Taxation of Trusts

There are various types of trusts, but usually they fall into one of the following categories:

Interest in Possession Trusts

One or more beneficiaries has a right to all or part of the income of the trust, perhaps with capital passing to other beneficiaries when the interest in possession terminates, (commonly on a death).
The trustees are chargeable to income tax and capital gains tax as follows:

  • Rent and trading income are chargeable at the basic rate (currently 22%).
  • UK dividend income is chargeable at the starting rate for dividends (currently 10%) and the tax credit attached to the net dividend meets the trustees' liability. 
  • Savings income, such as bank interest, is chargeable on the trustees at the lower rate (currently 20%) Such income usually has tax deducted at source by the bank or building society.
  • Capital gains are chargeable at 40%

Income to which beneficiaries are entitled is taxed on those beneficiaries with credit given for the tax suffered by the trustees.

Discretionary Trusts

The beneficiaries of a discretionary trust have no right to receive income and it is up to the trustees whether or not distributions are made.

The trustees are liable to tax on income and gains at the rate applicable to trusts (currently 40%), but dividends and other similar income are chargeable at the trust rate that applies to dividends (currently 32.5%).

Beneficiaries are only taxed to the extent that income is paid out to them and they receive a tax credit equivalent to 40% of the gross sum distributed.

In order to simplify the tax position of many smaller trusts the first £1,000 (the standard rate band) of trust income is taxable at rates similar to those applicable to Interest in Possession Trusts and only the balance of income is taxable at trust rates.

Accumulation and Maintenance Trusts

Such a trust allows income to be accumulated, frequently during children's' minority, with interests in possession arising thereafter. They will therefore tend to be taxed in the same way as discretionary trusts to begin with (including the standard rate band) but will convert to interest in possession trusts at a later date.

Mixed Trusts

For both trustees and beneficiaries, in a mixed trust the income for each part of the trust will be taxed under the rules for that type of trust. For example, the part of the trust in which there is an interest in possession will be taxed as such, while the discretionary part will be taxed as a discretionary trust.

Bare Trusts

Bare trusts are treated for tax purposes as if the beneficiary holds the trust property in his or her own name. Income tax and capital gains tax are charged on the beneficiary, as if the trust did not exist, except where parents declare trusts for their minor children.

For tax purposes, there are also 'settlor-interested trusts'. Different tax rules apply to settlor interested trusts, non-resident trusts and special trusts. Depending on the type of trust, when income and capital gains arise in a trust tax might be charged on the trustees, the beneficiaries or the settlor.

The Finance Act 2006 has made some fundamental changes to the way in which settling assets on Trustees are treated for Inheritance Tax (IHT) purposes.  Before 22 March 2006 lifetime transfers to Interest in Possession and Accumulation and Maintenance Trusts were Potentially Exempt Transfers so that there was no immediate liability to IHT and, so long as the donor survived seven years from the date of the gift, the assets settled would fall completely outside of his estate.  However from 22 March 2006 these trusts (with certain very restricted exceptions) will be charged to IHT at the lifetime rate (20%) to the extent that the value of the gift exceeds the taxpayer’s available nil rate band (currently £285,000).  This rate would increase to 40% if the donor died within 7 years of the gift.

The changes also bring these trusts into the 10 year charge and exit charge provisions previously only applicable to Discretionary Trusts.  As a result of these changes, it will be possible to take advantage of the Capital Gains Tax holdover relief on transfers into and out of post-21 March 2006 trusts of these types.

The new provisions are complicated and advice should be sort before taking any action to set up a new trust.