Income tax and settlor-interested trusts

One might expect that a trust where the individual creating it (the settlor) is also one of the beneficiaries is not likely to be very common under the current tax regime. In fact many such trusts are in existence, either because they were set up when the tax regime was more favourable to trusts or because they serve a particular tax purpose. A classic example of a settlor-interested trust is one made under a deed of variation of a will, by which a legatee under a will redirects his or her entitlement into a discretionary trust, with the legatee being one of the potential beneficiaries under the trust. Please see the news desk item 'Deeds of variation - traps and opportunities' (April 2009) for details of the inheritance tax advantages.

One of the problems with settlor-interested trusts is that the income tax position has become excessively complex, such that even local HMRC offices seem to struggle to understand it. Most of the complexity has arisen following the Finance Act 2006 which contained provisions designed to cause the income of the trust to be fully taxable in the hands of the trustees to tax at the trust rate. It will be appreciated that in the current tax year, this results in 50% tax being applicable to virtually all non-dividend income within the trust and 42.5% applying to the dividend income, less the dividend tax credit. Given that many of the trusts have not been set up by wealthy people, this is clearly an excessive burden of tax.

Because of the settlor's retained interest in the trust, the income is also treated for tax purposes as that 'of the settlor and of the settlor alone'. The apparent contradiction in terms here - the income being that of the trustees and of the settlor alone - is dealt with by HMRC allowing the settlor to claim credit for the tax which the trustees pay on the income. In most cases, this means that the settlor then recovers some or all of the tax which the trustees paid. It is not clear what the purpose of this bureaucratic exercise is, and to complete the circle, it was announced in the June 2010 Budget that a requirement would be introduced for the settlor to pay over any tax recovery of this type to the trustees.

This is the theory of how the income tax regime is designed to work, but in practice when the settlor has entered the trust income on his or her personal tax return and shown credit for tax paid at the trust rate, this causes the tax office either to request submission of Form R185E (certificate by trustees of trust income) or else an inquiry is opened into the return because the tax office considers that an incorrect rate of tax has been shown on the return. Advisers may therefore have found that the complexities of this regime have caused a lot of unnecessary correspondence. In particular, HMRC's official guidance states specifically that Form R185 should not be supplied in relation to income taxable on the settlor. Instead, the trustees should simply notify the settlor of the relevant amounts - but of course that was not acceptable evidence to the settlor's tax district.

HMRC has finally taken some action in order to resolve these problems by publishing a new certificate, R185 (settlor), which is to be used in these cases. Whether local tax offices will understand this form any better than they understood similar information previously provided by correspondence, remains to be seen.

For those interested in the technicalities of the legislation, it appears to be a common view at the London Tax Bar that there is in any event no charge on the income to tax at the trust rate. This is because the trust income is treated for tax purposes as that of the settlor alone; how then can it be taxed on the trustees? The legislation does preserve a charge on the trustees 'as persons by whom the income is received' but that may be sufficient only to give rise to liability at the basic rate, and not tax at the trust rate, which is in any event not charged on income which is 'the income of another person other than the trustee before being distributed'. The trust income is in fact treated for tax purposes as the income of another person, i.e. the settlor, so the trust rate should not apply. Needless to say, HMRC reject these arguments and their view is that only income which is in reality that of the settlor before it is distributed (rather than treated as that of the settlor) is taken out of the charge at the trust rate. If one responds to the effect that the courts have held that 'one must treat as real the consequences and incidents inevitably flowing from or accompanying' any deemed state of affairs' (as was stated in Marshall v Kerr [1993] STC 360) HMRC will not agree the point.

Equally, where the trust income is habitually paid direct to the settlor as principal beneficiary, one may argue that there cannot be a charge on the trustees at the trust rate because that charge is preserved on trustees only 'as persons by whom income is received'. This would seem to be a clear reference to the receipts basis of taxation which is of some antiquity and enables a person to be charged to tax on income belonging to another where he or she has receipt of it. In reply to this, HMRC state that they regard the trust income as being received by the settlor as agent for the trustees and then retained as beneficiary. One may reply that there is no justification for this convoluted theory.

In a recent case the trustees' intention was to appeal these points to the First Tier Tax Tribunal, but HMRC have withdrawn their arguments in that case on a without prejudice basis, whilst maintaining that they will continue to apply them in other cases.

For the future, those who wish to avoid all these complications should consider appointing the income on interest in possession trusts, whether revocable or irrevocable, in favour of the settlor, or some other suitable beneficiary.

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