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Tax quirks of discretionary trusts

11 November 2020

The Brand Financial Training team looks at tax quirks that apply to discretionary trusts.

This article was first published in the November 2020 issue of Professional Paraplanner.

There are a couple of oddities in respect of the taxation of discretionary trusts that paraplanners should consider when revising for exams.

The taxation of trusts can be tested in various CII exams but mostly they will appear in AF1 Personal Tax and Trust Planning, R03 Personal Taxation and J02 Trusts.

The first quirk is the taxation implications of creating a discretionary trust; this will be a chargeable lifetime transfer and an immediate charge to inheritance tax will be triggered if the transfer exceeds the settlor’s nil rate band (together with any other chargeable lifetime transfers in the previous seven years).

The rate of tax is half the death rate, in other words 20% – with nothing further to pay if the settlor lives for the next 7 years. This is the rate if the trustees pay the tax; where the donor (also called the settlor or transferor) pays the tax the transfer has to be grossed up.

An example

Murphy gifts £350,000 into a discretionary trust. He already regularly used his annual allowance of £3,000 but had made no other gifts.

If the trustees pay the tax on the gift, their liability will be:

£350,000 – £325,000 = £25,000 x 20% = £5,000

If Murphy pays the tax as settlor, then the value has to be grossed up.

The easiest way to work this through is by multiplying the net transfer by 1.25 (or divide by 0.8), i.e. £25,000 x 1.25 = £31,250 and multiplying this by 20% to give £6,250.

The reason we have to gross up is because IHT is based on the loss to the person’s estate. If they make a transfer to the trustees AND they pay the tax then the loss to the estate is the two added together and tax is worked out on that figure.

In the exam to save time and to easily remember, if the trustees pay the tax multiply the net transfer (in our example £25,000) by 20% and if it’s the settlor paying the tax multiply by 25% and you’ll get the right answer every time.

In particular look out for this question in R03; as it’s a multiple-choice exam often both answers will be an option and it’s easy to go for the 20% answer and miss the fact that they’ve said the settlor is paying the tax.

Testing in AF1

The way it has been tested before in AF1 (and J02) is as follows (adapted from a past AF1 paper):

In May 2020, James, having made no previous lifetime gifts, settled £650,000 into a discretionary trust, with his children as potential beneficiaries.

The question is, calculate the initial IHT liability on the transfer of the gift into the trust – assuming that James pays any tax due.

The information has been given that the settlor is paying the tax on the transfer. The answer, as given in the exam guide, is:

£650,000 ‐ £6,000 ‐ £325,000 = £319,000 x 25% = £79, 750

As you can see the exam guide just shows the net transfer being multiplied by 25% – however credit should also have been given for candidates showing the correct grossing up of the gift, i.e.: £319,000 grossed up by 20% (divide by 0.8) = £398,750 x 20% = £79,750

Note: Remember, if the trustees pay the tax multiply the net transfer by 20% and if it’s the settlor paying the tax multiply by 25%.

Income tax

The next quirk we are going to cover is an income tax issue.

As you will know the rates applicable to discretionary trusts are as those for an additional rate taxpayer. Trustees do have a standard rate band of £1,000; this must be split between the number of trusts the settlor has set up (to a minimum of £200 per trust). Dividend income up to £1,000 is taxed at 7.5%. Any dividend income received above £1,000 is taxed at 38.1%. Interest or rental income up to £1,000 is taxed at 20% with anything over £1,000 taxed at 45%. (Note that the standard rate band is firstly set against non-savings income, then savings income and lastly dividend income).

Example

A discretionary trust receives a dividend payment of £1,000. Assuming the standard rate band has been used by savings interest, the trustees will pay £1,000 @ 38.1% =£381

If the income was accumulated in the trust fund then the net amount accumulated would be £619.

If the net income is paid out to a beneficiary it gets slightly more complicated. The beneficiary would receive £550 with a tax credit of £450.

This is because the income stops being ‘dividend income’ and becomes ‘trust income’ meaning that the trustees are actually liable for 45% on £1,000 i.e. £450. From this the trustees can deduct £381 already paid leaving them with extra tax to pay of £69.

Once the beneficiary receives the net income with tax credit it then depends on their own income tax position as to whether they can reclaim all, or some, or none of this.

This tax credit (basically income tax that is treated as having been deducted) needs to have been covered by tax already paid by the trustees. After all, HMRC needs to make sure that any tax reclaim being made by a beneficiary is not more than the amount of tax originally paid by the trustees.

This is where the tax pool comes in; it is basically a record of the running total of income tax that has been paid by the trustees and if, at the end of the tax year, enough hasn’t been paid to cover the 45% tax credit then they owe the difference to HMRC paid through self-assessment.

The tax pool therefore is a record of the total income tax paid which can be used to offset the tax credit when a payment is made to a beneficiary. The pool is then reduced by the appropriate amount. If there is a balance outstanding then this can be carried forward to the next tax year and used to offset against future payments.

The tax pool record is sent to HMRC when the trustees submit their tax return.

Tax pools are more likely to be tested in AF1 and J02 rather than the R03 exam.

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