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KEY POINTS
- Change to settlor-interested trusts — TA 1988, s 686(2).
- Post-death variations are often settlor-interested trusts.
- Deemed income is not 'income of a person other than trustees'.
- Will both trustees and settlor pay tax on same income?
- Possible solution lies in mandating income to the settlor.
MAN NO 1: 'My wife tells me that if I don't give up golf she is going to leave me'.
Man No 2: 'Gosh that is terrible'.
Man No 1: 'Yes I know, I am going to miss her a lot'.
Whatever the first man's forthcoming tribulations may be, they are nothing compared to the hideous tangle which the legislation has now got itself into with settlor-interested trusts. A change is taking effect for the current fiscal year and the result is quite frankly ridiculous. Anybody affected will certainly miss the current reasonably sensible regime as much as Man No 1 says he will miss the current state of play at home.
Before you turn the page with a sigh of relief thinking that yours is just a straightforward accountancy practice and trusts don't feature much, let alone settlor-interested ones, allow me to say, fresh from a visit to the local pantomime a couple of weeks ago, oh yes they do, to which you will no doubt respond, oh no they don't. Then let me give you a classic example which is as common as garden gnomes and is to be found in nearly everybody's client list.
Post-death variation
Consider the case of Leslie and Lesley, who inconveniently married each other donkey's years ago and have caused endless confusion with their names ever since. Leslie died last year leaving everything to Lesley who was then advised that Leslie's will was not quite the best. He should have left his inheritance tax nil rate band on discretionary trusts which include his widow, but happily all was not lost, and this same result could be achieved with a deed of variation, which Lesley could now complete. Which is what she did.
Who then is the settlor of this trust for income tax purposes? Obviously it is Lesley, and not Leslie. This then is a settlor-interested discretionary trust, but I will bet anything you like that no-one to date has given a hoot about this. Lesley has been cheerfully putting all the trust income on her own tax return form, and like as not nobody even bothered to send in a notification of a new trust to any of HMRC's tax districts. The income would be taxed as that of the settlor, Lesley, so there should be no need for HMRC's trust tax offices to get excited about it all.
This is perhaps one of the most common examples of a settlor-interested trust. Eversden trusts are another; these had a short term interest in possession for the spouse followed by discretionary trusts which include the settlor. Non-domiciliaries also commonly set up discretionary trusts for their own benefit with non-resident trustees to secure various capital gains tax and inheritance tax advantages.
What has changed?
For some indescribable reason, TA 1988, s 686(2) was amended by last year's Finance Act to take out the exception from tax liability at the trust rates for settlor-interested trusts. The idea is that as they are no longer taken out of the section, they now pay tax on their income at the trust rates. Astute readers will soon exclaim 'ah, but wait. Subsection (2) still reads that the section only applies where income is (a) payable at the discretion of the trustees and (b) is not before being distributed the income of a person other than the trustees'. The income in Lesley's trust is hers for all tax purposes and so HMRC's change has fallen flat on its face.
Oh no it has not, say HMRC, the reference to income of a person other than the trustees means income belonging to that person in reality, and not deemed as such for tax purposes. Of course this interpretation makes no sense at all, because any such income would not be payable at the discretion of the trustees in the first place, so one would not even get past condition (a), let alone getting to think about condition (b). Anyway, we must move on because HMRC are clearly expecting the trustees to pay the tax, but you begin to see why my trip to the pantomime was quite a suitable thing to do before writing this article.
The ramifications
The local pantomime was, however, a pillar of pure, straightforward common sense compared to the nuttiness which this change to s 686 produces. Now, everyone involved is liable for tax on the trust income. The trustees have to pay tax at the rate applicable to trusts insofar as the income exceeds the starting rate band of £1,000. Lesley is also liable for tax at her top rate, possibly 40%, on the same income and quite likely on the same day, 31 January following the year end.
So that sounds like two lots of tax will be payable on the same income. Oh no it won't, say HMRC, because the charge to tax on the trustees is in their capacity as the persons actually receiving the income and that tax is allowed as a credit against the liability of the real taxpayer. Oh yes it will, say the rest of us, because in reality people's finances do not always run like a well oiled machine. The settlor might send in his tax return in May and the trustees might not get around to it until the following January. In his return, the settlor cannot claim credit for anything because nothing yet has been paid, despite assurances by the trustees that they will get around to it in time. So then we will quite easily end up with both the trustees and the settlor paying tax on the trust income. The settlor will then exercise the right of recovery from the trustees, so the trustees have paid it twice. Then HMRC will allow the settlor credit for the tax paid by the trustees and will repay the tax to him. The end result is that the trustees have paid twice and the settlor is a very happy person indeed with lots of money to spend. Now you begin to see why the pantomime looked now to be so completely sensible. And I have not even factored in the impact of the trustees' starting rate band, which will mean that the settlor cannot simply assume that full tax at the rate applicable to trusts will be paid on all the income.
A nightmare scenario
But it can get worse! If the trustees carry on as they have in the past, not realising that they now have to return the trust income and pay the top rate of tax on it, and the settlor inadvertently fails to pay tax on the income by 28 February after the year end, there seems to be no reason why the trustees would not be liable to a 5% surcharge as well as the settlor. Once the trustees pay, the settlor will get a credit, but it is still not a credit for tax paid before 28 February. Perhaps HMRC will allow credit retrospectively? I would not like to guarantee it in today's aggressive tax environment.
How did we get here?
All this, say HMRC, is just a development of the longstanding principle that income within the former Schedules A and D was and still is assessable on the person 'receiving or entitled to' the income. Provisions to this effect are now scattered throughout ITTOIA, and ITTOIA 2005, s 646(8) says that the charge on the settlor does not exclude a charge also on the trustees as persons by whom income is received.
However, it seems to me that this age-old principle is being pushed further than it was ever intended to go. As was made clear in Aplin v White 49 TC 93, we should be looking at alternative assessments here, either on the person receiving the income or else the person entitled to it and not double assessment on both of them, with the whole sorry mess being sorted out some other way. This is also clear from other cases on the same point, for example the House of Lords in Brown v CIR 42 TC 42: 'Tax is accordingly recoverable either from [the appellant] as recipient of that interest or from the client who was entitled to it'. In both cases, the proprietors of professional firms paid basic rate tax on client account deposit interest and there was no suggestion of the Revenue also pursuing the clients for the same tax as well.
A way out?
Perhaps, however, this offers us a clue as to how to escape from all this nonsense for the current year onwards. ITTOIA 2005, s 624 treats the income concerned as that of the settlor for all tax purposes, and the only way in for the charge on the trustees under TA 1988, s 686 is via s 646(8), which allows a charge on them as persons receiving the income. The section says nothing about a charge on the trustees as persons entitled to the income (and anyway perhaps they are not entitled for tax purposes as it is treated as the settlor's). Suppose then that the income is mandated to the settlor, or for that matter some other suitable beneficiary. The trustees are then not in receipt of it and the receipts basis charge on them can no longer apply. The Revenue's Tax Bulletin 84 contained an article about the change to settlor-interested trusts, but it does not in its terms countenance any circumstances in which the newly extended s 686 charge on the trustees will not apply. All the same, it does seem to follow that if the trustees do not collect the income, they cannot be liable.
What is the point?
It would be nice to know what the underlying policy is here. Is the charge on the settlor an anti-avoidance provision (as it no doubt was once), a relief (as it now seems to be), or just an irritating complication designed to catch people out and get some penalties off them?
Malcolm Gunn is a consultant with Squire Sanders & Dempsey and can be contacted at mgunn@ssd.com.
