Tax and Trusts: Discretionary Trusts and Taxation Explained

What is a Discretionary Trust?

Principally a discretionary trust allows the Trustees the discretion as to what to do with the Trust income and capital. No single beneficiary is entitled as of right to the Trust Income or capital.

Typically Trustees will have the power to distribute income to one or more of the beneficiaries included within the Discretionary Class, as set out within the Trust Deed or Will, or subject to the terms of the Trust there is usually a power or duty to accumulate the income within the Trust. It is worth noting here that the period for which income may be accumulated within the Trust (the accumulation period) is, for many older Trusts, a finite period of which 21 years is a standard period.

The Trustees of most discretionary trusts would also have a discretion over the distribution of the capital of the trust, thus enabling them to distribute capital by Deed to any one or more of the beneficiaries of the Discretionary Class if and when they see fit.

Inheritance Tax

There is a special Inheritance Tax regime called the relevant property regime which will apply to a Discretionary Trust.

What happens for Inheritance Tax purposes when I transfer assets into Trust?

If you transfer assets into a relevant property trust in your lifetime, this is referred to as a Chargeable Lifetime Transfer (CLT) for Inheritance Tax purposes. If that transfer of assets, and any other CLTs which you have made in the previous 7 years, exceed your Inheritance Tax nil rate band of currently £325,000 then, subject to the availability of any lifetime exemptions available, an immediate Inheritance Tax charge will arise.

The rate of IHT payable at the time of the gift is the lifetime rate of 20% if the Trustees pay (this is grossed up to 25% if you pay the tax charge personally as the settlor of the Trust).

What Inheritance Tax is charged on the Trust itself?

Once within the Trust, Inheritance Tax is charged:

• On the value of the Trust assets on every 10 year anniversary. The maximum Inheritance Tax charge every ten years is 6%.
• When capital is distributed out of the Trust to the beneficiaries, again at a maximum of 6%.

Capital Gains Tax

What happens for Capital Gains Tax purposes when I transfer assets into Trust?

If you transfer assets into a relevant property trust in your lifetime, a disposal takes place for Capital Gains Tax purposes. As a settlor, you will be charged to Capital Gains Tax on the Capital Gain arising based on the open market value of the asset at the date of transfer into the Trust. There are, however, possible Capital Gains Tax reliefs’ which may potentially be claimed such as Capital Gains Tax Holdover (‘Gift’) relief, but the availability of such reliefs would need to be carefully considered and depend upon the particular circumstances.

Is the Trust liable to Capital Gains Tax?

Yes, Trustees are liable to Capital Gains Tax at the rate of 28% on capital gains realised on the sale of residential property and 20% on gains realised on the sale of other assets, after deduction of the trust annual exemption. The maximum trust annual exemption is half of the exemption available to an individual and is currently £3,000. This amount is shared if the settlor has set up more than one trust.
As well as Capital Gains arising on the actual disposal of assets by the Trustees, there are also deemed occasions of charge to Capital Gains Tax when, for example, beneficiaries become absolutely entitled to trust assets.

It is important to note that there are a number of Capital Gains Tax reliefs potentially available to Trustees, the availability of which will depend upon the specific circumstances and the type of asset sold or appointed out. Reliefs include Private Residence Relief and Holdover (‘Gift’) Relief.

When a beneficiary becomes absolutely entitled to a trust asset from a Discretionary Trust, as it is the case that the transfer is usually chargeable to Inheritance Tax (as referred above), it may be possible for the Trustees to claim Capital Gains Tax holdover relief. Whilst this relief does not reduce the amount of the Capital Gain, rather than the Capital Gain becoming immediately chargeable to tax on the Trustees on the transfer of the trust assets, the beneficiary instead acquires the asset at the original cost of that asset to the Trust. This enables the Capital Gain to be deferred until such time as the beneficiary later sells or transfers the asset/s. The beneficiary would then be chargeable on the gain with their personal reliefs and tax rate/s applying.

Income Tax

The Trust Income is charged to tax at the Trust Rates which are currently 39.35% on dividends and 45% on other income.

Income of the Trust is declared by the Trustees to HM Revenue & Customs on an annual Trust and Estate Tax Return.

If a distribution of income is made to a beneficiary, there is a 45% tax credit on that distribution.

The Trust must have paid sufficient tax to meet this tax credit. Where the tax credit exceeds the tax paid by the Trustees, then the Trustees must pay the difference as part of the Self-Assessment process.