We act for trustees who have a property rental business and we have come across a problem relating to lease incentives and trust income. The question is whether income which is accrued for accounting purposes is distributable income for trust law purposes. There is no guidance in the Trust deed and no precedent we are aware of.
As a general principle FRS102 and UK GAAP allow for other accruals and prepayments as well. Frequently, when a commercial lease is granted, there is a rent-free period, followed by a longer period during which rent is paid. For simplicity, suppose the rent-free period is two years and the balance of the term is eight years. During the initial two years, rent is not actually due under the terms of the lease, ie, it is not a case of it just being deferred. However the rent in the last eight years is commensurately higher than might otherwise be the case. This higher rent can also be a benefit in marketing other units and acts as a baseline for future rent reviews.
In our case, the beneficiaries all have fixed life interests, so are entitled to the net income, and there is little flexibility in the trust terms. For reasons extraneous to this question, the trustees are obliged to prepare their accounts under FRS102/UK GAAP.
For income tax purpose, the income is treated as being received evenly across the 10-year period and taxed accordingly. Accounts prepared under FRS102 and UK GAAP adopt the same approach. This means that in the rent-free period income is recognised and taxed even when there is no cash. In the later years the income that is recognised and taxed is lower than the cash received. Over the full term of the lease, the beneficiaries are in the same position they would have been in had the trustees adopted a cash basis.
In our case the Trustees have paid to the life tenants the accrued income they are deemed to receive for both tax and accounting purposes during the rent-free period. Any accrued income paid to the life tenant during the rent free period could appear to be a loan of capital repayable from future income, and if he dies during the rent-free period it becomes a debt against his/her estate (which may or may not be recoverable). The subsequent life tenant would receive less distributable income than the actual cash receipts.
If only cash is treated as distributable income it sits uneasily with the tax code and conflicts with FRS102 and UK GAAP. In particular, the life tenants would have to pay tax during the rent-free period on income they hadn’t received. It also means that no income is payable to the life tenant during the rent-free period even though the property has been let and occupied.
Has anyone else come across this problem and, if so, how was it resolved?
Annabel Spearman
Farrer & Co