The use of Discretionary Trusts in Tax Planning

Transcription

1 The use of Discretionary Trusts in Tax Planning 1. What is a trust? A trust is created where:- a person referred to as "the Settlor" transfers assets to "Trustees" (appointed by the Settlor who could be friends / family / solicitors etc) entrusting them to hold those assets for the benefit of others called "beneficiaries" for a certain period of time ("the Trust Period") which is usually a period of up to one hundred and twenty five years 2. The use of trusts in tax planning. A client with assets to spare may be prepared to make absolute gifts of those assets to relatives or friends. A direct gift has the merit of simplicity and will be classed a "Potentially Exempt Transfer". In other words, providing the donor survives for seven years, the value of the gift will not be added to the value of that donor's estate for the purpose of calculating Inheritance Tax on death. There are a number of reasons why a client (who wishes to divest himself of assets so as to reduce the value of his estate at death) may not wish to make absolute gifts. The following are examples:- A donor may not consider that children or grandchildren are mature enough to deal with sums of money There is the possibility that more children or grandchildren will be born and so a donor may not wish to make gifts until he or she can be certain that there will be no further children or grandchildren whom they may need to consider The donor may not wish to make gifts to children whose own estates would suffer Inheritance Tax at death. At the same time, a donor may wish to keep assets available to those children for unforeseen or unexpected needs The donor may not wish to lose complete control over the assets he has gifted By gifting the assets to a trust rather than to an individual outright, a donor is able to remove assets from his estate, so that the "seven year clock" can commence ticking, whilst at the same time avoiding some of the disadvantages associated with an absolute gift. 3. What are discretionary trusts? Discretionary Trusts are a particular type of trust often recommended for use in tax planning and mitigation because they have the merit of flexibility. The Settlor who creates the trust will specify a list of potential beneficiaries who may benefit from the trust funds. Those beneficiaries might be named persons, or they might be objects such as charities. Alternatively, a settlor might define a "class" of beneficiaries, such as the children, grandchildren, nephews and nieces of the Settlor. By listing a class of beneficiaries, the Settlor can include any future generations, for example, by listing "grandchildren born during the trust period".

2 The Trustees will have a complete discretion as to which beneficiaries or which class of beneficiaries will actually benefit, at what time they will benefit, and in what proportions they will benefit. The Trustees will also decide how those beneficiaries will benefit. They may choose to distribute only the income of the fund to one or more beneficiaries. Alternatively, they might choose to "advance" or "appoint" all or part of the capital, either to a beneficiary outright, or indirectly by contributing towards his maintenance or education. The Settlor can give guidance in a Letter of Wishes or Memorandum, although this will not be binding on the Trustees. In practice, the Settlor may appoint himself or herself as a Trustee and so retain a degree of control and be actively involved in the decision making process. If, for any reason, the Trustees do not distribute or appoint the Trust Fund by the end of the trust period, it will pass to the ultimate "default" beneficiaries named. 4. Taxation Consequences Before creating a Discretionary Trust, it is advisable to explore the tax implications of creating such a trust. The following represents a summary of the taxation treatment of a Discretionary Trust (under current legislation): Inheritance Tax ("IHT") IHT is currently payable at the rate of 40% on any "chargeable transfer" arising on a death, and at the reduced rate of 20% on certain lifetime "chargeable transfers", including transfers into and out of Discretionary Trusts. However, provided that the value of the transfer into the Discretionary Trust, when added together with any other chargeable transfers made in the preceding seven years, does not exceed the Settlor's "nil rate band" for IHT purposes, then no IHT will be payable on the "creation" of the trust. The nil rate band for the 2013/2014 tax year is 325,000. If the Settlor survives the date of the transfer into the Trust by seven years, then the transfer will become completely exempt from IHT and will not form part of the Settlor's own personal estate for IHT purposes. If the Settlor does not survive the requisite seven year period, then the value of the chargeable transfer into the Discretionary Trust (at the date of transfer into the Trust and not the date of death) is aggregated with the value of the Settlor's estate at death in order to assess the liability to IHT. Alternatively, if the value of the Discretionary Trust created (when taken together with the value of any chargeable transfers made in the last seven years) does exceed the nil rate band, then IHT at 20% is immediately payable on the excess. Furthermore, should the Settlor die within seven years of making the transfer, then a further charge of 20% will be payable by the trustees on the excess. In addition, to the extent that the trust fund (when accumulated with other relevant chargeable transfers) exceeds the nil rate band, it will be subject to complex rules that may give rise to a charge to IHT during the trust period, and not just on the creation of the trust. A ten yearly periodic charge to IHT may be payable on the historic value of the trust fund. This IHT cannot arithmetically exceed 6% of the fund value. There may also be an exit charge to IHT when a beneficiary becomes entitled to an income or capital interest in the whole or any part of the trust fund. Credit would always be given for a ten year periodic charge previously paid by the Trustees.

3 Capital Gains Tax ("CGT") Generally, a charge to CGT may arise on the "disposal" of a "chargeable asset" that gives rise to a "chargeable gain". In other words, this is a tax levied at the time of disposal, on the increase in value of the asset, since the time it was acquired. Not all assets will be chargeable assets. Cash is not a chargeable asset, so there can be no chargeable disposal for CGT purposes where cash is transferred by the Settlor to the Trustees. Alternatively, if for example a property were transferred to the Trust, then this would qualify as a transfer of a chargeable asset. The chargeable gain would be calculated by establishing the market value of the asset, as at the date of the trust's creation, and then deducting the Settlor's acquisition value, any applicable reliefs and any annual exemption available to the Settlor. The resulting net figure would be liable to CGT at 18% or 28% depending upon the level of the Settlor s taxable income for the tax year in question. Where gains qualify for entrepreneurs relief and an eligible claim is made for relief the rate of tax is 10%. A Settlor may wish to elect to "hold over" the chargeable gain, which simply means that the Settlor can defer the tax payable until the chargeable asset is sold or distributed by the trustees of the trust fund, who will then be responsible for the payment of any CGT. In this situation, the CGT would be calculated by reference to the value of the asset at the date of acquisition by the Settlor. A charge to CGT may also arise during the trust period, if the trust either sells assets or transfers assets to a beneficiary or beneficiaries. This latter situation is referred to as a "deemed disposal" of assets. Either a sale or a deemed disposal will give rise to a chargeable gain if the sale or market value at the time of disposal exceeds the value of the assets at the time of transfer to the Trust (or the Settlor's acquisition value, if the Settlor elected to hold over the gain). A Discretionary Trust is a separate entity for CGT purposes and has its own applicable values, exemptions and reliefs, completely distinct and separate from those of the Settlor who created it. The annual exemption available to a Discretionary Trust has, for a number of years, been one half of the exemption generally available to individuals ( 5,450 for the 2013/2014 tax year). Any chargeable gain realised by the Trustees would be subject to CGT at a rate of 28%. On the disposal of an asset to a beneficiary, hold over relief will be available to the Trustees in the same way as hold over relief is available to a Settlor. Again, such an election would defer any chargeable gain that would otherwise have arisen, until such time as the beneficiary personally disposes of the assets. Income Tax Any income generated by the trust assets will be subject to income tax and payable by the Trustees of the trust fund. The Trustees would be responsible for submitting Trust tax returns to HM Revenue and Customs. The applicable rates are as follows: For the first 1000 of income: dividends at the ordinary rate, satisfied by the 10% tax credit on dividends; and other income (such as savings income and rental income) at 20%, deducting any tax paid at source of 20%.

4 For income received over 1000: on dividends at the trust rate of 37.5%, deducting the 10% credit; and on other income at the trust rate of 45% deducting any tax paid at source of 20%. In other words, the newly settled assets would cease to be those of the Settlor for income tax purposes. The exception to this is where the Discretionary Trust might have a class of beneficiaries who constitute the minor children of the Settlor. Any income paid to, or applied for, the benefit of those children while they are both unmarried and under the age of 18, will be treated as taxable income of the Settlor and not the Trustees. It should be noted that if income is distributed to a beneficiary whose rate of tax is lower than that of the Trustees, then that beneficiary is entitled to make a repayment claim for the additional tax paid by the Trustees. For example, if the beneficiary pays income tax at 20%, then the beneficiary could reclaim the additional tax paid by the Trustees on any income that the beneficiary has received from the trust fund.

5 For details of who to contact for more information or to arrange a meeting: 28 Bartholomew Street Newbury Berkshire RG14 5EU Telephone (01635) High Street Hungerford Berkshire RG17 0NF Telephone (01488) Brooklands 48 Newbury Street Wantage Oxfordshire OX12 8DF Telephone (01235) Eastcott House 4 High Street Swindon Wiltshire SN1 3EP Telephone (01793)