What do we mean by a ‘UK’ trust?
The tax status of a trust depends on a variety of factors, but for the purposes of this briefing note, we have used the term ‘UK trust’ to mean a trust which was settled by a UK domiciled settlor (or with UK assets) and which is resident in the UK for tax purposes.
How are trusts classified?
The tax considerations will depend on the type of trust being created and whether it is established during lifetime or on death.
Inheritance tax (IHT):
The creation of a lifetime trust generally results in a Chargeable Lifetime Transfer (an “Entry Charge”), causing an immediate IHT charge on the settlor. The taxable value for IHT is the amount by which the chargeable transfer exceeds the settlor’s available tax free sum (known as the Nil Rate Band (‘NRB’)) and is taxed at 20% (although if the settlor were to die within 7 years of the transfer there could an additional charge).
There are, however, various exceptions to the Entry Charge including:
- assets qualifying for business property relief and agricultural property relief;
- trusts created using ‘normal expenditure out of income’, bare trusts and vulnerable beneficiary trusts.
Capital gains tax (CGT):
A transfer into trust is generally a deemed market value disposal by the settlor for CGT purposes on which tax is payable on any gain. It is, however, possible to defer CGT in certain circumstances by claiming ‘holdover relief’, the effect of which is that the trustees take the asset transferred at the settlor’s base cost and pay any CGT on the relevant gain on a subsequent disposal.
What are the tax considerations throughout the lifetime of a trust?
The tax considerations will primarily depend on the tax profile of the trust and its settlor.
In broad terms, if the trust was set up after 22 March 2006 the trust will enter the ‘Relevant Property Regime’ (“RPR”). As part of the RPR, the trustees will be subject to IHT charges of up to 6% on the 10 year anniversary of the trust’s creation or to pro-rata charges on distributions of capital (based on the time elapsed since the last 10 year charge) (“the Exit Charge”). The assets will not form part of the beneficiaries’ estates for IHT purposes.
The main exceptions to this are for Interest In Possession (IIP) trusts:
established prior to 22 March 2006; or
created on death, i.e. through a Will.
These will not form part of the RPR at the outset but instead the trust assets will be treated as though they belong to the life tenant for IHT purposes. This type of trust interest is known as a ‘Qualifying IIP’
Trusts generally pay CGT on disposals at the same rates as individuals, ie 20% (or 28% on residential property gains). The trustees will also be able to utilise a CGT annual allowance, although it is restricted to 50% of an individual’s allowance and further restricted if the settlor has created multiple trusts in their lifetime.
Under certain conditions, trustees are able to make tax relief claims such as Business Asset Disposal Relief, Investors Relief and Private Residence Relief.
The income tax treatment will be dependent on the type of trust in question:
- Discretionary trusts:
Trustees are subject to income tax at the ‘Rate Applicable to Trusts’, which is the same as additional rate taxpayers (i.e. 45% or 39.35% for dividends). The tax paid by the trustees is then added to a notional ‘tax pool’. If trust income is distributed to a beneficiary, this is treated as having had 45% tax deducted at source (which is treated as coming out of the tax pool). For example, a payment of £55 to a beneficiary will represent £100 of gross income on which £45 tax has been deducted at source, so the beneficiary will be able to reclaim some or all of the tax if they are not an additional rate taxpayer.
The fact that dividends are taxed at a lower rate than other income will often mean that the notional tax pool is not sufficient to cover the 45% tax credit if all of the net income is distributed to beneficiaries; in that case, the trustees must pay further income tax to make up the shortfall.
- IIP trusts (whether or not the IIP is a Qualifying IIP):
Trustees are subject to basic rate income tax (i.e. 20% or 8.75% for dividends) before the net income is paid to the life tenant, who then declares the income on their personal tax return and either pays additional tax or reclaims part of the tax, depending on their marginal rate.
What are the tax considerations on the termination/end of a trust?
As explained above, if a trust is within the RPR the trustees will be liable to Exit Charges on the appointment of capital to a beneficiary or when an individual becomes absolutely entitled to trust assets.
On the death of a life tenant with a Qualifying IIP, the value of the trust forms part of their estate and will broadly be chargeable to IHT in the same way as the life tenant’s personal assets. There will, however, be no Exit Charge.
In the absence of any reliefs, the termination of a trust will be a deemed disposal at market value by the trustees, resulting in CGT on any gain. It may, however, be possible to claim holdover relief on the transfers out of the trust if the trust is in the RPR (or qualifies for other reliefs).
The position is different on the death of a life tenant with a Qualifying IIP; the trust assets will be rebased for CGT to their current market value (in the same way as the life tenant’s personal assets).
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Is the tax the same for UK trusts from which the settlor can benefit?
No – if the settlor can benefit from the trust various anti-avoidance rules mean that income will be taxable on them and the trust assets will remain in their estate for IHT purposes (as well as entering the RPR).