In the second in a two-part series, Jo Summers addresses the key taxation issues trustees must be aware of when winding up a trust
In the last edition of PS, I looked at the different options for winding up a trust. However, before any steps are taken to bring a trust to an end, the potential tax consequences of doing so must be assessed. After all, a beneficiary might be delighted to hear they are about to receive money from a trust, but less pleased at receiving an unexpected tax bill after the distribution.
This article looks solely at the taxation issues relevant to terminating a UK resident’s trust. There are numerous and complex tax provisions relating to offshore trusts: specialist advice must be taken before winding up an offshore trust if any of the trust assets are to be distributed to UK-resident beneficiaries, or if the trust holds any assets situated in the UK.
Whose tax liability is it?
When winding up a UK trust, there are two separate issues to consider. First, what tax (if any) will the trustees have to pay? Second, what tax (if any) will the beneficiaries pay upon receipt of a distribution?
In practice, it makes sense to look at both these issues at the same time. The trustees are entitled to an indemnity, permitting them to pay the tax due from the trust assets. They also have a lien so they can retain any assets that are to be distributed out, on winding up the trust, until such time as the tax has been paid.
Clearly, trustees will be concerned to ensure all potential taxes have been paid, before they wind up the trust and no longer have control over the trust assets. This will include any future taxes that might be due, or become due, as a result of terminating the trust. The case of X v A  1 All ER 490 confirmed that the trustees’ lien does permit trustees to retain trust assets to pay future tax liabilities.
A standard deed appointing out the trust assets will contain indemnities in favour of the trustees from any beneficiary who is to receive assets on the trust’s termination. It will then be a decision for the trustees to make, as to whether they are willing to rely on those indemnities, or whether they wish to exercise their lien to retain sufficient assets to pay the tax liability.
This decision is likely to be based on the financial circumstances of the beneficiaries, as well as the relationship between the beneficiaries and the trustees. It isn’t uncommon, for instance, for a beneficiary to be acting also as a trustee. Clearly, such a trustee / beneficiary will have a personal interest in making sure the tax is paid. In other cases, where the trustees are independent and perhaps professionals, they may well feel unhappy relying solely on an indemnity from a beneficiary, who, after all, might well have spent the funds received from the trust by the time the tax is due.
The trustees will have to calculate the tax due on any income received on the trust assets up to the date of termination. The trustees must account for the income tax in the usual way. This is normally in a trustee self-assessment tax return, but occasionally HM Revenue & Customs (HMRC) permits trustees to account for the tax by informal correspondence, if there have been no tax liabilities to date (so no tax returns have previously been issued).
Once the income tax has been settled, the trustees then need to inform the beneficiaries of the amount paid, usually via form R185. The beneficiaries require this information for their personal tax returns. Depending on the type of trust and what rate of tax the beneficiary pays, either further tax or a refund may be due.
For example, the trustees of a discretionary trust pay income tax at 45 per cent (non-dividends) or 38.1 per cent (dividends) on any trust income over £1,000. If the beneficiary is a non-taxpayer or pays tax at a lower rate, they can claim a refund for the additional tax paid by the trustees. The beneficiary will use form R40, available from HMRC’s website, to claim the refund, or include the claim in their personal tax return.
For life interest trusts, although the life tenant is entitled to the income as a matter of trust law, from a tax perspective the trustees are still chargeable to tax on the income, before they pass it on to the life tenant. However, in this instance, the trustees will pay tax at the basic rate. If the life tenant is a higher rate taxpayer, they will need to include the trust income on their tax return, as well as claiming credit for the amount of tax paid by the trustees. The life tenant will then pay the difference between the tax paid by the trustees at the basic rate and the higher rate due. If the life tenant isn’t a taxpayer at all, again, a refund claim can be made using form R40.
It is also possible for the trustees to ‘mandate’ trust income to one or more beneficiaries. This is more common for life interest trusts, but is also possible in a discretionary trust, by the trustees exercising their discretionary powers of appointment. Where the trust income has been mandated, the beneficiary who receives the income is directly liable for the tax due. The trustees will want confirmation that the tax has been paid before they terminate the trust.
A final possibility is that the trust may be ‘settlor-interested’, as defined in the Income Tax (Trading or Other Income) Act 2005 (ITTOIA 2015). There are two ways this can arise. First, the trust will be settlor-interested if the settlor and/or their spouse or civil partner can benefit (see section 625). In that case, the settlor is taxed on all the trust income as it arises, even if not paid out, and ignoring any trust expenses (the income is calculated as if the trust didn’t exist).
The second way is if the settlor’s minor children receive income from the trust (section 629) subject to a de minimis threshold of £100; so, the trust is only settlor-interested if more than £100-worth of trust income is paid to the settlor’s minor children in the tax year. Care is also needed with ‘bare trusts’ for minor children, as the income arising is treated as having been distributed to the beneficiaries. This means the bare trust will be settlor-interested if the settlor’s minor children are beneficiaries and there is more than £100 of trust income (irrespective of whether it has actually been distributed).
In both cases, the trustees still have to account for income tax to HMRC, but the settlor also has to include the income in their personal tax returns. Specialist advice should be obtained before winding up a settlor-interested trust. The settlor has a statutory right to reimbursement from the trust for the tax paid on the trust income, under section 646 of the ITTOIA 2015. Also, there are provisions relating to tax-accumulated income which is distributed to the settlor’s minor children, so even capital distributions can be caught by the settlor-interested trust rules.
Section 631 of the ITTOIA 2015 explains that where income is accumulated in a trust before being distributed to the minor child of the settlor, the trustees need to calculate the amount of ‘retained’ income. This is the total income received by the trust, less certain ‘disregarded income’. So, any income that has already been taxed on the settlor is ignored, as is any income paid to another beneficiary (who is not a minor child of the settlor). Finally, income applied in meeting the trustees’ expenses that are properly chargeable to income can also be deducted. The remaining income is taxed on the settlor when the capital distribution is made to the minor child.
Capital gains tax
UK-resident trustees are also liable to pay capital gains tax (CGT) on their worldwide gains.
Most trusts have an annual CGT allowance, which is £5,550 in 2016/7, equal to half the allowance for individuals.
One potential trap for trustees is that distributing assets to a beneficiary may well be a disposal for CGT purposes, even though no consideration is being received. The CGT treatment will depend on the type of trust. If the trust is a bare trust, then no charge to CGT arises on transferring the assets to the beneficiary, as there is no actual change of beneficial ownership.
If the trust comes to an end on the termination of a life interest, there may be an uplift in value for CGT purposes without any charge to CGT arising. This will depend on whether the life interest pre-dated the Finance Act 2006 (FA 2006) changes, or was one of the types of life interest still permitted post-FA 2006 (such as an immediate post-death interest in a will).
It is clear that the tax charges on winding up a trust can be complicated, depending on the type of trust in question. Settlor-interested trusts in particular need care
If the trust is a discretionary trust, then a transfer of assets to the beneficiary will be a disposal for CGT purposes, but holdover relief may be available. This will permit the trustees to transfer the asset to the beneficiary without any immediate charge to CGT arising. Effectively, the beneficiary accepts the trust asset with the original ‘base cost’ paid by the trustees, so the beneficiary’s tax bill is likely to be larger when they later dispose of the asset. The holdover relief has to be claimed, on a form that is attached to HMRC’s helpsheet HS295. There are conditions which must be met before the holdover relief is available, and the relief can be lost (eg if the beneficiary leaves the UK within a set period), so again, specialist advice is recommended.
There are also other reliefs from CGT, such as principal private residence relief. Section 225 of the Taxation of Chargeable Gains Act 1992 extends the principal private residence relief to trustees, where a beneficiary occupies the trust property, under the terms of the settlement, as their principal residence.
Trustees can also claim entrepreneurs’ relief on the sale of assets which have been used in a beneficiary’s business, or if they hold shares in certain qualifying companies.
Inheritance tax (IHT) is probably the most misleadingly-named tax, because it can apply during lifetime as well as on death. More importantly, it can apply to distributions from trusts (as well as to settlements or additions into a trust).
The UK’s ‘relevant property regime’ raises IHT charges on the trustees of ‘relevant property trusts’. The first of these tax charges is payable on every 10th anniversary of the trust’s creation: this is the ‘decennial’ or principal charge in section 64 of the Inheritance Tax Act 1984 (IHTA 1984). The second charge, in section 65 of the IHTA 1984, applies when funds or assets are distributed from a relevant property trust. This ‘exit’ tax is the one trustees need to be aware of when terminating a trust.
The calculation of the IHT charge is not at all straightforward. It involves the trustees knowing certain information about the settlor’s gift history, before setting up the trust. The calculation also requires information on how long assets have been held in the trust, as well as whether there have been prior distributions or additions to the trust.
The IHT is charged at a maximum rate of six per cent above the IHT threshold. This is the same as the personal nil-rate band (NRB), but depends on whether the settlor had a full NRB at the time of setting up the trust.
Often, only one settlor is named on the trust deed, but the trustees may discover that the funds settled came from a joint bank account, or that other jointly-held assets were settled. In that case, there are actually two settlors (assuming two joint owners), so potentially two NRBs can be claimed. This means the trustees also need to file two separate IHT forms, and will need two IHT reference numbers for the same trust.
HMRC has been trying to simplify this calculation, which often costs more to undertake than the actual IHT bill that is due. HMRC had announced a radical change to the relevant property charges, so each settlor would be given one settlement NRB to be divided between however many trusts the settlor created. These proposals were dropped in favour of more minor changes, such as the way accumulated income is taxed as capital, and the way assets settled on the same date into different trusts (eg on someone’s death) will be added together to calculate the tax charge.
Prior to the FA 2006, these relevant property charges only related to discretionary trusts and were easily avoided. Settlors could choose to set up a life interest trust or an accumulation and maintenance trust, either of which would not be subject to the relevant property regime. Unfortunately, since the FA 2006, this distinction no longer applies, so the relevant property charges will apply to any trust set up post-FA 2006, even if it is a life interest trust or is set up for children / grandchildren under the age of 25 (subject to exemptions for certain trusts for vulnerable beneficiaries and certain will trusts).
Note that there is no exit charge at all if the distribution takes place within the same quarter (three months) of the last 10-year charge or of the trust’s creation. Trustees can take this into account when deciding on the date of termination.
Trustees will need to ensure no other taxes are due, such as stamp duty or stamp duty land tax (SDLT). This will depend on the types of assets which are being distributed on trust termination.
The usual rule for both stamp duty and SDLT is that no duty is owed when assets are being distributed from a trust to a beneficiary. If you look at the back of a stock transfer form for a share transfer, for example, you will see that category F is the exemption from stamp duty on ‘the conveyance or transfer of property out of a settlement in or towards satisfaction of a beneficiary’s interest acquired for money or money’s worth, being conveyance or transfer constituting a distribution of property in accordance with the provisions of the settlement’ (see regulation 4 in the schedule to the Stamp Duty (Exempt Instruments) Regulations 1987).
Care is needed, however, if the trust is distributing land that is mortgaged or otherwise secured with a debt. The amount of that debt is treated as ‘consideration’ for SDLT purposes if the beneficiary is assuming liability for payment of the debt. In that case, SDLT will be due on the value of the debt (as opposed to the total value of the land). This is because of the definition of ‘chargeable consideration’ in paragraph 8 of schedule 4 to the Finance Act 2003, which introduced SDLT.
In practice, it is probably unlikely that trustees will be attempting to distribute mortgaged land without first having paid off the mortgage, but this is still a potential trap for the unwary.
It is clear that the tax charges on winding up a trust can be complicated, depending on the type of trust in question. Settlor-interested trusts in particular need care, given the way accumulated income can be taxable when it is later distributed as capital. Clearly, specialist legal and tax advice should be obtained if there is any doubt as to the tax consequences of winding up a trust.