04: The taxation of trusts

There are special rules for taxing settlors, trustees and beneficiaries, which may vary according to the different types of trust. There are also special rules that can apply where the settlor, trustees or beneficiaries are domiciled outside UK.

Trusts are often used in tax avoidance schemes, so it is not surprising that they are the subject of a great deal of complicated anti-avoidance legislation. The following outline is a very simple explanation of the more straightforward rules. For further information, see our PDF guide Taxation of trusts.

The taxation of trusts may well change in the next few years and has been the subject of HMRC consultation documents.

Inheritance tax

The rules for the inheritance tax treatment of interest in possession and accumulation and maintenance trusts were generally aligned with those for discretionary trusts on 22 March 2006.

When the settlor creates a trust or adds property to it, this counts as a transfer of value for the purposes of inheritance tax. Transfers into the majority of trusts are taxable at 20% if the settlor has exceeded their nil rate band (£300,000 in 2007/08).

Broadly speaking, the property held in the trust, in excess of the nil rate band, is subject to a periodic charge of up to 6% every ten years and there could be a further charge when capital is distributed to the beneficiaries.

If beneficiaries have an interest in possession created before 22 Mach 2006 or, in some instances, on the settlor’s death, there could be an IHT charge if the beneficiaries either die or give away their interest.

A transfer into a bare trust, a disabled person’s trust or a trust for a bereaved minor counts as a potentially exempt transfer, which will normally be inheritance tax-free as long the donor survives the following seven years.

See also: Inheritance tax

Income tax

Trustees are liable to tax on the income they receive at special rates of tax and beneficiaries are taxed on the income that is distributed to them. Generally, the tax the beneficiary pays takes account of the tax already deducted by the trustees. So it is normally possible for a non-taxpaying beneficiary to reclaim the basic rate tax deducted by the trustees for bank interest – but not dividends from shares or unit trusts.

See also: Income tax

Capital gains tax

When assets enter or leave a trust, there could be a capital gains tax charge on any gain. The trustees of a trust are subject to CGT on the disposals of trust property in much the same way as individuals. In general, the annual exemption that applies to trustees is half the level that applies to individual taxpayers. The rate of tax is a flat 40%.

See also: Capital gains tax