Following a two year consultation process, which began with the Pre-Budget Report in December 2003 when the Chancellor announced plans to modernise and simplify the tax treatment of UK resident trusts, Her Majesty’s Revenue and Customs (HMRC) yesterday issued draft legislation covering a number of the provisions which have been under discussion. The main aims of the changes are to make the taxation of trusts for income tax and capital gains tax purposes more consistent and to reduce the administrative burdens on trustees, in particular, the trustees of smaller trusts. Two of the provisions stemming from the trust modernisation process have already been introduced (in Finance Act 2005):
- a new trust regime for trusts for the most vulnerable,
- a £500 basic rate band applying to the income of all trusts otherwise chargeable at the rate applicable to trusts.
The main provisions of the draft legislation issued yesterday are summarised below.
Definition of settlor
A common definition of settlor will apply for both income tax and capital gains tax purposes. A settlor will include a person who makes or enters into a settlement directly or indirectly. Also where the settled property or property derived from it, is property which a person was competent to dispose of immediately before his death, that person will be treated as the settlor.
If one person (A) makes or enters into a settlement in accordance with reciprocal arrangements with another person (B), then B will be treated as the settlor. Where assets are transferred between two settlements, the settlor of the transferor settlement will be treated as the settlor of the transferee settlement (except in certain specified circumstances, one of which is where the transfer happens on the exercise of a general power of appointment).
There will also be common rules setting out who will be treated as the settlor in relation to post death deeds of variation.
Definition of settled property
There will be no generally applicable statutory definition of settlement. The wide definition of settlement contained in the income tax anti-avoidance provisions will continue to apply only for those purposes. Instead, the current capital gains tax definition of settled property will also apply for income tax purposes. This definition covers all property held in trust other than as a nominee or under a bare trust (where the beneficiaries are absolutely entitled to the assets).
Residence of trustees
The residence test for trustees will be the same for income tax and capital gains tax purposes. The test will be based on the current income tax test. This uses the residence status of the trustees, and takes into account the residence and domicile status of the settlor at the relevant time where there is a mixture of UK resident and non-UK resident trustees. The common test will apply for the purpose of determining the residence status of trustees from 6 April 2007, whenever the trust was created. This will give trustees time to rearrange their affairs to avoid any unintentional change of residence status due to the introduction of the common test.
Non-resident election for certain trustees
One of the effects of the introduction of the new common residence test, is that the current capital gains tax provisions which allow certain UK based professional trustees to be treated as non-UK resident would no longer apply. Concerns had been expressed that this could make the UK unattractive as a location for international trust administration work. The draft legislation provides that for both income tax and capital gains tax purposes, trustees of a settlement who act as trustees in the course of a business and who are UK resident could, in relation to settlements created by non-domiciled, non-resident and not ordinarily resident settlors, make an election to be treated as non-UK resident. HMRC have stressed that they are currently consulting with the DTI, as there is a concern that these provisions may constitute state aid for the purposes of EU law.
Assuming there is no EU objection, this proposal will be good news for UK-based trustee providers seeking to attract international trust business, because it dispenses with the need to appoint a non-UK resident trustee as is currently required for income tax purposes. The draft legislation applies only to trustees who carry on a business and act as trustee in the course of that business.
Definition of settlor-interested trusts
The draft legislation includes changes to the definition of settlor-interested trusts for capital gains tax purposes. HMRC have indicated that this is to bring the capital gains tax treatment more closely into line with the income tax treatment. However, as drafted, a settlement would be settlor-interested for capital gains tax purposes if a minor unmarried child, who is not in a civil partnership, could or does enjoy a benefit from the settlement. For income tax purposes, a settlor is taxable on the income of the settlement in these circumstances only when such a child actually receives a benefit. The new definition will apply to settlements, whenever created, from 6 April 2006 and the concern is that many settlements, which are not currently settlor-interested for capital gains tax purposes, would automatically become so on 6 April as a result of this provision.
Limitation of holdover relief
One of the (presumably unintended) consequences of this change to the definition of settlor-interested settlements is that holdover relief, on a transfer of business assets or a transfer which gives rise to an immediate inheritance tax charge, will not be available where the settlor transfers assets into a settlement from which his minor unmarried children, who are not in a civil partnership, are potential beneficiaries. This is a substantial shift in Government policy. Since 1979, an individual making a gift into a trust for such children could do so without triggering a capital gains tax charge. An individual could still make an outright gift of business assets to such children or make gifts either outright or on trust for the benefit of children who are over 18 or are married or in a civil partnership without triggering a capital gains tax charge. It would appear this inequality of treatment has been created as a result of the widened definition of what constitutes a settlor-interested trust – it is to be hoped that the legislation can be amended to remove this anomaly.
For those contemplating gifts of business assets into trust for such minor children, it may be as well to take action before 6 April 2006 in case this anomaly is not corrected.
Where a settlement has been divided into one or more sub-funds which are administered by either the same, or different, trustees for different beneficiaries, administrative problems often arise because the main settlement and any sub-funds are treated as a single settlement for capital gains tax purposes. The draft legislation would allow the trustees of the principal settlement to elect that a sub-fund be treated as a separate settlement for capital gains tax purposes. In order to be able to make the election, some assets must remain in the principal settlement, the sub-fund must not contain certain jointly owned assets and there must not be any beneficiaries who could benefit under both the sub-fund and the principal settlement.
Making the election would give rise to a disposal, by the trustees of the principal settlement, of the property in the sub-fund for capital gains tax purposes. This means that the trustees would be in the same position as trustees who had used their powers to transfer property out of the principal settlement into a new settlement. Once made the sub-fund election could not be revoked. The availability of this election will only be of real benefit to trustees of settlements who lack the powers necessary to settle property on new trusts.
Other issues included in the draft legislation
The draft legislation also includes provisions in relation to the following:
- anti-avoidance provisions to stop a settlor taking advantage of the new £500 basic rate band by setting up numerous trusts each having a separate basic rate band,
- the treatment of income from a settlor-interest settlement as though it had arisen directly to the settlor, thus removing the anomalies in the rates of tax that currently exist,
- the treatment of trustees as a single continuing body of persons for income tax purposes to bring this into line with the current capital gains tax position,
- a common charging mechanism for various types of receipts, which are capital receipts for trust purposes, but are treated as income for tax purposes.
Issues not dealt with in the draft legislation
The draft legislation does not contain provisions on certain important elements of the trust modernisation proposals. Whilst acknowledging that the streaming of income and the abolition of tax pools are important elements of the modernisation process, HMRC have decided to introduce these measures at a later date. In addition, the draft legislation does not cover any changes in relation to the taxation of personal representatives. HMRC have decided to defer these provisions to a later date when they will form part of a wider package of measures to improve the tax treatment of estates.
As most of the provisions, with a notable exception of the trustee residence provisions, are due to come into force on 6 April 2006, trustees will need to consider urgently whether they need to take any action in light of any of the draft provisions.