The taxation of trusts is a particularly complex area of tax and this article is intended to provide an overview of some of the tax issues which will need to be considered when seeking to create a trust structure.
What is a Relevant Property Trust?
A relevant property trust is defined in the negative – essentially, all trusts which do not meet certain exceptions will be relevant property trusts. Generally speaking, trusts established with UK assets or by someone domiciled in the UK will qualify as a relevant property trust.
Some exceptions include trusts for charitable purposes, employee benefit trusts and employee ownership trusts. Please speak to a tax adviser If there is any question over the categorisation of a trust.
The relevance of this definition is that it applies a regime of taxation. When terminating a trust, the key tax consequences may include CGT, IHT, SDLT and Income Tax.
Creating a Trust
In most cases, a lifetime trust will be created by a deed of trust which outlines the purpose of the trust, the initial trustees and details of the beneficiaries and their interests in the trust. There will be a process required to transfer assets into the legal ownership of the trustees.
Trusts are a flexible structure and can be formed for a number of reasons. Trusts may offer a beneficiary a lifetime interest or fixed-term interest in trust assets (such as a main home or a right to income generated by an asset) with the asset passing to another person on their death or after the end of the fixed-term.
Usually, trusts will be established with the view to earmarking assets for family members without providing outright control and ownership to those family members. There may be a number of reasons for this such as protecting family assets from divorce, creating an on-going family legacy or preventing certain individuals from fettering away cash.
Types of Trust
The two most popular types of trust are life interest trusts and discretionary trusts. They both fall within the relevant property regime and face similar tax implications.
A life-interest trust is one which provides an interest to an individual beneficiary for a fixed period or their lifetime. For instance, grandparents may establish a trust providing an adult child with the right to live in a property (or the right to income from that property during their life) with the asset passing to a grandchild (or grandchildren) after their death.
Alternatively, a trust may be established in which the trustees have absolute discretion as to who is able to benefit, how they are able to benefit and when they are able to benefit. This type of trust is referred to as a ‘discretionary trust’ on the basis the trustees have discretion.
Both may fall within the relevant property regime and are subject to the same regime of tax (broadly speaking).
When forming a trust, the objectives of the settlor should be clear and reflected correctly in the trust deed. It may be possible to build in flexibility should circumstances change. For tax purposes, however, it is generally recommended that the settlor, their spouse and minor children are not able to benefit from the trust.
If such persons are able to benefit, the analysis below is fundamentally different and advice should be sought.
Capital Gains Tax
The transfer of assets into trust will be an event for CGT purposes. Usually, the settlor would be treated as selling assets to the trust at market value thereby crystallising any capital gain.
Relief can usually be relied on to defer the charge until such a point that the trustees dispose of the assets. However, there are a number of exceptions to this rule and advice should be taken in each case. Where the relief is not available, the settlor will need to consider how they may meet this charge or whether any other reliefs are available.
Where property is being transferred to a trust, it may be possible to utilise any equity to meet a tax liability.
It is a common misconception that IHT is only due on death – this is not correct. A transfer of assets to a relevant property trust will be a chargeable lifetime transfer for IHT purposes.
This imposes an immediate tax charge of up to 20% to the extent the transfer of value is in excess of available allowances. Often, trusts established with assets worth less than £325,000 (or £650,000 for couples) will mitigate a charge.
Alternatively, depending on the type of asset certain reliefs may be available to mitigate some or all of a charge. However, care needs to be taken and advice sought in each case.
Once the asset is within the trust, it will generally be considered outside the estate of any persons after seven years. This means that it is ignored for IHT purposes on the death of the settlor thereby potentially mitigating an IHT charge of up to 40%.
Relevant property trusts are subject to on-going IHT charges on every 10th anniversary of the trust. If assets leave the trust between 10-year anniversary charges, there will also be a charge based on the value of the asset leaving the trust – this charge is effectively a proportion of the 10-year charge that would have applied had the asset remained in the trust.
Each 10-year charge imposes a maximum liability of up to 6% of the value of the trust and any charges between 10-year charges will be a proportion of this.
The computations here are complex and advice should be sought in every case. However, as a rule of thumb, this charge should be manageable if the trust was established with assets within the nil-rate band (£325,000 or £650,000 for couples) and the value of the assets within the trust has not grown significantly.
Trustees should also consider whether the trust assets may qualify for any reliefs such as business property relief (“BPR”) or agricultural property relief (“APR”). Other reliefs may be available depending on the facts of each case.
If land is being transferred to a trust, then one will need to consider whether there is any SDLT liability. A gift of property to a trust will not generally be subject to SDLT on the basis that the trustees are not paying for the asset, nor providing any other form of consideration.
However, if the property is mortgaged and the trustees take over the obligation for that debt then the assumption of that debt by the trustees will be treated as consideration for the property. This would therefore crystallise an SDLT liability.
Trusts may often be established by selling assets to a trust and leaving the consideration outstanding – this is often to prevent an immediate IHT liability. However, the existence of consideration (i.e. the loan owned to the settlor) will be considered chargeable consideration.
There may be several tax reliefs available to reduce or mitigate an SDLT liability.
There are not generally any immediate income tax consequences of establishing a trust. However, there is a specific regime of taxation which applies to relevant property trusts which will be covered in a separate article.
The tax analysis may seem straightforward but will be complicated by the facts of each case. One will also need to consider the various reporting requirements, self-assessment tax returns and IHT returns for the relevant parties.