How much retained income is being paid?

I am dealing with the termination of a discretionary trust. The trust assets were private company shares and retained income from dividends - approximately £84,500. The Deed of Appointment to terminate the trust appoints the shares specifically to the beneficiaries (in unequal numbers) and the balance of the Trust Fund equally between the beneficiaries after payment of all taxes and expenses. There is £100 in capital cash as well as the retained income. There will be CGT of just over £30,000 to pay and professional fees too.

Am I right in assuming that it is only the balance of the retained income, after tax and expenses, being paid to the beneficiaries on the termination and to be covered by the available tax pool? The alternative is that all of the retained income is being paid to them in which case the tax pool is unlikely to be sufficient.

The usual ploy is to distribute only such amount of net income as will exhaust the pool. Income to distribute = Pool Amount x 55/45. Presumably as favourably as possible to generate refunds for those not liable at 45%. The balance of net income, if paid out, will generate additional tax deductible that would have to be paid out of capital. That would be deductible for IHT (small beer if any use at all) but be a true additional cost if no beneficiary can recover any part of it. Is there further taxable capacity among the beneficiaries to absorb all or part of that? There is really no point in distributing income taxable at 40-45% just to use the pool and certainly not if the pool would be insufficient. Beneficiaries may not see it that way of course.

Instead you could capitalise it (trust instrument permitting) and distribute it subject to IHT at a maximum of 6%. You would waste the pool by so capitalising it all but the cost of messing about with income distributions may be cost-ineffective unless the prospective refunds justify it. If there would be no marginal cost of IHT on distribution as capital (e.g. the rate might be nil) trying to finesse the income tax “loss” of the wasted pool may appear a palaver too far when the incremental fee cost of it hits the fan. Is the trust deed and the Deed of Appointment silent on distribution of income as opposed to the shares or does either limit your discretion over income? Is there any IHT to pay on the shares themselves? If there is you could just use net income to pay it. If these shares attract BPR there must be a sporting chance that the IHT bill will be low or nil and perhaps even if they don’t.

Possible issues with the trust instrument/DoA are: different income and capital beneficiaries, no power of accumulation, and no discretion to distribute income differentially to maximise net of tax benefit. Clearly some juggling may be needed on the basis of facts known only to you but typical of this situation. It may be advisable to secure the beneficiaries’ agreement to your plan, using the leverage of your discretionary powers (if you have them) to pay them less if they won’t play ball. Beneficiaries may be content in a family situation to accept a skewed distribution scheme which minimises what HMRC get out of it but in some cases (including in some families!) they can be more concerned about what they each get personally even if overall HMRC get a bigger pay day.

Jack Harper

Thanks for the detailed reply, Jack. However, my question was about the quantum of income being paid to the beneficiaries rather than minimising the tax effects.

The trust is being terminated and so all the cash must be paid out either to HMRC, professional advisers or beneficiaries. Because the power to accumulate has expired and was never exercised, all the income retains its character as income. However, there is no other source (apart from the £100 originally settled) from which to pay what would otherwise be capital expenses.

If the taxes and expenses are paid out of the retained income, does that mean that the trustees can only exercise in favour of the beneficiaries their discretionary power over the balance of the retained income so that it is just this lower amount that needs to be covered by the tax pool?

Retained income is usually net of any expenses deducted from it, so if only income cash is available then that is what has to be used to settle trust management expenses, tax etc. Whatever is left should then be distributed and any available tax pool can be used against it…
Maxine
TC Citroen Wells

It seems to me that where an income discretionary power trust that is concluded by the exercise of a deed of appointment in respect of all the trust fund [ i.e. capital and undistributed/retained income ] the trustees at that point hold all the trust fund [undistributed income and capital] as bare trustees to those entitled under the terms of deed of appointment.

Consequently, there will no longer be any trustee discretionary powers over income [or capital] and the unused tax pool will become irrelevant i.e. lost.

In these circumstances I think HMRC may well take the view that there is no tax available to frank the retained income that is distributed in accordance with the deed of appointment.

On occasions where there has been a desire to, in accordance with the trust powers, bring an income discretionary power trust, holding both undistributed income and an available unused tax pool, to a conclusion I have used a very carefully worded trust deed/resolution to make full use of the available unused tax pool.

Andrew Mortimer [previously a TEP and trust tax adviser]

The wording of the trust instrument and DoA are plainly crucial. It seems that the latter has not dealt with retained income as such but that arguably it may be part of the “balance”. It is quite possible that its actual wording is apt indirectly to vest the retained income in the beneficiaries; but if not the trust instrument will still govern its destination. The critical issue will then be: do the trustees still have discretion over it.

Graeme indicates that the power to accumulate has expired. The general law in such circumstances re a DT is that the income beneficiaries (or all if no distinction is drawn between eligibility for income and capital all beneficiaries) are entitled collectively to the income, net of expenses (which ones are deductible being a separate important issue). While I repeat that entitlement could be extinguished by the exercise of a PoA it has not been in terms or an experienced practitioner like Graeme would not be posing the question. That it should have been is a separate issue but the trustees must quite rightly now take care not to compound that.

The overriding obligation on them is to pay the expenses and they are not restricted as to the sources of the funds to which they can resort in order to do so. But they must as far as possible then attempt to ensure an outcome which accords with the law on who should bear which expenses, those entitled to capital and to income. This arises most graphically in a life interest trust where the LT and remainderman are different. It is rare in a DT. Also modern precedents include a variety of provisions that permit trustees to ignore balancing rights of beneficiaries and the need to treat income and capital differentially. See Step Standard 3rd Ed cl 19. Statute may assist: see ss8(3) 2000 and new s19 (5) TA 1925 substituted by s34 TA 2000. The question does not mention the relevant admin provisions and I assume they do not assist.

I do not agree with Andrew that the existence of a DoA automatically makes the trustees functus officio depriving them of any powers under the trust instrument only that it can do. Here it may well do if income must be part of the “balance” vested in the beneficiaries.

Subject to all those caveats I think the trustees are entitled to pay the expenses out of whatever funds are readily available. It seems that apart from the shares the beneficiaries are entitled to what is left. We are not told how they all respectively share but that is important if they do not all share equally in each and every asset of the trust fund. Before the DoA the trustees were strictly entitled to sell the shares to pay the expenses but that document may not only have now prevented them from doing so (leaving aside whether it was a practicable or popular proposition!) but they may be left with no effective way of compensating income beneficiaries for any expenses paid out of income which were properly chargeable to capital. For example, the shares could have been transferred subject to a charge for that equitable compensation. As a matter of general law some like CGT and probably professional fees seem very likely to be properly so chargeable. If the beneficiaries are not concerned by the de facto outcome of paying all expenses out of available realisable funds the point is academic.

HMRC TSEM8000 et seq sets out HMRC’s view of the law as they see it and their practice on the tax issues. These are helpful in what they say given the constraints of brevity and generality. They do not express a view on the dilemma here nor on what the nature of equitable compensation would be for income tax, though no doubt they would seek to tax it as income! My view is that you cannot tax what is not paid out. HMRC would seem to accept that in the way that they agree that while trust expenses are not deductible for tax a LT is taxed not on gross trust income but on net income grossed up: TSEM8300 generally and note their view in 8335 of when the correct charging of expenses is not followed.

It seems that the capital of the shares has not and probably cannot be charged to those entitled to them. By analogy with 8335 if money has been expended in paying expenses (rightly or wrongly) it cannot be actually distributed as income because unlike a LT no beneficiary has an entitlement to it until distributed. A LT whose actual income is depleted by expenses properly chargeable to capital is agreed by HMRC to “deduct” them in grossing up per 8335.

If the “balance” distributed to beneficiaries by the DoA contains income then it is taxable on those who receive it with a credit from the pool if sufficient. HMRC may argue that it is all income (if within the total amount of retained income; and there are no legal rules or practice on this) but not that the beneficiaries should be taxed on notional equitable compensation that, arguably, is due from capital beneficiaries but which is not actually made good by them. TSEM8200 onwards says much about the quantum of net income of the trustees at various rates of tax but diminution of the net income itself by payment of expenses is not mentioned, only their “deductibility” or otherwise to arrive at the total quantum for distribution.

Jack Harper

Jack

I find your response to my post interesting and stand to be corrected by those more knowledgeable and experienced than me.

I do not claim to be a legally qualified trust law legal expert and my views are to some extent based, in part, on what I learnt many years ago whilst working with the Inland Revenue and in particular with the trust taxation ‘experts’ in the old Claims Branch Advisory Division in Bootle.

Their view was that when a trust was brought to a conclusion by whatever means there was no continuing trust period for tax purposes akin to post death administration period.

However, I accept that HMRC now appear to change their views ( move the goal posts! ) when it suits them.

I would be interested to learn the trust law reason why discretionary powers are considered to be retained after the trust (granting discretionary powers to trustees during the existence of a trust) has been brought to an end .

Below are excerpts from ITA 2007.

493Discretionary payments by trustees

(1)Sections 494 and 495 apply for income tax purposes if—

(a)in a tax year the trustees of a settlement make an annual payment to a person (“the beneficiary”) in the exercise of a discretion (whether exercisable by the trustees or any other person),

494Grossing up of discretionary payment and payment of income tax

(1)The discretionary payment is treated as if it were made after the deduction of a sum representing income tax at the trust rate on the grossed up amount of the discretionary payment.

(2)The grossed up amount of the discretionary payment is the actual amount of the discretionary payment grossed up by reference to the trust rate.

496Income tax charged on trustees

(1)Income tax is charged for a tax year if—

(a)in the tax year the trustees of a settlement make payments as a result of which income tax is treated as having been paid under section 494, and

(b)amount A is greater than amount B.

(2)Amount A is the total amount of the income tax treated under section 494 as having been paid.

(3)Amount B is the amount of the trustees’ tax pool available for the tax year (see section 497).

(4)The amount of the tax charged under this section is equal to the difference between amounts A and B.

(5)The trustees are liable for the tax.

It appears to me that for section 494 grossing rules to apply in accordance to section 493 a discretion has to be exercised and similarly for the section 496 ‘tax pool’ rules to apply section 494 has to apply.

Andrew Mortimer [previously a TEP and trust tax adviser]

Andrew, it is a matter of interpretation of the documents whether trustee powers have been exercised, on one or more previous occasions, exhaustively so that there is no longer any trust property over which such powers can still be exercised. The statutory provisions you cite only come into play if the trustees have made a payment which is valid in trust law. If that power has expired a purported payment will be a legal nullity.

This forum inevitably suffers from an inability of contributors to see the actual documentation. Some questioners quote verbatim. Otherwise we rely on what they tell us has happened in their opinion. As a former tax officer you will recall that a future Inspector of Taxes’ first words are not “Mumma” or “Dadda” but “It all depends on the facts”. Sometimes we have to guess at the facts and answer in the alternative based on stated hypotheses.

The key issue here is what is meant by the word “balance”. A reasonable inference is that the DoA was intended to and did in law distribute all remaining trust property exhaustively. After that the trustees’ powers ceased or rather lapsed (see below). One consequence may be a lost opportunity to distribute specifically income to selected beneficiaries with maximum tax efficiency. It becomes a question of interpreting how much of the distributed "balance " comprised income and who received it. Given that payment of such income generated an obligation to deduct tax at 45% it is to be hoped that the pool was sufficient to frank it in full. If not it may be difficult for the trustees, whose primary liability it is, to recover it as all trust property has been distributed and so their lien over it no longer exists. In theory they can still recover by action from the distributees but their defence will be that the trustees acted negligently by distributing too much income so that the pool was inadequate, a well-known trap of which trustees should have been aware and could and should have sought advice about.

We are reluctant to pontificate on the quality of documentation as we have not seen it, and are not always in possession of all the facts, and the questioner may not be the drafter of it. No one likes to hear “I could have told you so” unless what should be done instead is itself the question. But a DoA is in principle a badly drafted document if it distributes all the trust assets without also providing for how known expenses are going to be met and by whom, leaving the trustees at risk of bearing the liabilities themselves. The appropriate remedy is for the trustees to retain sufficient assets for the purpose, or distribute subject to a charge, or take an indemnity; in the last two cases taking advisedly a view of the distributee’s creditworthiness.

Finally, there is no such concept as the “termination” of a trust or its “closure”, only colloquially. HMRC do use these terms in that sense and the latter has caused confusion for the TRS. Where trust property has been fully distributed it is perfectly feasible for the same or a different settlor to settle further property on the trusts of the same document and if the named trustees will not act the Court will find some who will. Of course it would be barmy and no one does it but it illustrates that in theory a trust is never “terminated” only dormant. It cannot be formally dissolved like a company or partnership. In fact if by mistake trustees discovered many years later the existence of a trust asset the trusts would attach to it since in theory they would always have done so. Consequently it may sometimes open to question precisely when a trust is “closed”. The admin period ends when all estate assets are identified and all estate liabilities paid or provided for but this does not mean that PRs still have no further duties to carry out e.g. transferring assets and paying liabilities or securing their payment by others.

Your mention of HMRC at Bootle is nostalgic. In my early career I was instructed to attend a meeting there for a client accused of being the settlor of a settlement for income tax. To my surprise while I was alone they were six in number. Each was the specialist on each relevant section of ICTA 1970! They all agreed that none applied to my client. Those were the days when such discussions were possible to avoid an assessment or quickly dispose of it without litigation. And every taxpayer could pop into his hometown local district office to discuss his or her affairs; and the DI regarded it as a success for his employers to settle cases if he could properly do so. Now it is adversarial and HMRC don’t reply to letters or answer the phone.

Jack Harper