Trustees incur general management expenses in managing a trust’s affairs. The allowable trust management expenses may be used to reduce the tax paid by trustees of a discretionary or accumulation trust, and in the case of a trust with a life tenant who has an interest in possession the trust management expenses may reduce the amount of the beneficiary’s taxable income.
The trust management expenses are not the same as the expenses involved in running a trade or a property business, which are deductible from the relevant business or property income in computing the taxable profit.
Discretionary and accumulation trusts
The income tax liability for the trustees of a discretionary trust is computed at the “dividend trust rate” of 42% (for 2010/11) and the “trust rate” of 50% (2010/11) for income of the trust. Allowable trust management expenses may be used to reduce the amounts of tax payable by the trust. Only trust management expenses properly chargeable to income in general law are allowed. Management expenses are taken into account in the tax year when they are incurred. Expenses that would be allowable as trust management expenses include the following:
Costs of preparing the tax return for income received by the trust; Determining which beneficiaries to pay and deciding on the amounts to pay; Costs of arranging payment to the beneficiaries.
The actual payments to beneficiaries from a discretionary trust are not management expenses of the trust for this purpose.
Where trust management expenses have been properly paid out of income and are allowable expenses, they reduce the amount of tax paid by the trustees. The income of the discretionary trust that has been applied in paying the allowable trust management expenses is not chargeable at the special trust rates but at lower rates. So to the extent that there are allowable trust management expenses, income of the discretionary trust will not be taxed at the trust rate or the trust dividend rate but at the 10% ordinary dividend rate or the 20% basic rate of income tax.
The allowable trust management expenses are allowed to reduce the tax on categories of income in a particular order, this being the following:
Firstly they are allowed against income that carries a non-repayable ordinary dividend rate tax credit or notional tax credit at 10%, e.g. dividends or stock dividends from UK companies; Any excess expenses are allowed against other dividend income (not part of 1. above); Any further excess expenses are allowed against savings income; and The remaining excess management expenses are then allowed against other income.
The first £1,000 of the income of a discretionary trust that would otherwise be taxed at the trust rate and trust dividend rate is known as the “standard rate band”. This is also not taxed at special trust rates but at the dividend ordinary rate of 10% or the 20% basic rate. In identifying the first £1,000 of trust income, the non-savings income is considered first, then savings income, then dividend income.
Interest in possession trusts
In the case of an interest in possession (life rent) trust, trust management expenses do not reduce the trustees’ taxable income. They are however taken into account in arriving at the income of the income beneficiary, so the income remaining after tax and expenses is paid to the life tenant. In determining the amounts of each type of income payable to the beneficiary, the general administration expenses of the trust are set against dividend income first, then savings income and finally non-savings income.
The provisions of the trust deed of an interest in possession trust are taken into account in determining the distribution to the beneficiary, so that the beneficiary is taxable on the income entitlement under the trust deed.
The trustees of an interest in possession trust do not pay tax at the special trust rates but are liable to income tax at the 10% ordinary dividend rate and the 20% basic rate.
Mixed trust
Where beneficiaries have a discretionary interest in a part of the income of a trust while a beneficiary has an interest in possession in the rest of the trust income, the trust is referred to as a “mixed trust”. In this case, in computing the tax liability the trustees should make a “just and reasonable” apportionment of trust management expenses between income chargeable at the special trust rates and the income of the beneficiary who is entitled to income from part of the trust.
Trusts with a vulnerable beneficiary
A vulnerable beneficiary could be a disabled person or possibly a minor. A trust with a vulnerable beneficiary is subject to tax treatment that ensures that the tax payable by the trustees is the same as the tax that would be paid if the trust income and capital gains accrued directly to the beneficiary. The trustees must make a claim to HMRC for this special tax treatment to apply to the trust.
Trust tax return
With the above rules applying to trust management expenses, completion of the trust tax return is inevitably a complex task. HMRC provide guidance in the form of notes on filling in the tax return and have also produced Helpsheet 392 on the subject of identifying allowable trust management expenses. The most important issue is to correctly identify the type of trust, discretionary, interest in possession or mixed, and to know what types of trust management expense are allowable. This will determine the correct treatment of the trust management expenses on the trust tax return.
Sources:
HM Revenue and Customs www.hmrc.gov.uk
“Taxation” by Alan Melville, fifteenth edition 2010, FT Prentice Hall