Malcolm Finney looks at the income tax anti-avoidance rules where a settlor has an interest in the trust they create.
The tax treatment of trusts is, and always has been, extremely complex. HMRC seems to take the view that taxpayers who utilise trusts are probably ‘up to something’; of course, sometimes they are, but by no means always.
Income tax rates for trusts
The income tax treatment of trusts depends upon whether the trust is a discretionary trust or a fixed interest trust. A discretionary trust is subject to income tax at a rate of 45% (or 38.1% on dividend income). A fixed interest trust is subject to income tax at the basic rate of 20% (or 7.5% on dividend income).
These rates compare with those for an individual; namely, basic rate (20%), higher rate (40%), and additional rate (45%). Corresponding rates for dividend income for the individual are 7.5% (basic rate taxpayer), 32.5% (higher rate taxpayer), and 38.1% (additional rate taxpayer) respectively. Thus, the use of a trust may reduce an individual’s tax liabilities.
Settlor-interested trusts
However, in two sets of circumstances, any income of the trust may not fall subject to income tax on the part of the trust but on the settlor (i.e. the person creating the trust). This is achieved by imputing the income of the trust back to the settlor, causing a liability to income tax to fall on the settlor (as if the trust didn’t exist).
The first set of circumstances arises where either the settlor or their spouse may benefit from the trust. The second set of circumstances arises where minor children (i.e. under age 18) of the settlor benefit under the trust (the settlor and spouse being excluded from benefiting). Trusts falling into either set of circumstances are commonly referred to as ‘settlor-interested’ trusts.
Generous grandparents!
Consider the following scenario:
X owns three rental properties, each producing significant rental income. X is a 45% rate taxpayer and is thus subject to income tax on the rental income at 45%. Each year, he shares out (i.e. gifts) the income amongst his four children (all under age 18).
He is advised he can save income tax by setting up a discretionary trust to hold the properties under which he, spouse and children may benefit. Unfortunately, this would constitute a settlor-interested trust and X will continue to be subject to income tax on the rental income (even though the income is not his but that of the trust), and so no income tax saving arises.
Another adviser, to circumnavigate the above, suggests setting up a discretionary trust, but only for the benefit of the children (i.e. excluding the settlor and spouse) and paying out some/all the trust income to the children each year. Again, unfortunately, in such circumstances the trust income will be treated as that of the settlor and not the trust or the children.
A third adviser suggests that if one of the grandparents is a higher rate or additional rate taxpayer, they should consider setting up a fixed interest trust for their grandchildren. The settlor-interested provisions do not apply. Instead, each child is liable to income tax on their share of the rental income but at their own rate of income tax, which will typically be the basic rate, namely, 20%; a not insignificant amount of income tax is thus saved by utilising a trust.
Practical Tip:
Trusts do have a place in family tax planning but are not for the ‘do-it-yourself’ enthusiast; always take professional advice.
