How do changes to dividend tax apply to discretionary trusts?
25th July 2015
Simon Cole See profile
The tax rules on dividends are set to change in April 2016 and this will inevitably affect the investment strategy of trustees of discretionary and accumulation trusts.
Currently the position with these trusts is that they have a £1,000 standard rate tax band (which can be diluted if the settlor has created more than one trust) with dividend income above this being taxed at 37.5% on the grossed-up dividend. Grossed-up dividend income that falls within the trustees’ standard rate tax band will not suffer further taxation.
So, for example, if the trustees of a discretionary trust receive dividend income of £90, this will be grossed up to £100 for tax purposes. The trustees’ tax liability will be 37.5% of £100 which equals £37.50 less the tax credit of £10, leaving them with a liability of £27.50. Thus they will be left with net dividend income of £62.50.
Under the proposed new rules for individual investors that will apply from 6 April 2016:-
- the dividend tax credit will be abolished
- investors will pay tax based on the dividend they receive
- investors will have a £5,000 per annum tax free dividend allowance
- dividends over this amount will be taxed at:
7.5% for basic rate taxpayers
32.5% for higher rate taxpayers
38.1% for additional rate taxpayers
To the extent that the other income of a discretionary trust causes it to exceed its standard rate allowance, it would seem likely that the trustees will suffer tax on dividend income at 38.1%. We think it is unlikely that the £5,000 tax free dividend allowance will apply to the trustees of a discretionary trust (although at the moment we cannot be certain of this and it is notable that additional rate taxpayers will have the full £5,000 allowance).
This means that some discretionary trusts could be facing significantly higher income tax bills on dividends after 6 April 2016.
For example, the £90 dividend received by trustees after 5 April 2016, could suffer tax at 38.1% leaving only £55.71 available to them – a reduction of 11% in net return.
For trusts who wish to retain exposure to equity investment (as many do) there are four possible courses of action:-
- Distributing income out of the trust to a “low-tax” beneficiary with a view to recovering the high rates of income tax the trustees have already paid.
- Subject to the terms of the trust allowing them to do so, appointing a life interest to a low taxpaying beneficiary with a view to ensuring that trust income is taxed on that beneficiary – and without the trustees having to pay high up-front rates of income tax.
- Investing for capital growth with a view to, in future, using the trustees’ annual CGT exemption of £5,550. (This exemption will be diluted by the number of non-bare trusts created by the same settlor since 7 June 1978 but the exemption will never be less than £1,110 – 10% of the full individual annual exemption).
- An investment in a single premium life assurance investment bond can be tax efficient for trustees because:-
it is not subject to CGT in the hands of the investor;
it enables the trustees to draw 5% of the initial investment, for 20 years, with no tax charge at that time;
it permits switching within the bond wrapper without a tax charge at that time; and
assignment to a beneficiary (or an absolute appointment) will not give rise to a tax charge.
We await further detail and will issue further guidance as we know more. If you have any questions contact your usual Old Mill contact.