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Mark McLaughlin CTA (Fellow) ATT TEP highlights some of the complexities of settlor-interested trusts when it comes to tax compliance.

Introduction

It is commonly thought that trusts in which the settlor can benefit (ie actually or potentially) are a ‘bad thing’. In fact, this is not always the case. For example, if the capital gains of a discretionary trust are attributed to the settlor under TCGA 1992, s 77 (ie. including where a dependent child of the settlor can benefit), it may be that the settlor can utilise his or her excess personal losses (TCGA 1992, s 2(5)(aa), 6), taper relief  and/or a full annual exemption, and that their marginal rate of tax may be lower than the 40 per cent rate applicable to trustee gains.

Reporting income

However, settlor-interested trusts are potentially an administrative burden for income tax purposes. Since 6 April 2006, if the trustees of a settlor-interested discretionary trust pay income to a beneficiary other than the settlor, the beneficiary is treated as having paid notional, non-repayable tax of 40 per cent (ITTOIA 2005, s 685A). The trustees must complete form R185(Trust Income) in respect of such payments (see ‘Busy Practitioner’, May 2007), and the beneficiary must return that income on the Trust and Estate supplementary pages (SA107) of their tax return. In addition, for 2006/07 and later years, the trustees of settlor-interested discretionary and accumulation and maintenance trusts are required to account for income tax at the special trust rates of 40 and 32.5 per cent. Previously, there was an exception from tax liability at trust rates for the trustees of settlor-interested trusts in ICTA 1988, s 686(2)(b), but this exception was removed in FA 2006 (and the amended legislation rewritten in ITA 2007, s 480(3)), regardless of when the trust was created. The trust income retains its character (eg. as dividends or interest income), and is charged on the settlor by virtue of ITTOIA 2005, s 619(2) as if the income had arisen directly (Tax Bulletin 84, August 2006). 

Payment and repayment of tax

This change to the tax treatment of settlor-interested trusts means that the same income is reportable on the tax returns of both the settlor and the trustees, ie. the settlor must declare the income on the Trusts and Estates supplementary pages for 2006/07 and later years. Are both persons required to pay tax on the same income? Fortunately, it appears not. HMRC have confirmed that the trustees will be liable for the tax, and that the settlor will be given credit for the tax paid by the trustees. This may result in a tax repayment for the settlor (assuming that the trustees have paid the tax liability) if his personal tax rate is lower than the 40 and 32.5 per cent trust rates. However, the settlor is not entitled (as before 6 April 2006) to receive a form R185 showing the relevant income and tax credit entitlement. This begs the question whether the settlor will be aware how much income and tax credit to declare in every instance.

Settlor-interested?

There have been reports in the tax press of HMRC issuing standard letters to some trustees following receipt of the 2005/06 tax return (i.e. when the trustees were not generally liable to income tax at the special trust rates) indicating that unless a tax return was issued, it is only necessary to file a future tax return if there is a tax liability. No mention has apparently been made of the fact that settlor-interested trusts must account for tax at the special trust rates. It is true that this may not always be the case (eg. a small discretionary trust receiving taxed investment income not exceeding the £1,000 ‘starting rate’ band for trusts (this limit is divided if appropriate by the total number of settlements made by the same settlor, subject to a £200 de minimis per trust; ITA 2007, s 492)). However, trustees of settlor-interested trusts will need to be aware of the general requirement to file returns for 2006/07 and later years, particularly if returns were not previously required. Practitioners also need to be aware of situations in which a trust may unintentionally be regarded as settlor-interested for tax purposes (eg. see ‘Tax charge doubled!’ by Malcolm Gunn, Taxation, 22 February 2007, regarding deeds of variation). Overall, the provisions and compliance requirements are potentially complex. Trustees and practitioners will need to exercise extra care and diligence in most cases as a result of the law changes.