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A testing time for trusts?

This article looks to get to grips with the tax changes for discretionary trusts, and how using an offshore bond may provide trustees with greater flexibility than holding investments directly

First up a quick look at Capital Gains Tax (CGT). As a result of the emergency budget, discretionary trusts will see a 55.6% rise in the tax payable on gains following the increase in CGT from 18% to 28%. Our example below highlights how this is the case:

£200,000 is held within a discretionary trust, and is invested in a number of UK unit trusts. It grows to £500,000 after 10 years when the gain is eventually realised. Based on the current CGT exemption, the first £5,050 of the gain would be exempt from tax, with the remainder taxed at 28%.

Example 1 – New CGT rate

£500,000 less £200,000 = £300,000 (overall gain)

£300,000 less £5,050 = £294,950 (gain less CGT exemption)

£294,950 x 28% = £82,586 (CGT payable by trustees)

Compare Example 1 above with what would happen under CGT at 18%, below:

Example 2 – Old CGT rate £500,000 less £200,000 = £300,000 (overall gain)

£300,000 less £5,050 = £294,950 (gain less CGT exemption)

£294,950 x 18% = £53,091 (CGT payable by trustees)

Difference in CGT payable at 18% and 28% = £29,495

Percentage increase in the tax payable = £29,495 / £53,091 = 55.6%

Of course the above example assumes that the trustees only make use of their CGT allowance once after 10 years, although they could realise gains yearly and make use of the exemption each year. Additionally, it is likely the level of exemption would escalate between now and 10 years in the future.

It is worth bearing in mind that the annual exempt amount (AEA) available to trustees is a maximum of half the personal AEA. If a settlor has created more than one trust, even one not holding investments potentially subject to CGT, the AEA available to trustees is reduced, and can be as low as 10% of the personal AEA.

What about discretionary trusts and tax on income received?

Slightly more complex than the CGT position is that of the income received by discretionary trusts, and how that is taxed.

The position for a discretionary trust in the tax year 2009/2010 is that interest or dividend income received by a discretionary trust was taxed at the higher rate (40% and 32.5% respectively), apart from the first £1,000 which, when retained by the trust, was taxed at 20% or 10%.

Proceeds paid to beneficiaries were paid net of tax at 40%, regardless of whether it came from interest or dividends.

The position for a discretionary trust in the tax year 2010/2011 is that interest and dividend income received by a discretionary trust is now taxed at 50% and 42.5% respectively, apart from the first £1,000 which, once again, if retained by the trust is taxed at 20% or 10%.

The tax paid when distributing proceeds to beneficiaries has increased from 40% to 50%.

Summary of tax on income received by a discretionary trust

2010–2011 2009–2010 Tax on first £1,000* of interest 20% 20% Tax on first £1,000* of dividends 10% 10% Tax on interest 50% 40% Tax on dividends 42.5% 32.5%

* The £1,000 standard rate band is only available to one trust created by a settlor. Where there is more than one trust created, the standard rate band will be reduced and subject to a minimum of £200 (for five trusts or more). The standard rate band only applies once to all income received (not £1,000 for interest and £1,000 for dividends). The first income to be applied to the 10% band is nonsavings income, then savings income, then bond gains and then dividends.

Example 3 - Dividend income

This example is based on the tax rates for 2010/2011 and assumes that dividend income is paid out to beneficiaries in the same tax year in which it is received. Given the order in which income is applied to the 10% band, this example excludes the standard rate band for the purposes of the calculation.

Dividend received Net dividend £9,000 Plus tax credit 10% £1,000 Gross dividend £10,000

Trustee tax to pay £10,000 x 42.5% £4,250 Less tax credit £1,000 Tax payable £3,250

Amount available to distribute to beneficiaries Net dividend £9,000 Less tax payable £3,250 Available to distribute £5,750

Additional tax payable by trustees on distribution of dividend Available to distribute £5,750 £9,000 x 50% Payment to beneficiary £4,500 Additional tax payable £1,250

In order to distribute the £5,750 to a beneficiary or beneficiaries, the trustees would require sufficient credit within their ‘tax pool’ in order to treat the income as having been taxed at 50%. The result is an additional tax payable by the trustees of £1,250.

What are the impacts of the tax changes on the beneficiaries?

A tax credit of 10% still applies on income received from UK dividends.

UK interest received will continue to be net of 20% tax in most cases.

A further 32.5% tax is applied on dividend income received, and 30% tax on interest received, which exceeds the £1,000 standard rate band for trusts.

What are the impacts of the tax changes on the beneficiaries?

On distribution of income, beneficiaries will receive 50% of the net interest or dividend.

Non-taxpayers and basic rate taxpayers will continue to reclaim overpaid tax on their income from HMRC. Higher rate taxpayers paying tax at 40% will also need to reclaim overpaid tax on their income from HMRC.

How might an offshore bond help trustees reduce administrative burdens and mitigate tax?

A recent online poll of advisers conducted by International Adviser found that 70% of respondents would be more likely to use an offshore bond after the changes announced in the emergency budget. Here are a few reasons why this may be the case:

Gross roll-up

No tax to pay on funds within the bond (except for any irrecoverable withholding tax deducted at source on some investments).

Changing investments

No tax charge to worry about when switching investments. Investments within the bond can be changed at any time without incurring potential charges to Capital Gains Tax (CGT). Remember, the maximum trustee CGT allowance is only £5,050 for the tax year 2010/2011.

Tax deferred withdrawals

Trustees can receive and distribute 5% tax-deferred withdrawals (based on the premiums paid) from an offshore bond, without the need for any complex tax calculations or the completion of trustee tax returns. The withdrawals are cumulative, so if they are not taken they can be carried forward for use in future years.

Segments and assignment

Offshore bonds can be set up as a number of individual policies (often referred to as segments) which can be assigned to beneficiaries by the trustees with no immediate tax liability. Beneficiaries can then surrender the segments at their own rate of income tax, which is likely to be lower than the trust rate of 50%.

The beneficiary surrendering the segment may also be able to use top-slicing relief to their advantage to reduce the tax payable on any gain.

Administration costs

There is no requirement for the trustees to complete annual tax returns for the offshore bond, or record the income paid and income received, and no need to operate a ‘tax pool’. These should all lead to a reduction in the administration costs incurred by the trustees.

Important notes

Please note that every care has been taken to ensure that the information provided is correct and in accordance with RL360’s current understanding of the law and Her Majesty’s Revenue and Customs (HMRC) practice as at June 2010. You should note however, that RL360 cannot take on the role of an individual taxation adviser and independent confirmation should be obtained before acting or refraining from acting upon the information given. The law and HMRC practice are subject to change. Legislation varies from country to country and a policyholder’s country of residence may impact on any of the above. Whilst any examples or cases studies highlighted may offer an opportunity for planning, they are not intended to provide an exhaustive analysis of all the opportunities or pitfalls.