In August 2004, the UK Inland Revenue published its most recent consultation document relating to the proposals to modernise the tax system ...

In August 2004, the UK Inland Revenue published its most recent consultation document relating to the proposals to modernise the tax system for trusts. While this document elaborates on the main UK Government proposals, many details remain to be discussed.

Background

In 2003, the Government first announced its intention to introduce a new tax regime for trusts. The overall aim of the Government is to achieve a system of taxation of trusts that it is fair, clear and easy to operate and supports the competitiveness of the UK economy.

At the same time, however, the proposed reforms are aimed at discouraging people from using trusts to avoid tax. In summary, the Government wants to introduce a tax regime

“…that does not provide artificial incentives to set up a trust but, equally, avoids artificial obstacles to using trusts where they would bring significant non-tax benefits.”

At the 2004 Budget, the Government announced that, amongst other proposals, the following two changes will take effect on 6 April 2005:

• A £500 basic rate band applying to the income of all trusts otherwise chargeable at the rate applicable to trusts will be introduced; and
• A harmonised trust definition and tests for income tax and capital gains tax purposes will be introduced.

Basic Rate Band

The new basic rate band will apply to the first £500 of income of all trusts liable at the rate of tax applicable to trusts. Bearing in mind that the rate of tax applicable to trusts was raised from 34 per cent to 40 per cent on 6 April 2004, this is a real concession for smaller trusts. The Government estimates that around one third of all trusts have a total annual income falling below the basic rate band. These trusts will no longer be liable to pay tax.

The reasoning behind the introduction of this measure is that tax deductions at source (in the case of bank and building society interest) or the notional tax credit (in the case of dividend income) would satisfy the tax liability of the trustees up to the £500 threshold in any case.

Any trust income in excess of the £500 threshold would, prima facie, be assessable against the trustees at the rate of 40 per cent. However, it is also proposed that the basic rate band should be applied to trust income only after all streamed income and allowable trust management expenses have been deducted.

Accordingly, it is possible that a trust with an annual income in excess of the basic rate band still falls entirely within the basic rate band after the appropriate deductions have been made.

For the sake of completeness, trust income will qualify as streamed income if it is paid out to the beneficiaries by 31 December following the end of the tax year in which that income arose to the trustees. Also, while streamed income would be exempted from the rate of tax applicable to trusts, the trustees would still have pay tax in respect of this income at the basic, lower or dividend rates of tax.

In addition to the basic rate band, it has also been proposed that trusts consistently achieving an annual income of less than £500 should benefit from a reduced compliance burden. At present, the proposals would require the trustees of such a settlement to issue self-assessment tax returns once every five years. However, trustees will remain under an obligation to notify the Revenue of any tax liability they incur.

Harmonised Definition of "Trust"

There is broad agreement that the common definition of a "trust" for income and capital gains tax purposes should be based upon the definition of "settlement" used for inheritance tax purposes. The scope of this definition will, however, remain subject to the existing anti-avoidance definitions contained in current income tax and capital gains tax legislation, such as section 660G of ICTA 1988, for example.

Further, the new definition of "trust" for income and capital gains tax purposes will adopt the concept of a single and continuing body of trustees, as opposed to the inheritance tax concept of a trustee from time to time.

Finally, the Revenue’s consultation paper allays fears the new definition of "trusts" will include bare trusts. It categorically states that the new harmonised definition of "trusts" will ensure that:

“… the trustees of genuine bare trusts will not be subject to income tax or CGT, except in those rare circumstances […] where it is more convenient for both the trustees and the beneficiaries for the former to opt into the Self Assessment regime.”

More detail on the circumstances in which bare trustees might be liable to tax can be found in the Inland Revenue’s Tax Bulletin 32.

Harmonising the TestsM

Settlor-interested trusts

There is, as yet, no consensus on a definition of "settlor-interested trust", although the proposal that all trusts with a living settler should fall within the definition, has been rejected. The Revenue continues to consult on how best the tests for "settlor-interested trusts" contained in current income and capital gains tax legislation could be harmonised.

An important qualification to the new definition of "settlor interested trusts" is that this would only apply to UK resident trusts. Offshore trusts would remain subject to the extended tests currently being used.

The "minor children test" under current income tax legislation will be extended to the capital gains tax legislation. A trust would cease to be settlor-interested when the child reaches the age of eighteen.

Residence test

The Revenue has announced the alignment of the definitions of "UK residence" of a trust under the income and capital gains tax regimes.

The current proposal is for the income tax test to be used as the common test, as it is felt that this would introduce simplicity and clarity. Hereby, where all trustees are non-UK resident, the trust would be an offshore settlement, whereas where all trustees are UK resident, the trust is UK resident. Where there is a mixture of UK resident and non-UK resident trustees, the trust would be UK resident if the settlor was UK resident or UK domiciled at the time the trust came into existence. Needless to say, there is some resistance to using this as the common test for residence.

There will be a 12-month transitional period, during which non-UK resident trustees for CGT purposes will retain their existing residence status before the harmonised single test is applied to them. This will allow them to reassess whether or not they should retain their non-UK resident status and make the necessary arrangements.

Comment

The changes that are due to come into effect on 6 April 2005 are potentially far-reaching.The consultation process should be monitored closely to keep track of the final proposals, as these develop.