Getting To Grips With The New Dividend Tax Regime For Discretionary Trusts (Part 2)

In the second of his two-part article, Peter Rayney reviews the tax treatment of distributions made to beneficiaries of a discretionary trust.

Income distributions made by the trustees are deemed to have suffered tax at 45%. The trustees will provide the recipient beneficiary with an R185 certificate, stating the net distribution and the grossed-up amount (with the tax credit of 45%). Beneficiaries will pay income tax on the ‘gross’ distribution, and will often be able to claim a repayment where the 45% tax deemed to have been suffered exceeds their actual tax liability.

The underlying income from which the distributions are made effectively loses its original ‘character’. Thus, for example, where the trustees distribute dividend income, this is simply treated as a trust distribution (non-savings income) in the beneficiary’s hands. Consequently, since this is taxed as ‘trust income’ it does not attract personal dividend tax rates or benefit from the dividend nil-rate band.

The legislation provides a mechanism to enable the trust distributions to carry a tax credit of 45% in the beneficiaries’ hands. This has to be matched by the tax paid by the trustees, which is tracked by the ‘tax pool’.

Trustee’s tax pool

The tax pool will contain the cumulative total of the tax paid by the trustees. When the trustees distribute income, they must deduct the 45% tax credit attaching to the distribution from the tax pool. The tax pool, therefore, represents the total of tax paid by the trustees during the lifetime of the trust, less the amount of tax credits used to frank previous income distributions. However, the tax pool never included the 10% (non-repayable) tax on pre-6 April 2016 dividends (and excludes ‘basic rate’ tax adjustments charged on the trust expenses).

If the tax pool exceeds the 45% tax credit, no further action is required. This is because the tax credit available on the distribution can be ‘franked’ or satisfied by the income tax that has previously been paid by the trust (after allowing for the tax credits attaching to earlier distributions).

On the other hand, if the balance on the tax pool is insufficient to cover the 45% tax credit, then the trustees are required to pay a further amount of tax to cover the shortfall (ITA 2007, s 496).

From a conceptual viewpoint, unless the trustees have a sufficient capacity in the tax pool, the full distribution of dividend income that has been taxed on the trust at 38.1% will inevitably lead to an extra 6.9% (i.e. 45% less 38.1%) tax being paid under the s 496 charging procedure.

The mechanics of the s 496 tax charge on discretionary trust distributions are illustrated in the example below.

Example: Section 496 tax charge arising on trust distributions

On 31 March 2017, the trustees of The No 1 Hart Discretionary settlement made a cash distribution (on income account) of £55,000 to one of its beneficiaries. At that date, the balance on the trustees’ tax pool was £38,000.

The tax credit attributable to the distribution is £45,000 (i.e. £55,000 x 45%/55%) and the gross distribution is £100,000.

However, since the balance on the tax pool is only £38,000, the trustees must pay a further £7,000 (i.e. £45,000 less £38,000) tax to HMRC under ITA 2007, s 496.

Assuming the recipient beneficiary’s marginal rate of tax is (say) 40%, they will be able to reclaim a tax repayment of £5,000 (i.e. £100,000 x 40% = £40,000 less tax credit of £45,000).

Practical Tip:

Trustees must be particularly vigilant and prepare up-to-date tax computations, since potential tax charges on distributions to beneficiaries may affect the amount that can be prudently distributed to them.