Capital Gains Tax may be usefully exploited provided trustees have considered whether it is appropriate to skew investments away from a balance between income production and capital growth

5. Settlor Interested Trusts

Where a trust is not already settlor interested, but it is considered to be in the beneficiaries’ best interests to be so, it can become settlor interested by means of, One, the trustees exercising a power to include the settlor's spouse as a potential beneficiary depending on the terms of the trust (they may of course have been drafted to prevent settler-interested provisions from applying and so trust deed may specifically prevent this being done). Secondly, distribute gross income of more than a £100 each year for the benefit of the settlor's minor unmarried child not in a civil partnership. It would only be the income distributed in that case that would be taxed on the settlor.

When considering the advantages and disadvantages of settler trusts here are some considerations: The trustees are subject to trust rates, but the settlor can recover income tax if their top rate is below 50%. Beneficiaries are taxed on the income as if it had been received direct as interest, dividend or rental income; which can provide a better overall result where the settlor / beneficiary is taxed at a rate lower than the new trust rates, in other words where he or she is taxed at rates no higher than 40%. Any recovery of income tax by the settlor will need to be paid back to the trustees. There is no Capital Gains Tax downside arising from the creation of a settlor-interested trust since the removal of the anti-avoidance rules following the general alignment of the capital gains tax rate of 18% for all non-corporate taxpayers. And finally, there is an inevitable inheritance tax downside because trust assets will be deemed to be part of the settlor’s estate.

It goes without saying that any of these steps must be carefully considered with regard to the specific terms of the trust, the current investments and the needs of the beneficiaries.

Furthermore, it is important to take prompt action  in order to be effective before the end of the financial year .