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14/06/2013

Dividend taxation for trustees and beneficiaries of a discretionary trust

This article addresses the taxation position of trustees and beneficiaries in receipt of dividend income and savings income generated from trust assets. It does not consider all scenarios and Skandia recommends that independent tax advice be sought in all cases.

Introduction

A trust will generally receive income in the form of savings and dividend income. Trustees of discretionary trusts are charged income tax at the special trust rates, after deduction of trust expenses. The dividend trust rate is 37.5% in respect of dividend type income and the rate applicable to trusts (RAT) is 45% in respect of other income, such as interest.

The 45% income tax rate was introduced for individuals whose income exceeds £150,000 and the personal allowance is now reduced where income exceeds £100,000. Although not directly related to trusts, trustees and especially beneficiaries in receipt of trust income will need to take this into account.

Those individuals who are liable to tax at the 45% rate are known as additional rate taxpayers.

The first £1,000 of taxable trust income, which would otherwise be chargeable at the rate applicable to trusts or the dividend trust rate, is instead chargeable at the basic rate, or dividend ordinary rate, depending on the nature of the income. This part of income is known as the standard-rate band.

If a settlor of a trust has made more than one settlement, the standard rate band is reduced by dividing the £1,000 by the total number of settlements made and still in existence. The amount cannot be reduced below £200. So, if a settlor has made two settlements each will be entitled to £500. If a settlor has made five or more, each will be entitled to a minimum of £200.

Trustees may choose to distribute savings or dividend income to beneficiaries, or to reinvest in the trust. Where the trust investment is a collective (UK authorised investment fund (AIF)), an income tax liability will arise irrespective of whether the units held are accumulation or income units.

The following examples assume that the standard-rate slice of income has already been used.

Taxation of savings income in excess of the standard-rate band in the hands of trustees

Savings income (when issued from an AIF or deposit taker, ie interest) will have 20% tax deducted at source. Therefore the trustees are liable for an additional 25% tax as shown below. The additional tax would be paid via the trustees self-assessment return.

Interest received by trustees £800
Savings tax deducted at source £200
Amount on which tax is assessed £1,000
RAT at 45% £450
Additional tax payable by trustees £250
Amount available for distribution £550

 

Taxation of savings income which carries a credit at the RAT (45%), in the hands of beneficiaries

Additional rate taxpayer £550 (£550 received and no further liability)
Higher rate taxpayer £600 (£550 received and able to reclaim £50)
Basic rate taxpayer £800 (£550 received and able to reclaim £250)
Non-taxpayer £1,000 (£550 received and able to reclaim £450)

 

Taxation of dividend income in excess of the standard-rate band, in the hands of the trustees

UK dividends are issued with a 10% tax credit. The dividend trust rate is 37.5% and not 45% which means that the dividend is grossed up and then charged a further 27.5% (37.5% - 10% tax credit) to calculate the liability to the trustees.

The following example demonstrates how the dividend received (£800) and the 10% tax credit are used in the calculation.

Dividend received by trustees £800
10% tax credit £88.89
Gross amount on which tax is assessed £888.89
RAT at 37.5% £333.33
Less 10% tax credit £88.89
Additional tax payable by trustees £244.44
Amount available to trust £555.56

 

If the Trustees accumulate the income then the £555.56 is rolled up within the trust.

If they exercise their discretion and pay all the income to one or more of the beneficiaries, the taxation is different.

Taxation of dividend income in the hands of the beneficiaries

Any income distributed to the beneficiaries is deemed to be trust income not dividend income. If the trustees distributed £305.56 to the beneficiaries this would be grossed up trust income of ££555.56 (£305.56 x 100/55). As distributed trust income, it is deemed to have been taxed at 45%.

The trustees have already paid £244.44 to HMRC and cannot attribute the £88.89 tax credit to the difference and therfore have to pay a further £5.56 (£555.56 - £305.56 = £250 tax liability £250 - £244.44 already paid = £5.56).

Therefore in the hands of the beneficiary, this will be taxed as:

Additional rate taxpayer taxed at 45%* £305.56 (received from trust and no further tax payable and no reclaim due)
Higher rate taxpayer taxed at
40%**
£333.34 (£305.56 received from trust and a reclaim of £27.78)
Basic rate taxpayer £444.45 (£305.56 received from trust and reclaim of £138.89)
Non-taxpayer £555.56 (£305.56 received from trust and reclaim of £250)

 

The effective rate of tax for a beneficiary receiving dividend income from a trust is effectively 20% more when compared to interest since the discretionary trust also cannot use the tax credit already suffered. This does not mean trusts should not invest in dividend-producing assets, but where a significant proportion of the trust’s income is derived from dividends and there is an expectation for this income to be distributed, holding the assets in a suitable investment wrapper such as a single premium investment bond, rather than directly, may remove this tax disadvantage.

If income is accumulated, the net distribution after deduction of any additional tax will roll up within the trust. This will then become additional capital of the trust which, if distributed to beneficiaries as capital at a later date, will not be subject to income tax but may be subject to inheritance tax charges.

* 45% rate only applies where beneficiaries’ total income exceeds £150,000 in that tax year.
** Although 40% rate will still apply for those with incomes up to £150,000, the impact of the loss of personal allowances above £100,000 will increase the effective rate of tax paid for those affected.

This article is based on Skandia’s interpretation of the law and HM Revenue & Customs practice as at June 2013. We believe this interpretation is correct, but cannot guarantee it. Tax relief and the tax treatment of investment funds may change.

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