A little-known change to income tax will have major repercussions for beneficiaries of some trusts, says Rachael Dronfield, Tax Manager at Grant Thornton.
UPDATE March 2014: Trusts and tax – are discretionary trusts still relevant?
The introduction of the 50% income tax rate for higher earning individuals with effect from 6 April 2010 has been well publicised. Unfortunately, much less attention has been given to a similar increase in the income tax rates for many trusts, which may in turn leave some beneficiaries out of pocket unless they take further action.
Which trusts will be hit?
The trusts affected are ‘discretionary trusts’, where the trustees have discretion as to whether income is paid out to beneficiaries, and ‘accumulation and maintenance trusts’, which were often created for minor children or grandchildren.
‘Interest in possession’ trusts, where a beneficiary is entitled to the trust income are not affected, and may actually become more popular, as they can avoid some of the tax and administration problems now associated with discretionary trusts.
How will discretionary trusts be affected?
Discretionary trusts are still entitled to their basic rate band of up to £1,000. Thereafter, all income will be taxed at the increased rate of 50%, apart from dividends, which will be taxed at 42.5%. In comparison, individuals still have the benefit of their basic and 40% rate bands, so they are not affected by the 50% tax rate until they have taxable income of more than £150,000. This difference is going to affect many beneficiaries who receive income from affected trusts.
To make an income payment from a discretionary trust, trustees must now have paid 50% income tax already. This may mean additional tax is payable on income paid out now that has only been taxed at source at 40%, such as income that arose before 6 April 2010. Income received after this date will have been taxed at 50% on the trustees (apart from one exception) so they can pay out income straightaway. The exception to the rule is dividend income, and the impact of distributing dividend income can actually push the overall effective tax rate to be in excess of 50% and is best illustrated in an example.
Where trusts receive bank interest after 5 April 2010, this is usually paid net of 20% income tax which is effectively collected by the bank on behalf of the tax man. However, this tax paid at source is credited against the amount payable by the trustees, so now the trustees only need to pay an extra 30% tax to meet a trust’s 50% income tax liability. No further tax is required when they pay out this income.
In comparison, dividends are only taxed at source at 10% and this is a notional tax credit which cannot attach to an income distribution. So the trust must pay an additional 32.5% to bring the overall rate up to 42.5% and then a further 10% if they want to distribute the dividend.
Can beneficiaries claim a refund?
A beneficiary who is liable to tax at 50% will not have anything further to do, but a beneficiary in a lower tax bracket will be able to reclaim the additional income tax paid.
This is something quite common (but time consuming) for, say, grandchildren who do not receive any other income, but now even traditional 40% income tax payers will need to reclaim the difference. This is going to take much more time and effort just to put those beneficiaries back in the same net position as pre 6 April 2010.
Options for trustees
Fortunately, there are some options for trustees to consider.
- Non-income producing investments may be preferred, either where little income is paid out, or to take advantage of the current lower capital gains tax rate. Although trusts now pay capital gains tax at the new rate of 28% with effect from 22 June 2010, this is still lower than the new 50% rate of income tax paid by trustees.
- Alternatively, distributing capital may be suitable where paying out income would lead to an additional income tax charge. For trusts that do make regular income payments, giving the beneficiary an interest in possession can be beneficial as this avoids the need for repayment claims by basic and 40% taxpayers and can improve the cash flow position. This option is particularly beneficial if dividend income is received, as it will actually result in an income tax saving for all beneficiaries. It should be possible to vary most discretionary trusts in this way, but legal advice will be required.
- Finally, in some cases, trustees may decide that winding up the trust and distributing all the assets is worthwhile to reduce the costs for both the trustees and the individual.
Trustees affected by the new 50% income tax rate should review the trust assets and the income requirements.
Where income payments are not required, the trustees may wish to invest in non-income producing assets or invest for capital gains.
If income is regularly paid to beneficiaries, then varying the trust to create an interest in possession could be beneficial. It does not have to involve the whole of the trust fund and does not have to be permanent. There will, however, be legal costs involved.
Beneficiaries who receive regular trust income may wish to discuss their income tax position with the trustees, to see if the creation of an interest in possession is possible to prevent the need for repayment claims, especially if they are 40% income tax payers.