Malcolm Finney examines the important distinction between capital and income payments to beneficiaries of a discretionary trust.
A key distinction between discretionary trusts and fixed interest trusts is that the trust is the source of any income distributions to a beneficiary of a discretionary trust. For the fixed interest trust, the source of the beneficiary’s income is the underlying trust income itself, not the trust. In essence, the discretionary trust is not transparent.
Furthermore, until the trustees of a discretionary trust exercise their discretion in favour of one or more trust beneficiaries, the latter are entitled to nothing (whereas under the fixed interest trust, typically one or more of the trust beneficiaries (often referred to as life tenants) are entitled to the trust income as it arises).
Which is it?
For tax purposes, it is important for the beneficiary to know whether a distribution by trustees is of income or capital.
Where payments made by trustees are income, the recipient beneficiary is entitled to a tax credit of 45% (i.e. the rate payable by trustees on their non-dividend income), which may enable a basic rate or nil rate tax paying beneficiary to claim a refund of some or all of the income tax paid by the trustees on the distributed income. An income distribution will also result in the inflation of the recipient beneficiary’s taxable income and thus impact on the marginal rate of income tax payable by the beneficiary.
Neither of these consequences arise where the receipts are capital in nature. However, receipts of capital may give rise to an inheritance tax (exit) charge on the trustees (assuming that the trust qualifies as a ‘relevant property’ settlement, as most lifetime created trusts are).
Payments of an income nature?
Unfortunately, the relevant case law and legislation is not overly helpful in determining whether trust distributions constitute income or capital. The basic rule, derived from case law and HMRC practice, appears to be that any determination is not made based on whether the payment by the trustees is out of trust income or capital, but whether the receipt by the beneficiary has the ‘quality’ of income. Normally, trust distributions out of trust capital are not income. However, where a payment of trust capital by the trustees is designed to augment the income of the recipient beneficiary, the capital payment is likely to be treated by HMRC as income (not capital) on the part of the beneficiary and thus subject to income tax.
Once any trust income has been accumulated by the trustees and is subsequently paid out to beneficiaries, such receipts by the beneficiaries are treated as distributions of capital, not income. The effect of accumulation is that income is turned into capital and in principle, no income tax charge arises on distribution, although it then follows that the income tax paid by the trustees on such income cannot be recovered by the recipient beneficiary.
In the leading case of Stevenson v Wishart [1987] STC 266, the trustees made capital payments to one of the trust’s beneficiaries who had suffered a heart attack; the payments were designed to cover medical and care home expenses. HMRC argued that the payments were income as they were made for an income purpose and thus subject to income tax on the part of the beneficiary. Fortunately, the Court of Appeal did not accept HMRC’s argument, confirming that the payments were of capital.
