Workshop: private client

I have a client who is both a trustee and a beneficiary of his late mother's discretionary trust. He wants to use the income of the trust to pay for his young children's school fees. His children are also discretionary beneficiaries of the trust. As a higher rate tax payer himself, my client has approached me for some advice regarding the best way to achieve this.

The legal position

Discretionary trusts are subject to their own rate of income tax (the rate applicable to trusts). Since April 2010 this is currently 50 per cent on all income other than the 42.5 per cent payable on dividend income. As there is a non-recoverable rate of tax on ten per cent of dividend income deducted at source, an anomaly arises when the trustees wish to distribute income to the beneficiaries. The trustees can only pay out the income which is supported by a tax credit (i.e where tax has already been paid at the trust rate). Because of the irrecoverable ten per cent tax and because of the standard rate band, there invariably arises a pool of income which cannot be distributed without additional income tax becoming payable by the trustees.

With a discretionary trust of this sort, the trustees can choose either to distribute and pay the additional tax or to simply delay the decision by retaining the income. Most trustees choose to distribute the amount of income that can be distributed without additional tax becoming payable and retaining the balance. If my client, as trustee, pays the income to himself as beneficiary, then he can claim back a proportion of the tax. If he applies it for the benefit of his children to pay for their school fees, as non-taxpayers they would be able to reclaim most or all of the tax paid. But there would still be the income that cannot be paid out of the trust without additional tax.

The solution

Following the Finance Act 2006, the trustees can simplify the income position if they wish. They do this by giving one, or some, or all of the discretionary beneficiaries the right to receive the income, thus creating an income entitlement. The trust is then taxed at the basic rate and all of the income is distributed without additional tax being paid. The most tax efficient trusts are those where the income is payable to basic rate or non-taxpayers as the maximum amount of tax can be reclaimed.

By putting revocable income entitlements in place, my client can pay the income to his children and provide attractive tax advantages by being able to reclaim some or all of the tax deducted by the trustees via the children's personal tax returns. By giving one or more of the beneficiaries a right to receive the income from the trust, if they are basic rate or non-taxpayer beneficiaries, then they should be able to claim all or most of the 50 per cent income tax currently paid by the trustees.

The trustees would also be advised to make the appointment of the right to income revocable. A 'revocable' arrangement means that the trustees can remove the children's income entitlement at any time, simply by executing a further formal document. Such a document could, in effect, remove the children's entitlement to the income and give the income to other beneficiaries or give the income to the same beneficiaries in different proportions.

If a beneficiary is anything other than a higher-rate taxpayer, then they will be able to recover some or all of the tax paid by the trustees, depending on his or her personal rate of income tax. A further advantage is that enabling the beneficiaries to receive the monies directly improves cash flow in the trust. In addition, the need for beneficiaries to make tax repayment claims (except in the cases of non-taxpayers) will be avoided.

The execution of a deed creating a revocable income entitlement can therefore provide a real tax saving.