Response to consultation ‘The Taxation of Trusts: A Review’

5 February, 2019
by: Cripps Pemberton Greenish

         The government seeks views on whether the principles of transparency, fairness and neutrality, and simplicity constitute a reasonable approach to ensure an effective trust taxation system; including views on how to balance fairness with simplicity where the two principles could lead to different outcomes.


These principles are in themselves a reasonable basis for a tax system.  However, they are very broad and each is open to interpretation.  In addition, as the consultation document, recognises there can be tension between the different principles and the system does not achieve fairness and neutrality at present.


If a choice needs to be made between fairness (the fact that tax treatment should neither encourage nor discourage the use of trusts) and simplicity, we would favour simplicity.  Any increased complexity leads to significant costs for both clients and advisers in understanding and explaining the changes as well as the cost of compliance; given the circumstances set out in 3.4 in which trusts play a valuable role, this is to be avoided.


         There is already significant activity under way in relation to trust transparency. However, government seeks views and evidence on whether there are other measures it could take to enhance transparency still further.


We believe that there is enough, if not more than enough, transparency, which in certain circumstances could prejudice beneficiaries of trusts and their safety.


3          The government seeks views and evidence on the benefits and disadvantages of the UK’s current approach to defining the territorial scope of trusts and any other potential options.


We think that the Government should reconsider the rules on the tax residence of trustees.  We do not believe that non-resident trusts provide opportunities for tax evasion.


Given that there is a significant body of trust expertise in the UK we would recommend that the Government considers reintroducing legislation along the lines of what was section 69(2) Taxation of Chargeable Gains Act 1992 with a view to stimulating a flow of work to UK professional trustees.  These trustees are in one way or another regulated by the UK government and additional fees earned by such trustees would benefit the UK exchequer.


4          The government seeks views and evidence on the reasons a UK resident and/or domiciled person might have for choosing to use a non-resident trust rather than a UK resident trust.


The motivation is very unlikely to be taxation. We anticipate that a UK settlor would principally choose non-resident trustees with a view to achieving greater protection of assets against claims, particularly divorce claims.


5          The government seeks views and evidence on any current uses of non-resident trusts for avoidance and evasion, and on the options for measures to address this in future.


No comment.


6          The government seeks views and evidence on the case for and against targeted reform to the Inheritance Tax regime as it applies to trusts; and broad suggestions as to what any reform should look like and how it would meet the fairness and neutrality principle.


 It is difficult to compare the fiscal effects of ownership of assets by a trust with personal ownership.  There are clear differences of approach in relation to the various taxes and in particular scenarios and we can understand how that has come about.


In terms of aspiration, the overall tax treatment of trusts should be fair so that trusts are neither encouraged nor discouraged.  In some senses trusts receive penal treatment – for example the IHT charge on entry and if fairness and neutrality is the order of the day that approach should be altered – and we mention further instances of disadvantageous treatment below.


Subject to that general statement of principle it would probably be helpful if we now commented by reference to the “Potential Issues” in the order in which they appear in the consultation document.


“The IHT nil rate band” (section 5.5.1)


It is true that gifting assets during lifetime into a different trust every seven years means that each trust then benefits from its own separate nil rate band in relation to ongoing inheritance tax charges.  This is advantageous compared with a client leaving all of his estate to one trust on death.  However, as the fourth paragraph of this section suggests the benefit of the donor’s nil rate band is identical whether he makes a gift to a trust or to an individual outright.  Furthermore, if he exceeds the nil rate band that leads to an IHT charge at the lifetime rate.  We believe therefore that the current rules meet the fairness and neutrality principle as far as is possible.


“Trust IHT charges” and “Will Trusts” (sections 5.5.2 and 5.5.3)


As mentioned above, it is very difficult, if not impossible, to compare the overall tax effect of holding assets in a “relevant property” trust with personal ownership whether assets pass to the trustees on the donor’s death or during his lifetime.


In a lifetime gift scenario there may be more IHT  payable when compared with an outright gift to an individual (if one assumes an entry charge at 20% and a basic ten year charge rate of 6%).   The Government may receive additional revenue in terms of CGT and income tax.


Whilst there is no IHT charge by reference to an individual’s death when assets remain in a “relevant property” trust, and, so, potentially some reduction in the overall amount of IHT collected, making the comparisons mentioned in these sections is adopting a highly selective view.


It needs to be borne in mind that there are a number of disadvantages that flow from ownership of assets by a relevant property trust:


  • There is no scope for IHT “potentially exempt transfers” (though the IHT on passing the asset to a beneficiary may be limited to the “exit charge” under the relevant property regime).


  • Ownership of private company shares by trusts tends to promote IHT on higher values. Often trusts are seen as a mechanism for avoiding the fragmentation of shareholdings.  Personal ownership can result in the fragmentation of shareholdings.  The absence of the fragmentation factor means that when IHT is charged on a trust shareholding a lower discount is applied in determining the value to be charged to that tax.


  • Funding IHT ten year charges and exit charges is potentially much more expensive in terms of other taxes than IHT on death.


In the latter event there is a tax free rebasing for CGT purposes. 


No such rebasing occurs during the lifespan of a “relevant property” trust, so, raising cash to fund IHT by CGT disposals is more expensive.  Furthermore, it is not always possible to raise cash by such disposals.  We know of a number of trusts where the funds are raised from sources which are charged to income tax (sometimes receipts which a layman would characterise as “income” such as dividends but other times receipts which a layman would expect to be charged to CGT, such as sales of shares to the issuing company (often at a discounted value) but which are classified as “distributions” for income tax purposes and therefore charged to tax at a high rate). 


The cost of funding IHT is particularly onerous where the primary asset of a relevant property trust is a shareholding in a property investment company.  If funds are extracted by means of a “distribution” then only 61% of the distribution is available to fund the IHT.


A number of landed estates are held by trusts through the medium of property investment companies.  We know from experience that they find funding IHT ten year charges difficult but just about manageable.  If the rate were increased that could lead to the break-up of these estates which we believe would be contrary to the public interest.


  • In general terms trusts are subject to a less generous CGT regime than individuals, an obvious example being “entrepreneurs’ relief”.


  • In circumstances where income is not taxable from the outset in the hands of an individual (and therefore classically in the case of a discretionary trust) trust income is subject to the very highest income tax rates regardless of quantum. In addition the operation of the “tax pool” can result in additional income tax that no layman would expect to operate.


We think that ensuring overall fairness of tax treatment is not an easy exercise and believe that if the Government simply tinkered with the IHT rates applicable to “relevant property” trusts as hinted in these sections that would further penalise the use of such trusts rather than adhere to the principles of fairness and neutrality, and operate against the public benefit.


7          The government seeks views and evidence on:

7.1       the case for and against targeted reform in relation to any of the possible exceptions to the principle of fairness and neutrality detailed at paragraph 5.6;

7.2       any other areas of trust taxation not mentioned there that would benefit from reform in line with the fairness and neutrality principle.



Our response in relation to 7.1


Private residence relief” (section 5.6.1): We do not think that the possibility that the proceeds of sale of a residence owned by trustees might be applied for the benefit of a beneficiary who has not occupied the property is an argument for removing or limiting the relief to trustees.  The most likely scenario is that the proceeds will be applied to purchase a replacement property. Furthermore, when an individual owns a residence it is open to him to transfer all or some of the sale proceeds to another individual.


“Trust management expenses” (section 5.6.2): Income beneficiaries are only entitled to the net income of the trust after expenses, and management expenses are an intrinsic disadvantage of a trust.  Income beneficiaries also have little control over management expenses.  Consequently, we think that it would be unfair for such expenses to be disregarded in determining the income tax payable by income beneficiaries.


“Income and capital receipts” (section 5.6.3): The critical issue where there is a trust is the determination of whether a receipt is of an income or capital nature and income beneficiaries have no right to capital receipts, a point which the consultation document seems to ignore.  If a receipt is a capital item it would seem unfair to subject it to a fairly penal rate of income tax.  Consequently, we do not see the case for any change.


“Transactions declared void by the courts” (section 5.6.4): There have been important developments in case law in the last few years.  Whilst a number of cases have involved transactions by or with trustees we do not believe that the law on this subject gives more scope for trustees to avoid the consequences of defective transactions than individuals.


Our response in relation to 7.2


We have already referred to the tax treatment of discretionary trusts in the context of funding IHT charges.  Why are discretionary trusts taxed at penal rates?   When distributions are made the beneficiaries are taxed at their personal rates and usually obtain a tax refund.  This is particularly the case in relation to children.  Processing tax refunds causes everyone including HMRC additional work and in their case probably extinguishes the cash flow benefit of collecting tax from the trustees at the very highest rate.  In addition the operation of the “tax pool” can cause unexpected and arguably unfair results.


8          The government seeks views and evidence on options for the simplification of Vulnerable Beneficiary Trusts, including their interaction with ‘18 to 25’ trusts.


No comment.


9          The government seeks views and evidence on any other ways in which HMRC’s approach to trust taxation would benefit from simplification and/or alignment, where that would not have disproportionate additional consequences.


No comment.