Income received by a discretionary trust will usually be derived from a portfolio of investments. Trustees will hold various asset classes as they seek to diversify the portfolio and to meet beneficiaries’ differing needs.
Consequently, income in the form of interest and dividends is likely to be generated. The distinction is important because dividend income is taxed differently to other income sources.
The going rate
Discretionary trusts do not have a personal allowance, but the first £1,000 of gross income is taxed at a lower rate. This lower rate represents the standard rate of income tax, i.e., 10% in respect of dividends, and 20% on other income.
Within trust terminology, this is referred to as the ‘standard rate band’, and means that no additional tax, other than that deducted at source, becomes payable. It should be remembered that if the settlor creates more than one trust, then the £1,000 limit is divided between the number of settlements they create and subject to a ‘de minimis’ £200 if there are five or more such trusts.
Once a trust’s grossed-up income exceeds £1,000, it becomes chargeable at the ‘rate applicable to trusts’ (RAT) – currently 37.5% for dividends and 45% for other types of income.
The best way to understand this complexity is to look at an example of how the RAT works (ignoring the standard rate band).
Consider a trust where the standard rate band has already been utilised and the trustees receive a £5,000 net interest distribution from a collective fixed interest fund (see Table 1).
If the trustees decide to distribute this income to the beneficiaries it is vouched out (or franked) with a refundable tax credit of 45%. Let us now look at the position where trustees are in receipt of dividend income.
If the £5,000 represented dividend income then it would have been paid to the trustees with a non-reclaimable 10% tax credit. As noted above, the dividend RAT is 37.5% of the gross amount received so the calculation would be (see Table 2 below).
If the trustees accumulate the income, the position is the same as with an interest distribution.
However, the solution becomes more complicated if trustees distribute the resulting dividend income to beneficiaries. Trust income paid to a beneficiary is franked with a potentially reclaimable 45% tax credit. But because the trustees have actually only paid tax at a rate of 37.5% (less the non-reclaimable tax credit), there is a shortfall between the amount of tax that has been paid by the trustees and the amount of tax which could potentially be claimed back by the beneficiaries.
To be frank
This problem is caused by the notional 10% tax credit accompanying dividends as it forms part of the 37.5% deemed to have been “paid” by the trustees. Since this credit can never, in any circumstances, be reclaimed, it cannot be used to frank the 45% tax credit attaching to income distributed by trustees to the beneficiaries.
If it could, HMRC could find itself refunding more tax to the beneficiaries than it has received in from the trustees in respect of the same income.
So, continuing the example above: the trustees have £3,472.22 of dividend income available for distribution. If they choose to do so then it has to be franked at 45%. However, so far it has only been taxed at 37.5% – of which 10% is ineligible for franking purposes.
As a result, the trustees should distribute less than 50% of the dividend income they actually received.
Consequently, out of the £3,472.22 the trustees should retain a further £1,000 (i.e. £5,000 x 45% = £2,250 – £1,250 tax actually paid). Thus, out of £5,000 of dividend income paid to the trustees, they can safely distribute only £2,472.22.
Offshore investment bonds
It is not surprising that single premium offshore investment bonds are gaining further popularity with trustees of discretionary trusts as a way of sidestepping the complex income tax treatment of dividends received.
They can be used by trustees to build an investment portfolio designed to achieve their medium- to long-term financial objectives as well as shield the trust and the beneficiaries from personal liability to income tax on an arising basis in respect of any investment income and gains accruing within the bond.
When the trustees want to realise some of the bond’s value, an income tax charge can arise, where the withdrawal constitutes a chargeable event, which in turn, gives rise to a chargeable gain. Most bonds are written as a series of identical policies (often referred to as segments) and this allows the trustees greater flexibility in how they can make these withdrawals.
Structuring an offshore bond in this way enables the trustees to realise some of the bond’s value by either:
- The full surrender of one or more policies.
- The partial encashment of an equal number of units from across all the policies that make up the bond (usually within the 5% pa withdrawal facility).
- A combination of both full surrender and partial encashment.
Additionally, the trustees could assign one or more policies to the beneficiaries of the discretionary trust and this would be particularly beneficial where the beneficiaries pay income tax at a lower rate than that of the trustees.
An assignment in these circumstances will not be an assignment for money or money’s worth and will not trigger a chargeable event.
The beneficiaries could then realise some of the bond’s value by full surrender, partial encashment or a combination of both as described above. It is an ideal opportunity for advisers to demonstrate a simple and non-controversial way for discretionary trusts to mitigate income tax.