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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.
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. These are the dividend trust rate of 32.5% in respect of dividend type income and the rate applicable to trusts (RAT) of 40% in respect of other income, such as interest. It was announced in the 2009 Budget that from April 2010, these rates will increase to 42.5% and 50% respectively.
In addition to these changes, the Budget also introduced a 50% income tax rate for individuals whose income exceeds £150,000, and the loss of personal allowances 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 will be liable to tax at the 50% rate, will be known as additional rate taxpayers.
The first £1,000 of taxable 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.
Savings income (when issued from an AIF or deposit taker, ie interest) will have 20% tax deducted at source. The trustees are liable for an additional 20% tax. The additional tax would be paid via the trustees self-assessment return.
UK dividends are issued with a 10% tax credit. The dividend trust rate is 32.5% and not 40% which means that the dividend is grossed up and then charged a further 22.5% (32.5% - 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.
This demonstrates that both savings and dividend income are taxed at the same effective rate in the hands of the trustees when the rate is 40%, but at 50% and 42.5% this principle will no longer apply.
However, where trustees distribute dividend income to a beneficiary rather than accumulate it, the taxation is different. Beneficiaries are unable to reclaim the tax credit on the original dividend yet higher rate taxpayers retain an income tax liability of up to 40% in 2009/10 and up to 50% in 2010/11. This is because the income is then regarded as trust income, not dividend income, eg if you were a HRT solely because of UK dividend income your highest rate would be 32.5% in 2009/10 or 42.5% in 2010/11 but any interest would only suffer additional tax at 20% or up to 30% in 2010/11.
The effective rate of tax for a beneficiary receiving dividend income from a trust is effectively 20% more when compared to interest. 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.
* 50% 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 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 March 2010. 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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