Tolley® Exam Training TRUSTS AND ESTATES CHAPTER 3

CHAPTER 3

INCOME TAX ON DISCRETIONARY TRUSTS

In this chapter you will cover the income tax rules for discretionary trusts including:
– the tax rates paid by discretionary Trustees
– the “basic rate” band for trusts
– how the Trustees get relief for expenses
– the tax position of the beneficiary
– the operation of the “tax pool”
– interest restrictions on property income

3.1 The Rates Applicable to Trusts

Because a discretionary trust is such a flexible vehicle, the rates of tax which apply
to income received by discretionary Trustees are higher than those which apply to
interest in possession Trustees. ITA 2007, s.479

Trustees of a discretionary trust pay income tax at “the rates applicable to trusts”
(RAT) on “accumulated or discretionary income”. There are two rates which are
applicable to discretionary trusts.

Non-savings income is charged to income tax at a flat rate of 45%. Interest is also
charged at 45%. Dividends are charged at 38.1%. ITA 2007, s.479(3)(4)

The Trustees are not entitled to the Personal Savings Allowance or the Dividend
Allowance so the full amount of any interest or dividends is chargeable to tax.

Accumulated or discretionary income” is income which: ITA 2007, s.480

a. Must be accumulated; or

b. Is payable at the discretion of the Trustees.

This means that the rates applicable to trusts – 45% or 38.1% – only apply to income
which the Trustees are able (if they wish) to keep within the trust. This tells us two
things:

1. If any income is subject to an interest in possession – i.e. if the beneficiary is

entitled to income from part of the trust fund – the rates applicable to trusts do
not apply to that income.

Any income which is subject to an interest in possession is charged at 20% or

7.5% depending on the source of income.

2. To arrive at income which is chargeable at the rate applicable to trusts, some

relief is available for trust management expenses. Remember that the rates
applicable to trusts only apply to income which is available for distribution. If
the Trustees have received some income and that income has been used to
meet expenses of the trust, such income is not available for distribution and is
therefore not chargeable at 45% or 38.1%.

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Therefore when putting together an income tax computation for a

discretionary trust, we can take a tax deduction for trust management
expenses.

3.2 The “Standard Rate” Band

The rates applicable to trusts (45% & 38.1%) do not apply to the first £1,000 of
income. Instead such income is taxed at the basic rate or the dividend ordinary
rate. ITA 2007, s.491

The “standard rate” band applies to non-savings income in priority to interest in

priority to dividends.

For example:

Non-savings income: First £1,000 @ 20%. If some of the standard rate band still
unused then…
Interest: Within the standard rate band, interest taxed @ 20%. If
some of the standard rate band still unused then…
Dividends: Within standard rate band, dividends taxed @ 7.5%

If the settlor has made more than one current settlement, the £1,000 band is
divided between them, subject to a minimum band of £200 for each trust. A
“current settlement” is one which is in existence at some time in the tax year. Trusts
which were wound up before the start of the tax year are therefore ignored.
ITA 2007, s.492

 Illustration 1

A discretionary trust has the following income in 2018/19:

£
Rental profits 800
Bank interest 600
UK dividends 2,000

Calculate the tax payable for 2018/19.

Non-savings Interest Dividends

£ £ £
Rental profits 800
Bank interest 600
Dividends ___ ___ 2,000
Total trust income 800 600 2,000

Tax
“Standard rate”:
800 @ 20% 160
200 @ 20% 40
1,000
Rates applicable to trusts (RAT):
400 @ 45% 180
2,000 @ 38.1% 762
Tax payable by Trustees 1,142

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3.3 Trust Expenses

To arrive at the income that is chargeable at the rate applicable to trusts we

deduct trust management expenses from gross trust income. ITA 2007, s.484

Only expenses which are properly deductible against the income of the trust may
be relieved. This means that any expenses which should be charged against the
capital of the trust – for example legal fees associated with capital items or other
professional fees regarding trust investments etc – cannot be deducted for income
tax purposes.

As Trustees will have several sources of income, it is important to identify an order

of priority for the set-off of trust management expenses. As is the case for interest in
possession trusts, trust management expenses are set against dividend income in
priority to other income. ITA 2007, s.486

If there are insufficient dividends to meet the trust management expenses, the
expenses are next set against any interest and finally the expenses are set against
non-savings income.

When taking a deduction for trust expenses, we must gross up the expenses at the
appropriate rate. For example, if expenses are being deducted from dividend
income, the expenses must be grossed up at 100/92.5. The dividend income is still
subject to 7.5% tax. Consequently, if a trust expense of, say, £925 has been
incurred, the Trustees must have earned a dividend of £1,000 to meet that
expense.

 Illustration 2

A discretionary trust has income and expenses in 2018/19 as below:

£
Rental profits 30,000
Bank interest 20,000
UK dividends 10,000

Trust expenses (1,850)

Calculate the income tax payable by the trustees for 2018/19.

The income tax computation is as below:

Non savings Interest Dividends

£ £ £
Rental profits 30,000
Bank interest 20,000
Dividends _____ _____ 10,000
Total trust income 30,000 20,000 10,000
Less: Expenses (1,850 x 100/92.5) _____ _____ (2,000)
Income after expenses 30,000 20,000 8,000

Expenses are met from dividend income, and accordingly must be grossed up at
100/92.5.

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The tax payable by the Trustees is as below:

Tax
“Standard rate”:
1,000 @ 20% 200
Rates applicable to trusts (RAT):
(30,000 – 1,000) @ 45% 13,050
20,000 @ 45% 9,000
8,000 @ 38.1% 3,048
2,000 @ 7.5% 150
Tax payable by Trustees 25,448

£2,000 of dividends were used by the Trustees to meet trust management

expenses. This £2,000 of income cannot be accumulated and is not available for
distribution to a beneficiary, so it is not charged at the rates applicable to trusts.

Income earned by the Trustees which has been used to pay expenses is
chargeable to tax but only at the ordinary or basic rates as appropriate. Therefore
the £2,000 of dividend income used to pay the expenses will be charged at the
dividend ordinary rate of 7.5%.

An income tax computation for a discretionary trust differs from an income tax
computation for an interest in possession trust in three main ways:

1. Discretionary trusts can receive some relief for trust management expenses.
These expenses are deducted from dividend income in priority to other
income.

2. Discretionary Trustees will pay tax at the basic rate or the dividend ordinary
rate on the first £1,000 of income then at 45% or 38.1%.

3. When putting together a tax computation for a discretionary trust, the income
which has been used to pay the trust expenses is taxable, but only at the basic
rate or the dividend ordinary rate.

3.4 Tax Position of Beneficiaries

Beneficiaries of a discretionary trust have no entitlement to income, and only

receive income at the discretion of the Trustees. ITA 2007, s.493

Any income distributed to a beneficiary is deemed to have been paid net of a 45%
tax credit. This 45% rate applies irrespective of the income actually received by the
Trustees.

For example, if the Trustees' only source of income is UK dividends on which tax is
paid at 38.1%, then if that income is subsequently distributed to a beneficiary, it will
always carry a 45% tax credit. ITA 2007, s.494

If a discretionary trust makes a distribution to a beneficiary, the distribution, and

the tax deducted therefrom, is certified on Form R185. ITA 2007, s.495

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 Illustration 3

Assume that a discretionary trust distributes £5,500 to a beneficiary. The beneficiary

has received a net amount of £5,500. If we gross this up by 100/55, the beneficiary
is deemed to have received gross income from which 45% tax has been deducted
at source.

This will be certified as “trust income” on the form R185.

R185 Net Tax

£ £
Trust income 5,500 4,500

Unlike interest in possession trusts, there is no “transparency principle” for

discretionary trusts.

When a beneficiary receives a distribution of income from a discretionary trust, it is

certified as “trust income” on the Form R185 and is taxed as non-savings income in
the hands of the recipient. The beneficiary will enter a net sum of £5,500 on their
self-assessment return, and this is classed as non-savings income. The beneficiary
will not be able to use their Personal Savings Allowance or Dividend Allowance in
respect of discretionary income distributions.

If the beneficiary pays tax at the 45% rate, no extra tax will be due on the gross
trust income. If the taxpayer pays tax at the basic rate or at 40%, a tax repayment
will be due. The beneficiary may need to send the Form R185 to HMRC in support
of his repayment claim.

3.5 The “Tax Pool”

As beneficiaries in receipt of income distributions can always claim a tax credit of

45%, HMRC must have a method of making sure that any tax reclaimed by
beneficiaries does not exceed the tax originally paid by the Trustees. HMRC do this
by asking the Trustees to maintain a “tax pool”. ITA 2007, s.497

The “tax pool” is a running total of tax paid by the Trustees less any tax credits
which have been taken out of the pool by the beneficiaries. A record of the tax
pool is maintained and sent to HMRC along with the Trustees' tax return.

Every year tax will enter the pool. However when the Trustees pay income tax not
all tax paid by Trustees will be allowed as a “credit” to the tax pool. The credits to
the tax pool are as follows: ITA 2007, s.478

Standard rate band: Any tax paid at 20% and 7.5%

Non-savings income: Any tax paid at 45%
Interest: Any tax paid at 45%
Dividends: Dividends (after expenses) @ 38.1%

Tax on income used to pay expenses does not enter the pool (even if such income
is taxed at 20%).

Certain receipts of a capital nature are charged to income tax. These include
lease premiums, accrued income profits and chargeable event gains on certain
life assurance policies. The tax on these receipts which enters the tax pool is
restricted to 25% of the chargeable income (being the 45% trust rate less
disallowable basic rate tax). ITA 2007, s.498

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Whenever tax credits on distributions are claimed by beneficiaries, the balance in

the pool will go down. The tax claimed by beneficiaries is the total of the tax
columns on the form R185. For example, if a beneficiary receives a distribution of
£5,500, this is net of £4,500 of tax, and this credit of £4,500 will therefore leave the
pool.

Proforma Tax Pool

£
Balance b/fwd at 6 April X
Add: Tax paid by Trustees
Standard rate band @ 20%/7.5% X
Non-savings income @ 45% X
Interest income @ 45% X
Dividends after expenses @ 38.1% X
X
Less: Tax credits claimed by beneficiaries
Net distributions × 45/55 (X)
Balance c/fwd at 5 April X

If at the end of the year, the tax pool is in credit, this credit will be carried forward
as a positive balance at the start of the next tax year.

 Illustration 4

A discretionary trust has the following income and expenses in 2018/19:

£
Rental profits 5,000
Bank interest 6,000
UK dividends 20,000
Trust management expenses (555)

The tax pool at 6 April 2018 is £1,000. In 2018/19, the Trustees made an income
distribution of £11,000 to a beneficiary.

Calculate the tax payable by the Trustees for 2018/19 and show the tax pool.

First calculate the tax payable by the Trustees:

Non-savings Interest Dividends

£ £ £
Rental profits 5,000
Bank interest 6,000
Dividends ____ ____ 20,000
Gross trust income 5,000 6,000 20,000
Less: Expenses (555 x 100/92.5) ____ ____ (600)
Income after expenses 5,000 6,000 19,400

Tax
“Standard rate”:
1,000 @ 20% 200
Rates applicable to trusts (RAT):
(5,000 – 1,000) @ 45% 1,800
6,000 @ 45% 2,700
19,400 @ 38.1% 7,391
600 @ 7.5% 45
Tax payable by Trustees 12,136

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Next we put together the tax pool:

Tax pool £
Balance b/fwd at 6 April 2018 1,000
Add: Tax paid by Trustees
1,000 @ 20% 200
4,000 @ 45% 1,800
6,000 @ 45% 2,700
Dividends after expenses @ 38.1%
19,400 @ 38.1% 7,391
13,091
Less: Tax credits claimed by beneficiaries
(11,000 × 45/55) (9,000)
Balance c/fwd at 5 April 2019 4,091

The beneficiary receives net income of £11,000 with a 45% tax credit. This will be
certified as “trust income” on the form R185.

R185 Net Tax

£ £
Trust income 11,000 9,000

3.6 Shortfalls in the Tax Pool

Problems arise when the tax pool goes into deficit. Essentially, if a pool goes into
deficit, this means that the tax paid by the Trustees is less than tax that has been
claimed by the beneficiaries.

 Illustration 5

Assume in the above illustration, that the income distribution to the beneficiary in
2018/19 was £16,500 (instead of £11,000). All other information is as before.

The beneficiary receives net income of £16,500 with a 45% tax credit. This will be
certified as “trust income” on the form R185.

R185 Net Tax

£ £
Trust income 16,500 13,500

Show the changes to the tax pool and calculate the income tax payable by the
Trustees for 2018/19.

This changes the tax pool as follows:

Tax pool £
Balance b/fwd at 6 April 2018 1,000
Add: Tax paid by Trustees
1,000 @ 20% 200
4,000 @ 45% 1,800
6,000 @ 45% 2,700
19,400 @ 38.1% 7,391
13,091
Less: Tax credits claimed by beneficiaries
(16,500 × 45/55) (13,500)
Balance (409)

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Where a tax pool becomes negative, the Trustees must make up the difference,
and they will pay this tax under self-assessment. It will affect the payments on
account to be made for the following tax year. ITA 2007, s.496

The Trustees' tax payable for 2018/19 will now be:

£
Tax due as before 12,136
Add: s.496 liability 409
Revised tax payable 12,545

Therefore, as at 6 April 2019, the balance in the tax pool will be zero. Note that only
positive balances are carried forward. There is no negative balance to carry
forward as this tax will have been discharged by the Trustees.

A shortfall will typically happen when some of the trust income received is from
dividends. Dividends are taxed at the dividend trust rate of 38.1% and this tax
enters the pool. However income distributions always carry a 45% tax credit, so
Trustees with an asset base consisting mainly of shares need to be careful when
deciding how much income to pay out.

There is a “tax pool calculator” on the HMRC website which enables Trustees to
enter their estimated income and expenses for the year and the balance in the
tax pool. The tax pool calculator will then calculate the maximum amounts the
Trustees could distribute to beneficiaries in the tax year without creating a shortfall.

3.7 Tax Pools on Winding-Up the Trust

Trusts are wound up when the Trustees make a decision to distribute all remaining
funds to the beneficiaries. They will either do this:

1. Under the terms of the trust deed - for example if the deed gives beneficiaries
entitlement to capital at a specified age; or

2. At their discretion – for example if the Trustees decide that the beneficiaries
are sufficiently mature to accept the Trust assets or that the trust has fully
served its purpose.

The tax pool will therefore close when the trust is wound up. Any credits within the
pool at that point will not be repaid by HMRC and will then be lost. It is therefore
common planning for Trustees to make sufficient income distributions just before
the trust is finally wound up in order to enable the beneficiaries to take advantage
of the 45% tax credit (which often leads to tax repayments).

3.8 Property Income – Interest Restrictions

Trustees pay income tax on their annual net property income. Net property
income means income less allowable expenses.

The rules for deducting letting expenses against rental receipts are broadly the
same as those which apply for individuals. This means that Trustees who have
taken out a mortgage to acquire a residential property and who subsequently
pay interest on the loan will be affected by the interest restrictions brought in from
2017/18.

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Interest costs incurred by Trustees will be disallowed when computing the taxable
profits of the property business. ITTOIA 2005, s.272A

The restriction is being phased in as below:

% of finance costs % of finance costs given

allowable as an as an income tax
expense reduction

2017/18 75% 25%

2018/19 50% 50%
2019/20 25% 75%
2020/21 onwards Nil 100%

Discretionary trusts then receive tax relief for the disallowed interest as a tax
reducer in the income tax computation.

The tax reducer is the “relievable amount” multiplied by 20%.

The “relievable amount” is generally the lower of:

• The interest costs disallowed as an expense; and

• The taxable profits for the property business for the year (net of any allowable
losses brought forward).

ITTOIA 2005, s.274B

 Illustration 6

A discretionary trust has income and expenses for 2018/19 as follows:

£
Income:
Rental income on a residential investment property 10,000
Bank interest 1,500
Dividends 9,000

Expenses:
Letting expenses 4,000
General management expenses 925

The letting expenses include £1,000 of interest on a loan taken out to partially fund
the acquisition of the investment property.

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The income tax payable by the Trustees in 2018/19 is as follows:

£ £
Rental income 10,000
Less: Letting expenses (4,000)
6,000
Add: Disallowed interest (£1,000 x 50%) 500
Net property income 6,500
Bank interest 1,500
Dividends 9,000
17,000
Less: Trust expenses met from dividends (1,000)
(925 x 100/92.5)
Liable at rates applicable to trust 16,000

Tax:
£1,000 @ 20% 200
£5,500 @ 45% 2,475
£1,500 @ 45% 675
£(9,000 – 1,000) @ 38.1% 3,048
£1,000 @ 7.5% 75
6,473
Less: Tax reduction for disallowed interest (100)
(£500 @ 20%)
Income tax payable 6,373

Note:

The relievable amount is £500 as this is lower than the net property income for the
year.

Credits to the tax pool are 45% of the amount of taxable property income (being
45% of the property business profits after the disallowance of interest). There is no
further adjustment to remove the 20% tax reducer from the tax pool.

In the above illustration, the tax pool for 2018/19 would be as follows:

£
Rental income on a residential investment property 500
Add:
Tax paid at basic rate 200
Tax paid at trust rate £(2,475 + 675) 3,150
Tax paid at dividend trust rate 3,048
Pool balance (available to frank income distributions to 6,898
beneficiaries)

Beneficiaries are unaffected and income distributions (even when made directly
from property business profits) will continue to be treated as “trust income” and will
carry a 45% tax credit.

3.9 Property Income Interest Restrictions – IIP Trusts

If an IIP trust has a UK property business, the property business profits for the tax
year are calculated as for a discretionary trust. Any interest costs are subject to the
phased-in restriction as outlined above. The resulting profit is then taxed in the
hands of the IIP Trustees at the basic rate (20%).

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The IIP Trustees are not entitled to a 20% tax reducer on the disallowed interest as
such relief only applies to “accumulated or discretionary income”.

Instead the tax reducer is given to the life tenant via his own income tax
computation.

As well as giving the life tenant a form R185 which certifies income which has been
taxed in their hands, the Trustees will also notify the life tenant of the amount of
interest which has been disallowed. The beneficiary will then claim a tax reduction
for this disallowed interest under the normal rules for individuals.

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EXAMPLES

 Example 1

The Alpha discretionary trust has the following income and expenses in 2018/19:

£
Rental profits 24,000
Gilt interest 6,000
UK dividends 5,000
Trust expenses (185)

Calculate the tax due under self-assessment for 2018/19.

 Example 2

The Beta discretionary trust has the following income and expenses in 2018/19:

£
UK dividends 80,000
Trust expenses (9,250)

The tax pool at 6 April 2018 was £2,000. The Trustees made an income distribution
of £35,200 to a beneficiary in 2018/19.

Show the tax pool for 2018/19.

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ANSWERS

 Answer 1

Non savings Interest Dividends

£ £ £
Rental profits 24,000
Gilt interest 6,000
Dividends 5,000
Less: Expenses (185 x 100/92.5) _____ ____ (200)
Income after expenses 24,000 6,000 4,800

Tax
“Standard rate”:
1,000 @ 20% 200
Rates applicable to trusts (RAT):
(24,000 – 1,000) @ 45% 10,350
6,000 @ 45% 2,700
4,800 @ 38.1% 1,829
200 @ 7.5% 15
Tax payable by Trustees 15,094

 Answer 2

£ £
Tax pool @ 6.4.18 2,000
Add:
Taxable dividends above standard rate band @ 38.1%
Dividends 80,000
Less: Expenses (9,250 @ 100/92.5) (10,000)
Taxable dividends 70,000
Charged at 7.5% (1,000)
Chargeable at dividend trust rate 69,000

@ 38.1% 26,289
Tax @ 7.5% (1,000 @ 7.5%) 75
28,364
Less: Credits claimed (35,200 × 45/55) (28,800)
Trustees liability (436)

Balance at 6.4.19 Nil

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INCOME TAX ON DISCRETIONARY TRUSTS

TRUST RATES

Discretionary trustees pay income tax at the following flat rates, known as the rates
applicable to trusts (RAT):
(ITA 2007, s.479)

Non-savings income 45%

Interest income 45%
Dividend income 38.1%

The first £1,000 of trust income in the tax year is charged at the basic or dividend ordinary
rates. The £1,000 “standard rate” band is allocated to non-savings income in priority to
interest then dividends.
(ITA 2007, s.491)

RELIEF FOR EXPENSES

Some relief is given in respect of trust expenses, in that any income used for expenses is
taxed at the IIP rates of 7.5%/20%, again deeming expenses to have come from dividend
income in priority to interest and non-savings income.
(ITA 2007, s.484)

DISTRIBUTIONS

A beneficiary who has received a distribution is deemed to have received income net of
a 45% tax credit. The grossed-up distribution is treated as non-savings income regardless of
the type of income actually received by the trust.
(ITA 2007, s.494)

To ensure that the Trustees have actually paid sufficient tax for the beneficiary to be
entitled to a 45% tax credit, a running total of tax paid and tax credits on distributions to
beneficiaries, known as the tax pool is maintained.
(ITA 2007, s.497)

All tax paid on non-savings income and interest at both “basic rate” and at 45% and tax
on dividends (after expenses) at both the dividend ordinary rate and at 38.1% can enter
the pool.

Having deducted tax credits claimed by beneficiaries, if the tax pool is in credit the
balance is carried forward to the following year. If there is a negative balance on the tax
pool, this represents a further liability for the Trustees and a nil balance is carried forward.
(ITA 2007, s.496)

Trusts are subject to interest restrictions on loans taken out to acquire residential rental
properties. Some of the interest (50% in 2018/19) will be disallowed in calculating the rental
profits.
(ITTOIA 2005, s.272A)

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Discretionary trusts will receive relief for the disallowed interest as a 20% tax reducer in the
income tax computation. IIP trusts cannot claim the 20% tax reducer (this will instead be
claimed by the life tenant).
(ITTOIA 2005, s.274B)

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