Discretionary Trusts Print
Discretionary Trusts provide the trustees with wider powers than an interest in possession settlement, as they are not obliged to pay the income to the beneficiaries for any particular year, but may pay the income, or appoint capital to the beneficiaries at their discretion. For 2020/21 and 2021/22, the tax charged on the income and gains of a discretionary trust is at the RAT of 45%, and dividend income is charged at the rate of 38.1%.
Special consideration is required by Trustees where a substantial part of a Discretionary Trust or an Accumulation and Maintenance (“A&M”) Settlement (see below) consists of UK source dividend income. Dividend income of both Discretionary and A&M settlements is taxed at less than the RAT. However, where the dividend income is paid out to a beneficiary, the Trustees must account for tax at the RAT on the dividends so distributed, and the beneficiary will be entitled to a tax credit of the RAT.
A trust with no surplus tax credit relief brought forward from undistributed income would be required to pay income tax of £3,810 on receipt of a dividend of £10,000. On distribution of the dividend to the beneficiary, the Trustees must account for additional tax of £690 to frank the payment to the beneficiary at the RAT. This is demonstrated as follows:
|Tax thereon at the dividend rate of 38.1%||3,810|
|Tax payable by trustees on dividend income||3,810|
|Net Distribution to beneficiary||5,500|
|Tax deducted @ 45%||4,500|
|Less tax paid by trustees||3,810|
|Additional tax payable by trustees on distribution||690|
Where a Trust has a surplus tax credit brought forward this may be offset against the additional liability of £690 to the extent that there is credit available. This credit is referred to as the “Tax Pool” in the Trust Tax Return, and calculations.
No further tax is payable by the beneficiary. In the event that the beneficiary is not liable to income tax, because his personal allowances exceed his income, or he is liable to tax at rates below 45% he will be entitled to a repayment of all, or part of the tax deducted by the trustees at the RAT.
IHT arising on the creation of a discretionary trust during the settlor’s lifetime is charged at half the death rates, so that after using the Nil-rate band, the balance of the value transferred is charged to IHT at 20%. Where transfers have not been made during the previous 7 years, a discretionary trust may be created using the Nil-rate band of up to £325,000 without giving rise to an immediate IHT liability. This transfer falls out of account after 7 years, reinstating the full Nil-rate band, assuming no further transfers are made in the intervening years. In the event of the settlor’s death occurring within the 7 year period, a further charge to IHT may arise.
It is worth mentioning here that certain non-domiciliaries who benefit from exemption to IHT in respect of their overseas assets on death under beneficial double tax treaties (individuals whose domicile is in France, India, Italy or Pakistan) do not obtain any treaty benefit from lifetime transfers into trusts, irrespective of where the assets are situated if they have been resident in the UK for more than 15 out of the past 20 years at the time the settlement is made. Although these treaties provide for relief on death there is no corresponding relief for lifetime transfers.
In the event that a gain arises on the transfer of assets into a discretionary trust, the transferor may elect to hold-over the gain so that the CGT liability on the transfer to the trustees is deferred until such time as the trustees dispose of the assets. This relief is provided to compensate for the immediate charge to IHT on the creation of Discretionary Trusts, to avoid a double taxation charge arising.
IHT may also be payable under the ten-year charge. This is described in the section on Interest in Possession Settlements at 3. below.
Main Advantage: flexibility; ability for settlor to dispose of assets without giving control of the assets to the beneficiary.