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Tax treatment of Discretionary Trusts and ‘Relevant Property Trusts’

This guide provides information about the tax treatment of discretionary trusts which can be created by Will or during the Settlor’s lifetime. The tax regime is also applicable to trusts classed as ‘Relevant Property Trusts’ by HM Revenue & Customs even though some of these may not be fully discretionary.

Definitions

Taxes:

CGT – Capital Gains Tax

IHT – Inheritance Tax

Trust Definitions:

Beneficiary – a person or charity who is entitled to benefit in some way from assets within a trust.

Discretionary Trust – a trust where it is up to the trustees to decide who out the trust beneficiaries may receive payments of capital or income, and how and when such payments are made.

Relevant Property Trust – a trust falling within the Relevant Property Tax regime. This will include most trusts created by Will or by the Settlor during their lifetime, except for some trusts for vulnerable or disabled beneficiaries, some trusts for children set up by their parent’s Will, Life Interest Trusts and Rights of Occupation created by Will, and bare trusts.

Settlor – the person who creates a trust by transferring money or assets to trustees.

Trustee – The person (or in some cases company) appointed to hold and administer trust assets.

Capital Gains Tax

The trustees are a separate entity for Capital Gains Tax purposes and are liable to pay tax on any gains the trust makes over and above the annual allowance.

Gains are calculated by reference to the market or sale value of the asset at the date the trust disposed of it, compared to the value at the date the trust acquired it. Certain deductions are allowable to reduce the gain.

The annual allowance for trusts is half of that of an individual – currently (2023-2024) £6,000 (£3,000 for trusts).

If a beneficiary of the trust is occupying a property owned by the trustees then the trust can mitigate CGT by using the main residence relief provisions. However there is no rebasing of asset values on the death of a discretionary beneficiary.

Any investments owned by the trustees should be carefully managed to reduce this tax burden. Any transfer of an asset out of the trust may give rise to a liability if there has been a substantial gain prior to distribution though in some circumstances holdover relief may apply.

As from April 2016 CGT rates vary depending on the nature of the asset disposed of. Residential Property is taxed at 28% while other chargeable assets are taxed at 20%. This is subject to change by the government.

Income Tax

The trustees are also responsible for paying tax on any income received by the trust. Trustees do not have the benefit of any personal allowance.

The first £1,000 is taxed at 8.75% (dividend income) or 20% (all other types of income). Thereafter dividend income is taxed at 39.35% while all other income is taxed at 45% (2023-24).

These rates are subject to change by the government.

If income is distributed during the year, the beneficiary who receives the income may claim back the extra tax paid by the trust, if they are a non tax or basic rate tax payer. Therefore, careful planning can mitigate the additional income tax burden and distributions of the trust income can use up the personal allowances of young beneficiaries who have no other income.

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Inheritance Tax

If a trust is created whereby a beneficiary has a legal entitlement to income or capital from the trust or any part of it, then on that beneficiary’s death he or she may be treated as owning the trust fund which is aggregated with their own estate for Inheritance Tax purposes. With a discretionary or relevant property trust, no-one is legally entitled to any part of the income or capital and therefore the fund cannot be treated as belonging to anyone and cannot be taxed on their death.

As a result, under Inheritance Tax rules, there are provisions for an exit charge on each distribution from the trust and a ten yearly charge once the trust has been in existence for that period, and on every 10^th anniversary after that until the trust ends. On each 10 year anniversary the trust value at that date is assessed. Inheritance tax (IHT) will be payable once the trust value has exceeded the inheritance tax allowance. Tax is charged at a maximum rate of 6%. Distributions from the trust between 10 year anniversaries will also be subject to a proportional charge though the rate will usually be lower than 6%.

The rate of IHT payable compares favourably with the 40% IHT rate applicable on death. In addition, if the value of the trust does not exceed the available IHT allowance throughout the life of the trust there will be no tax to pay.

The Settlor of the Trust may pay IHT when they create the trust if the amount transferred exceeds their available allowance at that point. Tax would be payable at 20% on the excess. The current IHT allowance is £325,000 (2023-24), however gifts made to a trust within the previous 7 years can affect the Settlor’s available allowance, and therefore the allowance available to the trust once created.

Disclaimer

This Fact Sheet has been prepared to provide you with basic information. It is not to be treated as a substitute for getting full and specific advice from Wards.

If you require further information, please contact Mary Harty on 0117 9292811 or by e-mail at mary.harty@wards.uk.com.