UK: Trust Taxation - Latest Developments

Last Updated: 27 October 2004
Article by Janet Hoskin

The Inland Revenue has recently published its proposals for reform of the trust taxation system. The proposals build on the earlier consultation document published at the end of 2003, and have attracted considerable criticism from some quarters as being vague and ill thought-out. Nonetheless, whilst the Revenue has invited further consultation on certain points, it seems unlikely that further significant change will be forthcoming.

As the consultation document contains only broad statements of principle, and in the absence of draft legislation, it is at this stage uncertain quite what form the new rules will take. However, draft clauses are expected around the time of the Autumn Statement which should help to clarify what the new position will be.

The proposals for change fall into the following major areas:

New Definitions

  1. Trust Definition
  2. The Revenue intends to take forward the proposal to use the IHT definition of "trust" (contained in s.43 IHTA 1984) as a common definition for income tax and CGT purposes. However, the wider income tax definition is still to be used for various anti-avoidance provisions, which is likely to cause some confusion. This could also impact on certain non-UK entities which while presently trusts for IHT are not so for income tax and CGT.

  3. Settlor-Interested test
  4. Changes are also being made to the settlor-interested test. The current income tax and CGT tests are to be harmonised, although retaining the special extended test for non-resident trusts. The minor children tests used in the income tax legislation will apply for both income tax and CGT purposes. This will have a detrimental effect on those bare trusts for minor children currently used for CGT planning, because gains will now be treated as those of the settlor/parent.

  5. Residence Test

The trustee residence test currently used for income tax purposes is also to be used for CGT. In most cases this means that for a trust to be deemed non-resident for the purposes of either tax, all trustees will have to be resident outside the UK. This contrasts with the current system, whereby it is possible for a trust to be nonresident for CGT purposes if a majority of trustees are non-UK resident, provided that the administration of the trust is ordinarily carried on overseas.

Key dates for change

  • From April 2004 - 40% tax rate (dividends 32.5%)
  • From April 2005 - principal changes take effect
  • April 2005 - tax pool frozen
  • April 2006 - new residence rules to apply

Action list - to do before April 2005

  • Non UK organisations - keep new definition of trust under review
  • Non UK trustees - check all trusts with UK co-trustee or Protector and consider whether they should retire to safeguard non UK tax status
  • Trusts for minor children - consider triggering gains
  • Review trust pools

The new provisions could therefore potentially cause problems for trusts with, for example, one trustee remaining in the UK. A transitional period of 12 months is proposed before the new test takes effect, and trustees should note that they need to review their current arrangements including any Protector positions.

Income Streaming and the Abolition of Tax Pools

The Revenue is pressing ahead with plans to exempt from the RAT (rate applicable to trusts) income 'streamed-out' of a trust to beneficiaries. The income must be streamed by 31 December following the year in which it arose to the trustees, (a significant improvement from the original plan to restrict the exemption to income passed in the same tax year). The beneficiaries will instead pay tax at the basic/lower dividend rate as applicable. A further welcome change is that income will be treated as if it arose direct to the beneficiary and so not change its nature. Effectively, therefore, the trust will be treated as transparent.

The beneficiary will be treated as receiving the income in the year in which it is paid to him, which could therefore be a year later than the income was received by the trustees.

Income streamed to a particular beneficiary is to be treated as consisting of a proportionate share of each type of income that has arisen to the trustees.

However, the streaming rules will not apply to receipts that are deemed to be capital under trust law. It is also difficult to know (until draft legislation is available) what the impact will be on deemed income. In addition, the Revenue intends to introduce rules to catch artificial arrangements and attempts indefinitely to defer the charge to RAT by passing income between trusts.

In conjunction with the above proposals, the Revenue also intends to abolish the tax pool system. Pools will be frozen as from April 2005. A three year transitional period is proposed to allow trustees with large pools to use them up, but nonetheless some trusts could potentially be disadvantaged. In order to avoid losing-out, trustees should therefore review the current state of their trust's pool and consider what if any action they need to take in response to the new rules.

Finally, the Revenue has rejected the concept of capital streaming, which was floated in the previous consultation.

Changes to the Basic Rate Band

From 6 April 2005 a new basic rate band will apply to all trusts currently liable at the RAT, covering the first £500 of income otherwise taxable at the RAT. The new band will apply to trust income chargeable to the RAT after deduction of streamed income and allowable trust management expenses. Clearly, this change will be worth very little to all but the smallest of trusts.

Other Options for Change

The consultation document also floats various other options for change. The principal proposals are:

  • that trustees of trusts whose assets have been split-off into separate sub-funds should be able to elect for these to be treated as separate trusts. The Revenue is however concerned about the potential for tax avoidance.
  • the introduction of a single charging mechanism to ensure that items that are capital in trust law but deemed to be income by tax law and subject to the RAT would be brought into charge to the RAT in a consistent manner.

The full text of the consultation document can be found at www.inlandrevenue.gov.uk/trusts/trusts-modernisation.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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