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Taxation of collectives held in trusts

This article looks at how UK collective investments are taxed when they are held inside a trust.

In this article, we focus on three main types of trust:

  • Absolute or Bare
  • Interest in possession
  • Discretionary trust

Background

The Trustee Act 2000 (England and Wales) and similar legislation for Northern Ireland and Scotland widened the investment options for nearly all trusts. But it also put more responsibilities on the trustees to seek appropriate advice from suitably qualified individuals, to review the investments on a regular basis and to ensure suitability of trust investments and consider the need for diversification.

Trustees and their financial advisers are required to understand the tax consequences of the investments held within the trust, and the options available to them to try and reduce the tax burden.

This section addresses income tax, capital gains tax and inheritance tax for the trustees and where applicable, the beneficiaries and settlor(s).

Income tax

Absolute (Bare)

Assessed on the beneficiary unless a parental settlement.

Interest in possession 

Trustees are taxed at the basic rate, currently 20%. This liability will normally be satisfied by the tax credit accompanying any income payment to a beneficiary unless a parental settlement. The beneficiary in receipt of the income is then liable to income tax at their highest rate.

Discretionary

A standard rate band of up to the first £1,000 applies to discretionary trusts and is taxed at 20% from 6 April 2016; dividends received within the standard rate band are taxed at the dividend ordinary rate of 7.5%. Depending on the nature of income in excess of the standard rate band, the trust will suffer tax at 45% for savings income (with a credit for the 20% already taxed), and 38.1% for dividend income.

Capital gains tax

Absolute or Bare

Assessed on the beneficiary at 10% or 20% (2016/17 tax year) with full personal annual exempt amount available.

Interest in possession 

Trustees are taxed at 20% on any gains realised inside the trust for gains in excess of the annual exempt amount (£5,550* 2016/17 tax year) which is half the annual exemption for individuals.

Discretionary

Trustees taxed at 20% on any gains realised inside the trust for gains in excess of the annual exempt amount (£5,550* 2016/17 tax year) which is half the annual exemption for individual’s.

Holdover relief may apply.

*where a settlor has created more than one settlement the annual exempt amount is divided by the number of settlements to a minimum of £1,110 per settlement.

Inheritance tax

Absolute or Bare

The gift into the trust will be a potentially exempt transfer, to the extent that it doesn’t come within one of the IHT exemptions. If the settlor dies within seven years of making the gift, the gift will become chargeable. If the beneficiary dies at any time whilst the trust is in force, the value of the trust fund is included in the beneficiaries’ estate for IHT purposes.

Interest in possession

The trust is subject to entry, exit and periodic charges if it was established after 22 March 2006 and no value is included in the estate of the beneficiaries.

For trusts set up before 22 March 2006, the value of the interest is included in the estate of the life tenant, as long as no further capital is added after 22 March 2006.

Discretionary

The trust is subject to entry, exit and periodic charges. However, there is no value included in the estate of the beneficiaries.

Settlor interested trusts

Where the settlor (or their spouse or civil partner) can benefit from the trust, it will be treated as a settlor interested trust.

This means that income arising under the trust will be assessed on the settlor, even if he does not actually receive or benefit from it. The settlor has the right to recover the amount of any tax suffered from the trustees.

A flat rate of CGT has been introduced, which means that the anti­avoidance provisions applicable to CGT no longer apply.

Will trusts – post 22 March 2006 (Immediate Post-Death Interests – IPDI)

If a trust is created on death and creates an interest in possession and the life tenant is the spouse or civil partner of the deceased, it will remain outside the relevant property regime but the capital value will form part of the life tenant’s estate for IHT purposes. The gift into the trust will also be exempt for IHT purposes.

Where the life tenant is not a spouse or civil partner of the deceased it will still remain outside the relevant property regime but the gift into trust will not be exempt for IHT purposes.

Summary

With trusts now being liable to income tax rates of up to 45%, financial advisers should make sure the trust holds its investments in the most tax efficient manner. This is especially important if income is being reinvested. Understanding the beneficiaries’ need for and rights to income, their rights to capital and the investment objectives of the trustees will enable advisers to minimise tax and maximise planning and investment opportunities.

Old Mutual Wealth does not accept any liability for any action taken or refrained from being taken on the basis of information contained in this or any related article.

The information in this article is based on Old Mutual Wealth’s interpretation of legislation as at May 2016. While we believe this interpretation to be correct, we cannot guarantee it. Tax relief and the tax treatment of investment funds may change in the future.

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