Even More Changes

A complicated regime made worse

Trusts which can accumulate income i.e. discretionary trusts, have been subject to an increased tax rate of 50% since 6th April 2010 (42.5% for dividends). Unlike the 50% rate which initially applies for individuals with income in excess of £150,000, the new trust rate applies to all trust income over £1,000. This clearly makes the income tax treatment of trusts far more penal than personal taxation.

The income tax treatment of discretionary trusts is already an extremely complex area. The trustees are required to administer a ‘tax pool’ comprised of the tax paid by the trustees and any tax deducted at source (excluding 10% tax credits on dividends) on income received. Distributions of income to a beneficiary are paid with a 50% tax credit. Only where there are sufficient credits in the tax pool to cover this can income be distributed.

So what impact does this have on investment choice?

When considering the typical investment vehicles such as investment bonds and collectives, the headline rates of 50% on chargeable gains on bonds, compared to 18% Capital Gains Tax (CGT) on collectives, look compelling. However, this doesn’t tell the whole story.

Investment bonds

Investment bonds have always had appeal for the trustees of discretionary trusts as, being a non income producing investment, the trustees have not had to pay tax each year, administer tax pools or complete tax returns.

Set up costs have been an issue in the past but now Investment bonds can be set up through electronic wealth management systems with little or no initial charges – an option under Monahans Wealth Management Service - and so popularity of these highly efficient investment wrappers for Trustee investors has returned.

The main drawbacks of investment bonds are that rolled up income and gains within the fund ultimately become subject to income tax under the chargeable events legislation. This contrasts with other investments which are subject to CGT on the capital growth and have the ability to utilise the trust CGT exemption. The other advantages gained however are considered by some to outweigh this small disadvantage, particularly due to the cost savings that can be made in running a Trust utilising this type of investment wrapper.

Where an investment bond is held in a discretionary trust, special rules apply as to who is assessable upon any chargeable gains which may arise. If the gain arises during the settlor’s lifetime it will be assessed upon the settlor at the settlor’s marginal rate of tax and with the benefit of top slicing. The settlor then has the right to reclaim any tax payable from the trustees. Only where the tax can not be charged against the settlor, for example where the settlor is deceased or non UK resident, will the 50% trust rate apply.

Even where the trust is assessable it is still possible to avoid the 50% rate by assigning the policy or policy segments to a beneficiary prior to encashment. Any gain would then be assessable upon the beneficiary at their marginal rate with the full benefit of top slicing for the full term of the policy.

Collectives

The fact that capital growth within collective investments is taxed at a flat rate of 18% makes them attractive, particularly where the beneficiaries are likely to remain 40% or 50% tax payers.

Income in excess of the £1,000 standard rate band for trusts will be taxable at either 42.5% for equity based collectives (less than 60% invested in cash or fixed interest) or 50% for non equity based funds (greater than 60% in cash or fixed interest). This is still the case even where the income is reinvested through the purchase of accumulation units.
The additional tax payable by the trustees of 30% on interest distributions from non equity funds along with the 20% tax deducted at source will be included within the tax pool.

For equity based funds, only the additional tax payable at 32.5% on the dividend income will be included within the tax pool. The 10% tax credit is not included. When income is distributed to a beneficiary there must be sufficient credits within the tax pool to provide the beneficiary with a reclaimable tax voucher for 50%, irrespective of the source of the income.

This means that where dividend income is regularly distributed to the beneficiaries there will be a 17.5% shortfall in the tax pool, as it will only contain the tax paid by the trustees at 32.5%. The trustees must then reduce the distribution and use some of the undistributed income to make up the shortfall in the tax pool.

This is an extremely inefficient way of providing income and may result in an effective rate of tax on the income received by the beneficiary of:

• 55% for additional rate taxpayers
• 46% for higher rate taxpayers
• 28% for basic rate taxpayers

Where there is a need to provide regular payments to a beneficiary, as an alternative the trustees can make payments of capital and provided any gain is within the trust annual CGT exemption this could be tax free.

For more advice and assistance on this topic please call us on (01225) 785520 or send us an email.

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