Taxation of UK Resident Trusts

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Chris Gillman

Chris Gillman – Trust Specialist

It is important to understand the tax implications of trusts particularly in recent times where there is increasing complex anti-avoidance legislation in this area.  This is particularly the case for offshore trusts and is essential to obtain professional advice.  Menzies can provide advice to trustees, beneficiaries and settlors on the UK tax consequences of all trusts. 

The trustees of a trust are chargeable to tax, and so a trust will usually be subject to income tax and capital gains tax during its lifetime.  Self-assessment tax returns will need to be completed for trusts to report income and capital gains arising.  The only exceptions to this are bare trusts which are not subject to tax charges as the beneficiaries are the legal owners of the property and subject to any tax personally. 

Inheritance tax charges will also potentially apply to trusts. This may arise initially on the creation of the trusts, when capital is distributed from the trust, and every ten years as periodic charges.  Inheritance tax returns will need to be completed to report these charges. 

Each different sort of trust is subject to different tax regimes and so it is necessary to consider each different trust in turn when considering trust taxation. 

Discretionary trust Taxation

More about Discretionary Trusts

Income Tax and Capital Gains Tax 

Income tax is charged on any income received by the trust at what is known as the rate applicable to trusts: a flat rate of 45% for non-savings income and interest income, and 38.1% for dividend income (£1,000 can be taxed at basic rates). Trustees are not entitled to deduct any expenses although management expenses of the trust can be used to extend the £1,000 basic rate band.  

When income is paid to beneficiaries, they declare any distributions received on their tax returns, together with a tax credit of 45% in respect of tax paid by the trust.  They can claim back this tax to the extent that the 45% rate exceeds their marginal tax rate. 

Capital gains can arise in the trust on the disposal of trust assets or the appointment of assets to beneficiaries. Capital gains tax is calculated using the same rules that apply to individuals, but they typically only have half an individual’s annual exemption. Capital gains are charged at a rate of 20% (28% for residential property). 

Inheritance Tax 

When a settlor puts their assets into a discretionary trust, they remove the assets from their estate and as such, inheritance tax will not be due on these assets when the settlor dies, (as long as the settlor has not retained any interest in those assets).  

However, the transfer of assets into a trust is a chargeable lifetime transfer (CLT) for inheritance tax purposes and inheritance tax can arise on the transfer.  Every individual has a nil rate band of £325,000 available and so transfers above this amount are subject to inheritance tax (£650,000 for a couple combined). A CLT is charged at 20% although it could increase to up to 40% if the settlor passes away within seven years of the gift.  (Capital gains tax can also arise on any assets leaving the settlor’s estate that have accumulated capital gains, although “holdover relief” can usually be claimed to defer these gains). 

If the assets being transferred into trust qualify for Business Property Relief, it is possible to obtain up to 100% relief on the transfer depending on the assets being transferred. Company shares that have been held for a minimum time of two years would normally qualify for 100% provided the company is trading and have no exempted assets.  This can be hugely beneficial and can allow significant trading assets to pass out of your estate free of IHT. 

An inheritance tax exit charge may be payable when capital distributions from the trust are made, and periodic inheritance tax charges are typically due every ten years.  The charges are based on the value leaving the trust in the case of exit charges, and the value in the trust at the anniversary date in the case of periodic charges. They are capped to a maximum of 6%.  Again, reliefs are available in respect of business property. 


Interest in Possession Trust Taxation

More about Interest in Possession Trusts

Income Tax and Capital Gains Tax  

Interest in possession trusts are subject to tax at the basic rate: 20% on rental profits and interest, and 7.5% on dividends. The income after tax and expenses is paid out to the life tenant. The life tenant must report it on their self-assessment tax return, again with a tax credit, and either pay additional tax if they are higher rate taxpayers or claim back tax if they are entitled to do so. 

The trust will pay capital gains tax on any capital gains above the annual exemption. The annual exemption is normally half the personal annual exemption.  CGT is charged at 20% (28% for residential property).  

Inheritance Tax 

When a settlor puts their assets into an interest in possession trust, they remove the assets from their estate and as such, inheritance tax will not be due on these assets when the settlor dies assuming the settlor retains no interest.  

However, the transfer of assets into a trust is a chargeable lifetime transfer (CLT) for inheritance tax purposes and inheritance tax can arise on the transfer.  Every individual has a nil rate band of £325,000 available and so transfers above this amount are subject to inheritance tax (£650,000 for a couple combined). A CLT is charged at 20% although it could increase to up to 40% if the settlor passes away within seven years of the gift.  (Capital gains tax can also arise on any assets leaving the settlor’s estate that have accumulated capital gains, although “holdover relief” can usually be claimed to defer these gains). 

If the assets being transferred into trust qualify for Business Property Relief, it is possible to obtain up to 100% relief on the transfer depending on the assets being transferred. Company shares that have been held for a minimum time of two years would normally qualify for 100% provided the company is trading and have no exempted assets.  This can be hugely beneficial and can allow significant trading assets to pass out of your estate free of IHT. 

If interest in possession trusts are created on death, the identity of the life tenant determines the inheritance tax treatment. If the deceased’s spouse is given an interest in possession in the trust, then the transfer is exempt from inheritance tax.  If anyone else has the interest in possession, then the transfer is subject to inheritance tax as usual.  

Interest in possession trusts can also be subject to inheritance tax during their lifetime depending on whether or not they are qualifying or non-qualifying: 

  • Qualifying Interest in Possession Trusts include all those set up before 22 March 2006 and certain trusts created on death.  They are not subject to inheritance tax during their lifetime; instead the assets are treated as belonging the life tenant so are potentially subject to inheritance tax when the life tenant dies. 
  • Non qualifying Interest in Possession Trusts include all those set up after 22 March 2006 including certain trusts created on death. They are charged to inheritance tax exit and periodic charges throughout their lifetime just like discretionary trusts; they are not treated as belonging to the life tenant so do not suffer inheritance tax on the life tenant’s death. 

Bare Trust Taxation 

More about Bare Trusts

Income and Capital Gains Tax 

As the assets belong to the beneficiaries, any income or capital gains of the trust is taxed in the hands of the beneficiaries, at their marginal rate. However, if a parent gifts property to the trust, then any income from this property in excess of £100 must be taxed on the parent and not the child. This is an anti-avoidance rule the stops parents diverting their income to their children in order to use their personal allowances. 

Inheritance Tax 

Provided that the person gifting the property to the bare trust survives for seven years, there would be no inheritance tax on the creation of the trust. The gift would be a potentially exempt transfer. If the donor died within seven years, the beneficiary would need to pay any inheritance tax owing. 

There are no inheritance tax charges on a Bare Trust during its lifetime. 

If the beneficiary were to die whilst there was still property in their bare trust, it would form part of their estate and be subject to potential inheritance tax. 


Taxation of Offshore Trusts

More about Offshore Trusts

Income and Capital Gains Tax 

Offshore trusts do not have to pay UK income tax on foreign income.  However, they do have to pay income tax on most UK income, and so holding overseas investments in the trust can help avoid a UK tax liability.  If UK resident settlors can benefit from the trust, then income can be attributed to them to be taxed, and so usually settlors and their spouses are excluded as trust beneficiaries.  There are also circumstances where the beneficiaries of an offshore trust can be subject to income tax on any income arising either at trust level or in an underlying company. 

Offshore trusts are also exempt from capital gains tax on any arising capital gains (provided they do not arise on UK trading assets or UK residential property).  However, if a UK resident and domiciled settlor, their spouse, children, grandchildren and spouses are beneficiaries of the trust, then the settlor is taxed on any arising gains.  In other cases, any UK beneficiaries are subject to capital gains tax on attributed gains if they receive distributions of capital gains.  

Calculating what is and is not taxable and on whom liability falls, is often highly complex and is very much dependent on individual circumstances.  We would always advise seeking advice in this respect. 

Inheritance Tax 

If offshore trusts are created by UK domiciled individuals, they are subject to the inheritance tax rules in the same way as UK discretionary trusts. 

However excluded property trusts created by non-UK domiciled (and non-deemed domiciled) individuals, and that hold foreign assets, are excluded from the UK inheritance tax regime.  They are hence particularly useful for non-UK domiciled individuals who can now become deemed domiciled in the UK when they have been here a long time.  It ensures that their foreign assets if held in an excluded property trust, can remain outside UK inheritance tax even though all their other assets will be subject to inheritance tax

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