Geoffrey Shindler takes a detailed look at discretionary trusts
The discretionary trust is welcomed by many and hated by some. They are welcomed because they enable trustees to change their policies to individual beneficiaries at any time during the course of the trust's life. However, these trusts make it hard for the Revenue to pin ownership, or quasi ownership, on any one beneficiary. This can then lead to issues in ensuring trustees pay their 'fair' share of the tax burden.
What is a discretionary trust? Essentially it is a gift by a settlor to trustees of whatever assets he wishes to be held by those trustees normally among a class of beneficiaries, e.g. children, grandchildren and/or great grandchildren. Under English law the trust may last for up to 80 years before its final recipients need to be determined, but during that 80-year period the trustees can chop and change beneficiaries as many times as they want. They can also decide whether they wish to pay out income or capital or a mixture.
So you can see that with this amount of flexibility there is really no limit to the way in which the trustees can manage the trust assets. The beneficiaries will almost certainly include not only those people alive at the date the settlement is made but also include those born after the date the trust was made, but before the 80-year period has expired. In other words, trusts can provide for future children, grandchildren and great grandchildren.
For the first 21 years of the trust's existence the trustees are under no obligation to pay out anything at all, whether by way of income or capital. They may wish to do so but they are under no compulsion. However, most discretionary trusts are drafted so that 21 years after the date they were established all income received thereafter must be distributed. There is still discretion as to which beneficiaries are to be paid but the whole of the income received must be distributed after 21 years. The capital remains at the discretion of the trustees for the whole of the 80-year trust period.
If trust income is not distributed to beneficiaries in the first 21 years then it will be accumulated and added to the trust capital. There is no certainty as to what point in time this automatic capitalisation of income takes place - trustees and the Revenue often have different views and professional advisers sometimes have a third. Nevertheless, there is a point in time when income, not distributed but retained, automatically becomes added to capital.
Quite often the Trust Deed will provide that the income received but not distributed can be distributed in future years as if it were income in the year in which it is distributed. So quite often you see on the balance sheet of a discretionary settlement 'accumulated or retained income fund'. Strictly speaking it is not accumulated income because accumulated income is capital (if the technical terms are used, but it is a case of we all know what we mean).
It is not possible to look at the discretionary trust without considering its taxation implications. These are simple in principle but sometimes not so simple in practice. There are three occasions when the discretionary trust is liable to inheritance tax. The first is when the settlement is made if the value of the assets (which do not have any form of relief e.g.) exceeds £312k. The excess is taxed at 20%. There are two other occasions when there is a tax charge of 6%. The first is on the ten yearly anniversaries of the making of the trust and the third is if a capital distribution is made to beneficiaries.
On each ten yearly anniversary the assets subject to the trust, but without the benefit of a relief from IHT, pays tax at 6% over the excess of the nil rate band.
If a capital distribution is made to a beneficiary then again there is a 6% charge but this will be reduced because you look at the number of quarters that have passed since the last ten yearly charge and it is that number of quarters divided by a total of 40 (being four quarters for each 10-year period) that is the fraction liable to IHT at 6%.
That is the simple part. The complicated part is working out the rate of tax to be applied. It is never quite 6% and there are all kinds of highly complex issues that go to determine the precise rate of tax payable although it will never be more than 6%. You will need to provide full details of the trust fund, details of the previous 10-yearly anniversary charge, the number of quarters since that date, the value of the assets to distribute to the person making the calculations; a fully working calculator and a spare battery.
The merits of the discretionary trust with its overarching principles are worth very serious consideration notwithstanding its complexities.
In particular, now that all settlements when made are subject to IHT if the value is in excess of the nil rate band clients ought to be thinking of making discretionary trusts earlier in their life than they might previously have done. Every seven years the clock is wiped clean and a further nil rate band amount can be settled free of IHT on discretionary trusts. Perhaps it's a case of give less, but give earlier and more frequently.
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From 6 April 2019