Trusts

In this chapter, we consider the taxation of the different forms of trust. Tax will often be a key reason why trusts are set up, so a reasonable understanding of this issue is vital when discussing trust solutions with clients.

The taxation system divides trusts into these different five categories for most tax purposes.

Bare trusts, under which the trustees are effectively nominees of the beneficiary, who is either absolutely entitled or will become so at the age of 18. Most implied, presumptive and construc...

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...t property trusts’.

Gifts into interest in possession trusts prior to 22 March 2006 were treated as Potentially Exempt Transfers (PETs) for inheritance tax purposes. This means that lifetime tax was not payable, and the trust would not have been subject to exit or ten-year anniversary charges. However, the value of the trust fund would be included in the estate of the beneficiary with the interest in possession for IHT purposes on their death (even if they weren’t entitled to any capital from the fund).

Trustees’ taxation responsibilities

Trustees are required to pay tax on income and capital gains arising within a trust under th...

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...ith HMRC in terms of completing necessary returns, all other trustees are jointly responsible for the acts and omissions of that trustee.

The trustees of a bare trust have no tax liability on the trust’s income, which is usually regarded as belonging to the beneficiary. In this case, trust income is taxed according to the beneficiary’s own tax status, ta...

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...es, even if the trust was created by their parent(s). The gains from the trust are taxed as the child’s, so the child can use their own capital gains tax annual exempt amount – which is double that afforded to a trust.

The tax on income and gains for trusts set up to benefit certain “vulnerable” beneficiaries was amended by the Finance Act 2005 (and backdated to 6 April 2004) so that, the trust would effectively pay tax based on the beneficiary’s own tax position, rather than the normal arrangements for trusts.

There are two categories of vulnerable beneficiary:

Disabled persons and

'Relevant' minor children

Not all trusts which benefit a disabled person or a relevant minor qualify for special tax treatment. For a trust to receive this favourable tax treatment, during the disabled person’s lifetime or until the termination of the trust:

The trust property can only be applied for the benefit of the disabled person; and

The disabled beneficiary must be entitl...

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.... The difference is the relief by which the trustees’ income tax liability is reduced.

Vulnerability can describe a multitude of personal situations, so articulating what makes a person ‘vulnerable’ is not always easy. The FCA breaks down potential vulnerabilities into four categories:

Health (physical or mental disability, or severe or long-term illness).

Life events (bereavement, relationship breakdown, loss of employment).

Capability (poor literacy or numeracy skills or learning difficulties, or lack of confidence in managing finances).

Resilience (in debt, or with low and/or erratic income, or low savings)

The level of care that is appropriate for individuals with characteristics of vulnerability may be different from that required for other customers.

Trustees are not allowed any personal allowances to deduct from income received by the trust. They do not benefit from the starting rate of tax, the personal allowance or the dividend allowance.

Trustees of an interest in possession trust are liable to tax on income the trust receives at the basic rate, i.e. 8.75% on dividends and 20% on interest and other income received. They are not liable to the higher rate of tax.

The trust’s expenses are deductible from its income in a strict order, being offset first against UK dividend income, then foreign dividends, then savings income and finally other income.

Trustees complete tax forms R185E detailing the income and tax deducted and pass these to the beneficiaries s...

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... she can reclaim the tax deducted by the trustees. If she is a basic rate taxpayer, she will have no further tax to pay. If she is a higher rate taxpayer, she will have a further 20% of £2,094 (£419) to pay and will be entitled to net income of (£2,094 - £419 - £419) = £1,256.

In 2024/25, each individual is entitled to a dividend allowance of £500. After this, basic rate taxpayers pay 8.75% on dividend income falling within the basic rate threshold. Beneficiaries could be subject the dividend tax higher rate of 33.75% if the dividend income falls within the higher rate band, or the dividend tax additional rate of 39.35% where their taxable income exceeds £125,140 pa annum.

The trustees of a discretionary or accumulation and maintenance trust will have full discretion in terms of how, when and to whom income or capital is distributed.

 

When income arises to the trust, it pays tax on the full amount (i.e. no personal allowance can be applied).. Since 6 April 2024, where trust income is below £500, no reporting is necessary and so income tax is due. This is divided by the number of trusts created by the settlor and in existence during any part of the tax year, subject to a minimum of £100 per trust. If income exceeds this special allowance, it is all taxable.

 

Income is charged to tax at 39.35% in respect of UK and overseas dividend income and 45% for all other income. 

In some circumstances the income is treated as the settlor’s income and is chargeable on the settlor rather than on any of the beneficiaries, even if it was paid to them.

Expenses are allowable against the higher rates of tax, but not the basic (8.75% or 20%) rates. If the trustees accumulate the income, this would be the extent of the overall tax liability.

Expenses are initially set against dividend income, then savings income, then finally, other income. The expenses will be grossed up at the appropriate rate for the income – 8.75% if set a...

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....45 @ 5% = £110.27.

If Lucy is an additional rate (45%) taxpayer she will have been deemed to have received income net of 45% tax and will therefore have no further tax to pay but will not be able to reclaim any tax either.

[This means that, in order to be able to distribute all of the net dividend income (£1,213), the trustees have to pay a total of £992.45 to HMRC. Given that the gross dividend was only £2,000 to start with, they must have the available funds to be able to do this. If they do not have the funds to do this, the trustees can only distribute the £2,000 net of 45% tax (i.e. £2,000 x 55% = £1,100) so that they do not owe any more tax because of the distribution.]

As you can see from this example, the beneficiaries receiving income from dividends via discretionary trusts will receive less than had they received the income from shares held directly by them.

Accumulated income

If trustees accumulate income to the extent that it becomes additional capital of the trust, when distributed in a later tax year to beneficiaries it will be regarded as a capital payment and not a payment of income. Beneficiaries are not taxed on capital payments received and, therefore, can obtain no tax credit of tax paid by the trustees in previous years.

There are certain instances where trust income is treated under law as belonging to the settlor. The settlor will be taxed on the income even if he or she does not receive it. The rules apply to all types of trust previously mentioned, excluding trusts for vulnerable persons.

The first situation arises where the settlor or the settlor’s spouse/civil partner has retained an interest in the trust. A spouse would NOT ...

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...ome instances, there is a risk that regular payments of capital to a beneficiary will be regarded as income for tax purposes. The case of Brodie’s Will Trustees v IRC (1933) TC432 set a precedent for this. However, subsequent cases have contradicted this ruling, e.g. Stevenson v Wishart (1987) BTC 283, so each case will depend upon the wording of the trust and, on occasion, the tax status of the receiving beneficiary.

Usually, transfers of assets into a trust are treated as disposals and are therefore subject to capital gains tax. In most cases (other than bare trusts), if the trust was established on or after 22 March 2006, any chargeable gains can be ‘held over’ (i.e. deferred) until a subsequent disposal by the trustees. For this to happen, the beneficiaries should not include any minor unmarried children of the settlor.

The trustees are then subject to tax on any disposals that they make where gains are realised, including transfers out of trusts to beneficiaries. In certain instances, reliefs are available on transfers in and out of trusts.

If a trust has at least one trustee who is resident in the UK, there is usually a potential liability to CGT.

The creation of a trust and transfer of assets to that trust is treated as a disposal of the asset at market value by the settlor, even if the settlor retains an interest. This is a personal liability on the settlor but, in most cases, the gains can be held over until later disposal of the asset by the trustees.

A capital gain is calculated in the same way for a trust as for an individual, i.e. the gain represents the difference between the proceeds of sale and their cost or value when acquired. CGT is charged at a rate of 24% (20% for non-property related gains made between April 2024 and 29 October 2024), subject to any available annual exempt amount.

CGT - ...

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...ding the same benefits to them as to any other person selling their main home. This exemption can extend to gains on the trustees of a life interest trust or a discretionary trust, provided that the trust has been expressly created and the beneficiary of the trust has actually occupied the property. This relief is not available where the settlor has claimed holdover relief on the transfer of the property into the trust.

CGT - offshore trusts

A UK domiciled individual who placed assets into an offshore trust is liable to CGT on gains made by the trustees of the trust if he or she has an interest in the trust and is UK resident in the tax year in which the gain arises. This is the case whenever the trust was created.

An individual is deemed to have an interest in the trust if he or she, spouse, civil partner, or companies connected with them can benefit from the trust in any way. The Finance Act 1998 extended this deemed interest of the settlor to where the settlor’s grandchildren or their spouses could benefit.

UK resident beneficiaries are subject to CGT on the distribution of capital gains from offshore trusts where the gains are not taxable on the settlor.

Offshore trusts are subject to taxation in the country of their residence, but most offshore trusts set up by UK resident or UK domiciled settlors are likely to be in low tax jurisdictions - that is one of the reasons for having an overseas trust.

The creation of a trust is regarded as a transfer of value for inheritance tax purposes, with the amount of transfer being the loss to the transferor’s estate.

Tax may or may not be due depending on:

Whether the settlor’s nil-rate threshold has been exceeded

What exemptions are available

The type of trust being used and its terms

Whether the settlor has made any other chargeable lifetime transfers in the previous seven years

IHT - Relevant property trusts

A relevant property trust is the term used to describe a trust created after 22 March 2006 that does not fall within the specific exemptions. As we have already seen, trust property can include land, shares, money and other assets – in fact, most property held within a trust counts as ‘relevant property’.

IHT - Bare trusts

A transfer into a bare trust is:

A potentially exempt transfer if it is made during the settlor’s lifetime; or

A chargeable transfer if the trust is created on the settlor’s death

IHT - Trusts for vulnerable beneficiaries

The creation of a trust for a disabled or otherwise vulnerable person is a PET, even if it is a discretionary trust, and will only be taxable if the settlor dies within seven years. Additionally, there are no exit or periodic charges with this type of trust. If a person has a condition that will render them disabled in the future, they can transfer assets into a ‘self-interest’ trust which will be treated in the same way as if it were created for another vulnerable person.

IHT – Life interest and interest in possession trusts

With some exceptions, interest in possession trusts created on or after 22 March 2006 will not form part of the estate of the individual with the interest. They will be subject to the same IHT rules as discretionary trusts.

Trusts created pre-22 March 2006

For trusts set up before 22 March 2006, transfer to a life interest trust or interest in possession trust during the settlor’s lifetime was a PET, with tax only becoming payable if the settlor died within seven years of the transfer (and, as more than seven years have elapsed since March 2006, all such gifts will now be exempt).

For trusts created prior to this date, the trust assets are regarded as being owned by the beneficiary with interest. The ‘life tenant’ is the person entitled to the income from the trust property.

If there are two beneficiaries, they are deemed to have interest in possession in half of the trust fund. If there are three, they are each deemed to have an interest in one third of the trust fund, and so on.

Changes in ownership of an interest in possession trust created before 22 March 2006

Where...

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...based on the hypothetical CLT tax/current value of the trust fund

Therefore: £23,000/£500,000 = 4.6%

Of which 30% applies: 1.38%

10-year periodic charge is based on: current value of fund (£500,000) x effective rate (4.6%) x 30% (1.38%)

Therefore: £500,000 x 4.6% x 30% = £6,900 payable by trustees

IHT - Accumulation and maintenance trusts

A&M trusts were a special type of discretionary trust, governed by the Inheritance Act 1984. Before 22 March 2006, A&M trusts were taxed in broadly the same way for inheritance tax purposes as interest in possession trusts. There was no periodic charge, no exit charge and lifetime gifts into an A&M trust were potentially exempt transfers.

This favourable IHT regime continued for existing A&M trusts, provided that before 6 April 2008 the trust was modified to give a full entitlement at age 18.

If the trust was changed so that full entitlement is given after age 18, but by age 25, the discretionary trust tax regime will apply from age 18 onwards, meaning that there will be an exit charge when absolute entitlement is given.

If the trust has been left unchanged since 22 March 2006, it will be treated as a relevant property trust like a discretionary trust from 6 April 2008 onwards. No IHT charge occurred at the change of regime (6 April 2008) but ten-year anniversaries will arise by reference to the original date of settlement. Up to the first ten-year anniversary charge after 6 April 2008, the rate of charge will reflect the fact that the property has not been relevant property throughout the full ten-year period.

IHT - Offshore trusts

Specific rules to trusts established by non-UK domiciled individuals apply. These are complex and subject to anti-avoidance legislation.

Overseas trusts can be subject to UK income tax if there is a UK resident trustee.

If there are no UK trustees acting for the trust, there will be no UK income tax payable. Despite this, anti-avoidance rules state that trust income can be attributed to the settlor where the settlor or certain connected parties can benefit. Alternatively, beneficiaries can be taxed where capital is distributed from a trust within which income is accumulated.

Overseas trusts are not subject to UK CGT. However, anti-avoidance legislation can attribute trust gains to the settlor where the settlor or certain connected parties can benefit. Alternatively, the beneficiaries can be taxed where capital is distributed.

A transfer of property by a UK domiciled settlor into an overseas trust is a transfer of value for IHT purposes and all the normal consequences apply.

Overseas trusts will also be subject to the taxation laws of their country of residence.

On an individual’s death, all of his or her assets will pass to the personal representatives of the estate. Personal representatives are called executors where a valid will is in place. Where no will is in existence, the personal representatives are known as administrators.

Executors will prove their title by producing a grant of probate. Administrators will prove their title by producing a grant of letters of administration.

Personal representatives must distribute the deceased’s estate in accordance with the terms of any valid will or under the laws of intestacy. They must also pay off any debts owed by the deceased as well as any IHT on th...

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... and after death, the main residence exemption will apply where the beneficiary is entitled to at least 75% of the proceeds of the house.

When a person dies, personal representatives can claim for any losses which arose in the tax year in which the person died up to the date of death, to be carried back and set against gains in the three previous tax years. This could give rise to a refund of tax where claimed.

Inheritance tax

The estate of a deceased person will be subject to inheritance tax at the date of death.

A nil rate band of £325,000 is exempt from IHT and any excess over this amount will be chargeable at the death rate of IHT of 40%.

In this section, we consider the impact of the pre-owned assets tax charge on trust planning.

Gifts of propert...

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...e of the use of the assets. It is thus difficult to avoid IHT on any assets without gifting them away completely.

Summary of tax position for trusts created on or after 22 March 2006

Type of trust

Income tax

Capital gains tax

Inheritance tax

Bare

Beneficiary taxable at his/her rates

Beneficiary taxable at his/her rates

Gift into trust is PET

Interest in possession

Trustees taxable at basic savings/dividend rate. Beneficiary may reclaim/pay extra at his/her rates.

Trustees taxable at 2...

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...tment

If settlor’s spouse has an interest

Settlor taxable at his/her rates

Settlor taxable at his/her rates

Reservation of benefit rules do not apply provided no indirect benefit is received

Vulnerable beneficiary

Trustees effectively taxed as if trust income were that of the vulnerable beneficiary

Gains taxed on vulnerable beneficiary, not trustees

Does not alter treatment