Discretionary trustees should consider whether it would be advantageous to distribute trust income that has arisen more than five years before the next inheritance tax ("IHT") ten year anniversary of their trust. The reason for this is that the Government is going to change the way in which the IHT ten year anniversary charge applies to undistributed income that, as at the ten year anniversary, has been in the trust for more than five years. The change will apply in respect of ten year anniversaries occurring on or after 6 April 2014.
Under English trust law discretionary trustees have power to apply the trust income for the beneficiaries or formally to accumulate such income by resolving to hold it as part of the capital. Accumulated income is treated for tax and trust purposes as capital.
Under current law if trustees neither apply the income for the beneficiaries nor formally accumulate it but simply retain it as undistributed income its IHT status is unclear. If distributed in the future, is it taxed as an income distribution or as a distribution of capital, liable to an IHT exit charge? If retained in the trust at a ten year anniversary is it taxed as part of the capital? HM Revenue and Customs ("HMRC") might argue that undistributed income retained in the trust is deemed to form part of the capital after a period of time - but how long must it be held in the trust before this treatment applies? The position is unclear and might moreover depend on the circumstances of particular trusts.
As part of its longer-term project to simplify the IHT taxation of discretionary trusts the Government will be legislating to treat "old" undistributed income (that is, income that has been in the trust for over five years) as part of the capital at a ten year anniversary falling on or after 6 April 2014. Moreover there will be no reduction in the rate of IHT (as there is at present) to take account of the fact that some or all of the income might not have been in the trust for the full ten year period since the previous ten year anniversary.
In view of the above some of the options that discretionary trustees might consider are
- formally accumulating the income and distributing it as capital at a lower rate of IHT before the 10 year anniversary; or
- distributing the income as income before the 10 year anniversary if the trustees have tax credits available to them to offset any income tax on the distribution and if the recipient beneficiary is a lower rate income tax payer (although this depends on HMRC accepting that the income has not been accumulated under general trust law)
There might be other options depending on the circumstances.
Conclusion
For smaller trusts it might well not be cost-effective to spend time working out the optimum course of action in light of the change outlined in this briefing. However trustees with large amounts of old, undistributed income might want to consider how to deal with it in view of the forthcoming change in the treatment of such income. Such trustees with a ten year anniversary coming up shortly after 6 April 2014 might want to consider the position soon.
In addition to the change outlined in this briefing, we are awaiting further proposals from the Government on how it intends to simplify the IHT taxation of discretionary trusts. We will report any relevant developments in due course.
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.
