For many years, I have set up discretionary trust for grandparents. The trustees have then used the trusts to pay school fees for their grandchildren.
The grandchildren have had tax returns completed on their behalf and claimed back the tax paid by the trust.
HMRC have never raised any query.
I have recently been advised that there is an issue with this?
The problem appears to be that the liability to pay the school fees is usually that of the parent, not the trustees or the grandchild.
Therefore, the income should not be treated as a grandchildâs income.
Iâll be grateful to see what the forums opinion is of this new advice?
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I donât think this is new? A minor cannot contract to pay school fees, therefore the contract will be with the parents and HMRC can argue that the payment is for the financial benefit of the parents in discharging their legal liability and not for the benefit the child, and should be taxed accordingly. There is also an interesting discussion as to whether this represents use of the funds for the benefit of the minor, especially if fees are paid directly to the school, and if the net result is actually an increase in the parentâs estate by way of not having to pay the fees which may or may not be an issue depending on how itâs worded.
I am sure some of the more knowledgeable members of the Forum will be able to clarify!
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I do not see how a problem arises with a DT. Assuming the minor is a beneficiary it would be a very peculiar DT if the trustees did not have power to apply income and capital for the benefit of the minor for this purpose. Whose liability it is to pay the fees only arises when an individual other than a parent makes the payments because only a parent can claim the transfer of value disregard in s11 IHTA 1984. A payment by trustees is outside s11 and although it incidentally relieves the parent, or any other contracting party, of liability in my view that is not a breach of trust.
Given the insistence of the school to contract with the parent, or presumably other contracting adult, understandably to avoid the messy aspects of minors and contract law, the minor is the person receiving the ultimate benefit of the education. I cannot see a Chancery judge, who will probably be an Etonian or Wykehamist, holding that the trustees had acted outside their powers by making these payments either direct or via the contracting party, provided they confirmed in the latter case that they saw or retained an invoice and receipt from the school. If I were a trustee I would have no qualms about doing that as long as the trust document, which I have not seen, prevented me.
Jack Harper
I should have said âunlessâ the trust document prevented me
Jack Harper
As my colleague has just said, you know your ****, Jack. I applaud your succinct and laser-focussed reply.
Thank you Michael
Best Regards
Steve Nichols
Nichols & Co (Accountancy) Ltd
Does your answer encompass income tax, Jack?
Croner says this:
âThe provision of a childâs education is primarily the responsibility of its parent or guardian. Where the trustees of a trust pay a childâs school fees, the presumption is, prima facie, that this is the discharge of the parentâs pecuniary liability. The payment is therefore treated as if the trustees have paid the cash sum to the parent (see Drummond v Collins 6 TC 525). This treatment is almost certainly appropriate where the contract is between the parent and the school, the schoolâs invoice is raised on the parent, and the parent is alive at the time of payment.â
But Drummond doesnât seem (on a skim read) to support Croner. Lord Wrenbury says " Whether the money is paid to the child, or to the guardian of the child, or to the schoolmaster, or to the tailor or other person who supplies the wants of the child, it is paid to or to the use of the child and is income of the child." On the other hand he agreed with his brethren that the distributions were assessable on the mother.
The DT is just an ordinary DT for all tax purposes. The issue of whether payments are income or capital remains a matter of some uncertainty; the Law Commission as long ago as 2009 recommended that trustees should have a power of allocation to treat payments out as either income or capital. Even so if the trustees specifically purport to appoint under a power to distribute capital, that is not just desirable but probably essential.
You have to analyse the nature of the payment to determine the nature of the receipt for tax. Those most vulnerable to income treatment are regular payments of modest amounts. Their purpose is also relevant e.g. to maintain the beneficiaryâs day to day living costs. Lump sums especially if infrequent should be capital and again particularly if made to allow a beneficiary to buy a home, a car, or to set up in business.
School fees tend to fall between the two; if paid out on a term by term basis compared to a lump sum paid for the purpose either to the school or parent. Fortunately there is a case on nursing home fees, Stevenson v Wishart 59 TC 740 in the Court of Appeal. They held that recurrence alone was insufficient to make regular payments income and that despite being for an individualâs maintenance were emergency expenditure of such a significant amount that they were capital.
Sometimes particular facts will make the determination easier. In some DTs income and capital beneficiaries will be mutually exclusive. If a trust produces ÂŁ100 pa of income a payment of ÂŁ10000 out as income is implausible; even though strictly it is not permissible to attempt to trace the payment back into the trusteesâ sources of funds. Similarly if the trust fund is wholly invested in an insurance bond if the payments are funded by annual 5% withdrawals and possibly even if they are taxable as (deemed by statute to be) income. HMRC are hoist by their own petard here as they deny these are income for the IHT normal expenditure exemption.
Modern trusts do not confer a power to to augment a beneficiaryâs income which if exercised will generate income (the Brodie and Cunard Cases). The income of a DT is taxed at the trust rate(s) and if distributed net of 45% tax may give rise to a tax refund. If accumulated it becomes capital and if distributed possibly liable to IHT (see TSEM3781 and generally TSEM3754-90).
Trustees can make a payment to a non-beneficiary in appropriate circumstances without breach of trust e.g. direct to a school or nursing home or to the parent of a minor. These payments can be income taxable on the beneficiary benefited. Income treatment here would be highly disadvantageous if there is no tax pool and its absence strictly has no bearing on the true analysis of the receipt. There may be an argument mentioned above that the whole trust fund comprises only capital. It may help if the trustees have sold a capital asset in order to distribute the proceeds net of CGT or distribute a capital asset with a view to the beneficiary selling it.
Malcolm Finney has authored a useful article in the public domain on this subject athttps://www.taxinsider.co.uk/discretionary-trust-distributions-capital-or-income
Jack Harper
At the risk of being accused of putting words into Stevenâs mouth, I think that:
- He is happy that the distributions (payments to the school) are classed as income
- They are in fact paid out of income and thus there is a tax pool to frank them.
- Until now he considered the distributions to the be income of the child and is now unsure
- As the child has no other income all or nearly all of the tax âdeductedâ from the distribution has been reclaimed on the childâs behalf by the parent on Stevenâs advice
- His concern is that HMRC will consider the distributions to be the income of the parent and thus the tax repayment have been wrongly claimed, leading to discovery assessments and penalty assessments.
I cannot find (but I have only briefly looked) any statement from HMRC that that is indeed their view. One obvious place for HMRC to promulgate any such view is in the guidance notes to form R40. There is no mention of school fees or of trustees settling the pecuniary liabilities of parents more generally in the 2023 notes.
It seems to be only the likes of Croner and Stevenâs interlocutor that profess the view that the income is the parentâs and not the childâs.
Chamberlain and Whitehouse opine that the child is the person liable, without citing authority. Croner also says in summarising Drummond v Collins:
"Payments to beneficiaries under a discretionary trust are not treated as voluntary payments. In Drummond v Collins 6 TC 525, allowances were sent to children in the UK out of a discretionary trust set up on their behalf. It was held that these were not voluntary payments by the trustees but were income of the children. Earl Loreburn said:
â⌠it is enough to say that these were not voluntary payments in any relevant sense. They were payments made in fulfilment of a testamentary disposition for the benefit of the children in the exercise of a discretion conferred by the Will. They were the childrenâs income, in fact.â"
The DT was in the USA so the payments from it for the maintenance of children resident in the UK were taxed on the remittance basis. Apparently the taxpayer argued that because they were paid âvoluntarilyâ they were not income! Hopeless try on!
The money was paid to the mother, also UK resident. The income could be charged on the person receiving it, the mother in this case, or entitled to it, the child.
This was under s148 ITA 1952 which applied to all Schedule D income including remittances within Case V. This is now achieved more opaquely by a combination of ss 832 and 685 ITTOIA 2005. See also TSEM9310. NR trustees cannot be charged directly or by deducting tax at 45% under ss493-5 ITA 2007, so the person receiving or entitled to it is chargeable on the payment gross. ESCB18 may apply, if claimed, to tax instead the underlying income of the trust from which the payment is deemed to have been made: TSEM10444-55.
Duncan seems to own a very efficient Mind Reader but I refuse to use one. It is bad enough trying to extract vital omitted facts out of questioners in this Forum without speculating about them; and I get exasperated when encountering the faulty one that HMRC claim to own and, of course, the infallible top of the range one which my spouse assumes I own.
Jack Harper
This question was also asked in âTaxationâ magazine in 2022. For those of you with access, it is: Volume 189, Issue 4842, 2 June 2022, Readersâ Forum. The article is entitled âSchool fees - taxationâ.
In summary, the two people who responded to the question both considered that it would be the parent who is subject to income tax on the distribution of income.
Both also recommended that the trustees contract directly with the school for the payment of the fees. This does seem logical to me, as it will make the liability that of the trustees and not that of the parents. Whilst there is the argument that the trustees are entering into the contract âso that the parents do not have toâ and, as such, the trustees are still in effect taking on what would otherwise be the parentsâ liability, it is also quite possible that the parents might say: âWe cannot afford to pay the school fees and do not wish (for such and such reason) to expose ourselves to any potential liability for the fees (eg should the trust become insolvent before settling the bill), but if the trustees decide that they want to, then they are welcome to do so but they will have to make appropriate arrangements with the school themselves regarding payment of fees. If the trustees do do that, then we will be happy for our child to attend that school.â
That is the thrust of it. But⌠much of the Drummond case relates to whether the sums received by the mother (also referred to as the âguardianâ in that case) of the children should be treated as income or not - there is a more recent thread just started on TDF on this topic. Letâs assume that we are talking about income. The Drummond case also makes reference to s41 of the Income Tax Act 1842 - I am afraid I have not been able to lay my hands on that. In that case, the âincomeâ was paid to the mother/guardian of the children in question and the argument was about whether she should be taxed on the income herself. The judgment does include the following:
âSection 41 of the Act of 1842 makes a guardian having the direction, control or management of the property or concern of an infant chargeable to income tax âŚâ.
I am not sure if there is a precisely equivalent provision under the present legislation, but I do note that section 685 ITTOIA provides:
âThe person liable for any tax charged under this Chapter is the person receiving or entitled to the annual payments.â
That is specifically in relation to âannual paymentsâ which ITTOIA treats as income, rather than simply to payments which it is clear are actually income. Also, it does not specifically address the point of whether a payment of income received by P (parents) on behalf of C (the child) where the payment is solely for the purpose of paying Câs school fees should be treated and taxed as Pâs income or as Câs income. If Q and R (trustees of a bare trust for C) receive income as bare trustee for C, that is surely taxed as Câs income? Is it not the same here? It sounds as though s41 Income Tax Act 1842 might have overriden that position, hence the case, but I cannot be sure without seeing it.
I wonder therefore whether the courts would consider there to be a distinction between:
- payment of income to P so that P can pay Câs school fees for which P has just received the bill - here, P receives the money from the trustees and promptly pays out that same precise sum to the school
and - payment of income to P to assist P generally in making provision for Câs education and maintenance - here the money received by P is assimilated with Pâs other money and P will use it how and when P considers appropriate (albeit still for Câs education and maintenance).
The second of those is more likely to be treated as income taxable on P (the parent).
In the first scenario, on the other hand, P simply seems to be an agent for the trustees, to whom the trustees, for ease, transfer the money so that the schoolâs bill can be paid. However, I still consider that, strictly speaking, if it is P who has the liability to the school, the settlement of the bill by the trustees (even if settled by direct payment from the trustees to the school) results in the trustees transferring value to the parent. Whilst I have never come across HMRC taking this view, it does seem sensible for the trustees to be the ones incurring the liability with the school, rather than P.
Paul Davidoff
New Quadrant
If payments of an income nature from a DT are not annual payments, what is the statutory charging mechanism? If none they are tax-free. Income from a DT is an annual payment and was taxable under Case III of Schedule unless from a foreign source when Case V applied.
The Rewrite translated the schedular sources into ITTOIA as specific items each with its own charging provision. So interest which was also Case III (or case IV if foreign) is now charged by s370 or s829. DT income was never charged under Case VI so it is improbable that it is now charged by ss 574, 575 and 687 which is its equivalent Rewrite charging provision.
Jack Harper
TSEM3756 describes the receipt as an annual payment. They do not cite the charging provision despite doing so many times throughout the Manual. As we know the Manual is regarded by HMRC as a source of law superior to statute except when the latter favours HMRC.
The beneficiary of the trust is the person liable to income tax on income from it being the person âentitled to itâ so liable at all rates, with a refund of tax deducted at 45% if appropriate. Any other person to whom it is paid is assessable as âthe person receiving itâ but at basic rate creditable to the beneficiary. If the parent or other contracting party contracts with the school and is reimbursed by the trustee the parent is not taxable on the reimbursements as these are not income but is assessable as receiving the beneficiaryâs income.
If the trustees contract with the school the consequent payments are trading income of the school but not deductible to the trustees and arguably the school is also assessable at basic rate as the payments are income of the beneficiary and they are the person receiving it. I have never come across HMRC taking that point but I suspect contracts with trustees are uncommon. As Michael Caine may or may not have saidâŚ
I do not have access to Taxation so I donât know whether or not I should say âwith the greatest respectâ but I consider the two contributors to be erroneous if their view is that the parent is liable at all rates up to 45%.
The Drummond case is at
https://www.bailii.org/uk/cases/UKHL/1915/TC_6_525.html
Jack Harper
If the trustees distribute income, as income, then the beneficiary receiving the money is receiving trust income and will pay income tax on it at the relevant rate. For discretionary trusts, the rates will be non-dividend rates.
In many cases, the parent will be a discretionary beneficiary of the trust and therefore the transfer of the money to the parent could look like a receipt of income by the parent, in their capacity as a beneficiary of the trust. The position is, perhaps, clearer where the parent is not actually a discretionary beneficiary of the trust and therefore, arguably, the trustees have no power to pay them income, except where it will specifically be used for the maintenance / education / benefit of someone who is a beneficiary. If it is transferred to the parent for that specific purpose (and is so used), it seems to me that that ought to be treated as a distribution taxable on the child. However, in my previous post, I made the distinction between a payment to be used for a specific liability (for the benefit of the child - eg the school fees bill that has just been received) and a payment which is made to the parent to bolster their bank account generally, on the understanding that they are using their funds to maintain the child. I would argue that the latter is taxable on the parent, where as the former might not be.
The relevant question in my mind is this: who is financially better off as a result of the transfer of funds? If the trustees pay the school direct, the school isnât better off, as the contract liability is already incurred by someone: yes, the school has the money, but if the money isnât paid, it has the right to sue someone for the money (and the value of that right to sue will be the amount due under the contract). If the child hasnât entered into the contract, then the child is not better off - their net worth hasnât changed (notwithstanding the, hopefully, high quality of education they will receive). The parent, on the other hand, is better off, if the parent has entered into the contract with the school: before the school fees are paid, the parent owes the school, say, ÂŁ15,000; afterwards, the parent no longer has that liability.
Compare the scenario where the child (C) becomes an adult and goes to university and has a tuition bill to pay: it is C who is liable for the fees, not Câs parents. If the trustees use some of their income to pay the fees (direct to the university), it is the C who is âbetter offâ as a result. Surely, then, if C has no liability to pay the fees (eg at school), C cannot be considered the one receiving the income?
I am not saying that it should necessarily be taxed in that way, but that seems to me to be the argument. Perhaps the parent could be considered to be an âagentâ for the trustees in arranging the contract with the school.
I would be very interested to hear if anyone has any non-hypothetical experience of HMRC taking the view that the parent should be taxed as the recipient of the income.
Paul Davidoff
I donât know whether or not Paul disputes my income tax analysis
1 If parent and child are both eligible beneficiaries of the DT the trustees can choose which one to pay the income to. Their tax profiles may be quite different. The minor or the parent may have a PA and BR available, the parent may have trading losses or be non-resident with a DTT advantage.
To avoid ambiguity the trustees should resolve in writing for whose benefit they are making the payment of trust income. If to the minorâs benefit they should if actually paying the parent expressly rely on any relevant provision like 5.1 of STEP Standard (which also allows payment to a minor who is 16 or over). I see no way that HMRC could then impugn their choice. No doubt they can pay the school direct if they have contracted without breach of trust.
TSEM3788 deals with payments in kind from HMRCâs viewpoint. Though this refers to discharging a personal liability of the beneficiary it seems likely to cover a liability of the parent which is manifestly for the minorâs benefit. Even in the absence of an express power the trustees can probably pay the parent of a minor or the minor themself but it would be prudent too ensure the appropriate use of the money for the specific purpose they intend, to avoid exposure to breach of trust.
2 If only one of them is an eligible beneficiary to benefit the other would be a fraud on the power. Even if the non-beneficiary parent contracts, the reimbursement, appropriately documented, surely is in substance to benefit the minor and the relief of their liability incidental. Equity looks to substance not form. This cannot be taxed on the parent as a payment of trust income to them would be void.
3 It is certainly possible that a parent could act as agent for the trustees in contracting with the school if the necessary ingredients of common law agency were established. If not express it would have to be implied from conduct or by holding out or ratification. The average parent trustee or school is unlikely to be aware of the subtleties. It might arise in the context of the school suing for non-payment, or HMRC going unpaid where the trustees have failed to deduct 45%, but in a typical tripartite arrangement it would seem somewhat exotic though not wholly academic.
4 In my opinion, and I expect that of HMRC too, is that if trustees explicitly resolve to benefit a beneficiary by paying their school fees, whether direct to the school or by reimbursing any third party contracting with the school, who provides evidence of payment duly made, it is not breach of trust and it is the taxable income of the beneficiary, whether or not the third party is also a beneficiary, and not the income of that third party. However, a payment to a third party is strictly assessable at BR as the person receiving but HMRCâs primary concern and protection is the liability of the trustees to deduct tax at 45% and as long as the trustees account properly for that, and donât cock up the matching with the pool by paying too much income out leaving them short of trust funds, they will not resort to a BR assessment.
Jack Harper
Thank you, Jack. I think we are both on the same page. I certainly agree with your comments about the trustees making it clear, in writing, that they are resolving to apply the income âfor the benefit of beneficiary Xâ and âfor such and such purposeâ, even if they are then actually handing the money over to Xâs parent.
Paul Davidoff
Paul, I think there is a distiction to be made here. If the school fees are paid by the trustees to the school under a contract with them, or as principal of a parent acting as agent, then the school is not receiving the payment as income of the minor beneficiary (even though it is taxable on the minor as a benefit in kind). If the trustees resolve to distribute trust income to the minor and pay off the parentâs own contractual liability to the school or pay the parent in reimbursement, in theory, while the minor remains taxable as entitled, the recipient school or parent is receiving trust income assessable at BR only.
This is the same position as a land or estate agent who receives rental income of a Non-resident Landlord not in the Scheme or a trustee of an IIP trust where the IIP owner is entitled to the rental income received by the trustees from the tenant. Where the tenant is liable to deduct one imagines this is honoured more in the breach.
Provided the school or parent is paid net of tax at 45% and HMRC collect from the trustees by direct payment or set-off against the pool they will be happy. Indeed as you say they cannot then assess anyone else. But if the trust were insolvent and HMRC unpaid they could.
A similar position arises in PAYE where if they cannot collect from the employer they have the right (but here in limited circumstances) to resort to the employee. The employer who under-deducts and is obliged to meet the shortfall is paying someone elseâs tax. The worst case is when parties dispute whether tax is deductible e.g. from interest or royalties paid to a non-resident and HMRC leaves them to sort it out in court and await the event, probably having refused clearance, and declining to intervene if invited.
Jack Harper
Thank you, Jack. I understand the point you are making re the BR now.
Paul Davidoff
My understanding from an Investment Bond as an investment vehicle.
If the grandparents are investng in a discretionary trust and the investments are invested in a investment bond.
Trustees can assign segments. To someone that is not a minor. The legal and beneficial ownership of the segment passes to the assignee. They are liable for any tax and they will receive the proceeds. There may be an exit charge on assignment depending on value.
Trustees can appoint segments (usually to a minor but doesnât need to be it could be an adult and the trustees just want to do the admin/ deal with provider). This effectively creates a bare trust that needs to be irrevocable or doesnât work ( you canât change your mind if you make an outright gift).
The trustees remain the legal owners, but beneficial ownership passes to the beneficiary. The trustees control all the money admin and will receive the proceeds of any surrender to disburse to the beneficiary. The beneficiary is liable for any tax, but as the trustees are the legal owners of the policy, they will receive the chargeable event certificate, which they should pass on to whoever is legally responsible for the minor. Depending on value, there may be an exit charge when the appointment is made.
Once the bond is held within a bare trust, all chargeable events are generally assessed against the beneficiary. However, where the settlor is a parent of a minor beneficiary, and the chargeable gain exceeds ÂŁ100 in a tax year, the gain is assessed for tax on the parental donor(s)/settlor (Parental settlor rules). However, as you know, the rule only applies to funds from parents, not grandparents or any other family members.
Clive Perks
The gain on the the chargeable event is not income. So if it arises in a bare trust for a minor it is NOT taxable on a parent who has funded the bond. The chargeable events legislation identifies the person liable in a totally idiosyncratic way in ss464-472 ITTOIA 2005
While the bond is held on trust the trust document coupled with the law of trusts will determine whether a minor can be the assignee of a segment and from this point of view it does not matter whether the equitable interest is vested with the legal interest also or the trustees declare a bare trust. Trust law in the latter case will allow the trustees to retain the bare legal title until the minor is 18 and s31 TA 1925 and s480 ITA 2007 are inapplicable because a chargeable policy gain is capital not income either for trust law or income tax. It is also capital for charging trust management expenses.
Jack Harper