What are you doing about trusts affected by the increase in income tax rates?

 In Tax, Trusts

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The Finance Bill received Royal Assent on 21 July 2009 and as a result the new s.6 and Schedule 2 to the Finance Act 2009 brings in the provisions for an additional rate of income tax and an additional rate for dividends. The consequential amendments include increases to the trust rate and the dividend trust rate. By aligning the trust rate and the dividend trust rate with the highest rates of personal taxation this means that the trust rate increases to 50% from 40% with effect from 6 April 2010 and the dividend trust rate increases from 32.5% to 42.5%.

Which trusts affected?

These new rates will apply to discretionary trusts and any trust where the trustees can accumulate the income irrespective of the amount of income over the standard rate band of £1,000. This is because there is no gradual introduction of the new rates as there is with the personal tax rates. Personal income tax rates only increase to 50% if the individual’s income exceeds £150,000 but there is no similar increase in the standard rate band for trusts.

The position where the beneficiary is entitled to the income as of right or where the trustees distribute income immediately in exercise of their discretion is different. Where there is an interest in possession the trustees pay tax at the basic rate and the beneficiary only pays more tax than that on the trust income if their total income including the trust income exceeds £37,400 for 2009/10 (i.e. if the beneficiary is a higher rate tax payer).

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Repayment of tax

Where the trustees choose to exercise their discretion and distribute income from a discretionary trust then if the beneficiary to whom the income is paid is a none or basic rate taxpayer and even a higher rate taxpayer but not an additional rate tax payer there will be an entitlement to a repayment of the difference between the tax which has had to be paid at the higher trust rates and the beneficiary’s personal rate.

Example

Deposit interest received by trustees

  • Assume £1,000 after tax deducted at source at 20%
  • Trustees will have to gross up first to assume receipt of £1,250 gross
  • Apply new 50% rate = £625.00
  • HMRC already has £250; so pay additional £375.00
  • Trustees left with £625.00

If trustees distribute whole £625.00:

  • To Adam a non-tax payer – he will be able to reclaim £625.00 & so enjoy eventually the full £1,250
  • To Beverly a basic rate taxpayer – she will be able to reclaim £375.00 and so enjoy £1,000 in total
  • To Christopher who is a 40% tax payer – he will be able to reclaim £125.00 assuming he earns less than £100,000 and so benefit in total by £750

Should you accumulate income?

Trusts which accumulate income will be penalised for saving for the future. From 6 April 2010 they will have a powerful disincentive to accumulate income for the future benefit of beneficiaries. Paying income out each year to minor beneficiaries is not always possible or desirable and it may not be permissible to change the trust to an interest in possession.

If the trust accumulates income then income tax has to be paid on the accumulated income. If the trust distributes the income then tax has to be paid on the distribution unless there is a positive ‘tax pool’ to frank the distributions. If the trust has been running for some time without making income distributions then it is likely to have a positive ‘tax pool’ but this will quickly be used up if income distribution becomes the norm.

Inevitably there will become a smaller amount available for distribution to the beneficiary – some 43% of the sum potentially available for distribution will have to be paid in tax by the trustees whenever they make a distribution to beneficiaries!

Impact on Settlor interested trusts

Settlor interested trusts are problematic because under s.624 ITTOIA 2005 the Settlor and the trustees (under s.479 ITA 2007) are liable for income tax on income accruing to the trust. In many cases a Settlor will not be paying the new additional rate of income tax and will probably be paying the higher (40%) or standard rate (20%). HMRC allow the Settlor to claim as a credit against the Settlor’s liability the tax paid by the trustees there may well be ‘cash flow’ problems where the Settlor submits his tax return before the trustees submit their return and so the Settlor cannot claim the tax credit.

Should you change your investment strategy?

For these reasons, trustees may wish to re-think their investment strategy before 6 April 2010. If capital investments can be switched at a low or no CGT cost to be invested for capital growth rather than income this would provide the opportunity in future to make capital distributions at less than 6% IHT and possibly 18% CGT rather than 50% income tax.

© Gill Steel, LawSkills Ltd. 2009

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