Dividend Changes to Trustees
On the surface, the new dividend tax rules may appear to be bad news for trustees – there’s no £5k dividend allowance for them and trust dividend tax rates have increased. But scratch a little deeper and the impact on the levels of income received by beneficiaries may not be as bad as first feared. And with careful planning it is possible to reduce the tax impact on the income some beneficiaries receive.
However, those trusts where dividend income is accumulated have been hit the hardest, with dividend yielding investments proving less attractive than in previous years.
A reminder of what has changed
The actual amount of dividend distributed to shareholders remains the same, but they are now received gross, and are no longer be accompanied by a notional 10% tax credit. Instead, individuals will receive an annual £5k tax free dividend allowance. Everyone will get this, whatever their income levels. Dividends in excess of this allowance will be taxed depending on which tax band the excess falls:
- Basic rate – 7.5%
- Higher rate – 32.5%
- Additional rate – 38.1%
But the new £5,000 dividend allowance is only available where the dividends are assessable upon an individual and not where the trustees are responsible for any tax.
What does it mean for trusts?
Trustees will not receive the £5k dividend allowance and the rate of tax payable depends upon the type of trust. But it isn’t always the trustees who are taxable. For trusts such as bare trusts and interest in possession trusts it is possible to look through the trust and tax the beneficiary on income received. This allows the beneficiary’s own dividend allowance to be used.
Here is a quick look at the different trust types and the implication of the new dividend rules.
The beneficiary will normally be taxed on dividends in excess of the first £5k at their own tax rates, that is, in the same way as an individual. If the gift into the trust came from a parent, then the parental settlement rules will apply. Dividends will be taxed on the parent if income exceeds £100 a year, but that parent will be able to use their own £5k dividend allowance.
Interest in Possession Trusts
Where dividends are received by the trustees they must deduct tax at the dividend basic rate before paying the balance of the income to the beneficiary. A tax credit is given to the beneficiary which they can reclaim if they have unused dividend allowance to cover it.
Alternatively, the trustees can simply mandate the gross dividend to the beneficiary. The trustees don’t receive the dividends as they are paid directly to the beneficiary. Tax is then assessed upon the beneficiary as if they own the shares directly, and they will not pay any tax provided they stay within their dividend allowance. This would avoid the extra administration of trustees having to collect tax, and the beneficiary having to make reclaims. The potential downside is that the trustees will not be able to deduct any trust management expenses from the mandated income.
Discretionary trusts do not get the dividend allowance nor can it be looked through to make use of the beneficiary’s own allowance.
The first £1k of income in a year will still be taxed at the standard rate, which is 7.5% for dividends. This standard rate band will be shared if the settlor has created more than one trust but each trust will have a minimum of £200.
All other income will be taxed at the trust rate. For dividends this will be 38.1% of the gross amount received. The trustees of a discretionary trust must decide whether to distribute income as it arises or whether to accumulate it and add it to the capital of the trust.
Paying out income as it arises
Where the strategy of the trustees is to distribute income, beneficiaries will receive the same amount this year as they did last. This may seem odd at first glance as the trust rate last year was only 37.5%.
This is because trustees still have to account for income tax at 45% on any income distributed.
For example, say the trustees receive a dividend of £1k and they choose to pay this out to beneficiaries. After paying £450* to HMRC, they pay the other £550 to a beneficiary with a tax credit of £450. And this will be the case for both 2015/16 and 2016/17. So although the mechanism for taxing dividends has changed, the net result is the same. A beneficiary may be able to reclaim some or all of this tax credit depending on the rate of income tax they pay.
However, because it is regarded as ‘trust’ income and not dividend income they can’t use their £5k dividend allowance. So the allowance could be wasted unless they receive dividends from other sources.
*assumes no tax pool available
One possible solution trustees could consider is that, instead of making discretionary distributions of income, they could create an interest in possession (IIP) for a beneficiary and mandate the dividend to them. The beneficiary could then use their allowance and not pay any tax on the first £5k of dividends received. The IIP does not need to be permanent, but legal advice must be sought if the trustees wish to take this route.
Creating an IIP will not make any difference to non-taxpaying beneficiaries. But on a gross dividend of £1k, a basic rate taxpayer would be £200 better off if they could use their dividend allowance with the tax savings rising to £400 and £450 for higher and additional rate beneficiaries.
Clearly, adopting this strategy (if appropriate to the overall aims of trust) means that beneficiaries will be no worse off if an IIP is created, and in most cases better off. And of course an IIP can be given to more than one beneficiary. Each IIP beneficiary could use their own dividend allowance against their share of the mandated dividend income. This could be a useful strategy for trusts receiving large amounts of dividend income they wish to distribute as it means there may be multiple dividend allowances to set against the trust income.
But it is important to ensure that the trust’s overall objectives continue to be met before any changes are made to the terms of the trust. Any attempts to reduce tax shouldn’t compromise the trust’s aims.
Trustees accumulate income
If the trustees plan to accumulate income, the dividend tax changes could mean that there is more tax to pay which will have a knock on effect on total returns compared to last year.
In 2015/16, trustees paid an extra 27.5% on the cash dividend received (or 37.5% on the cash dividend plus the 10% notional credit).
This year they will pay 38.1% on the same cash dividend received. So for every £1k of cash dividend received, last year £725 could be accumulated. This year, it drops to £619.
This will clearly impact the investment returns for trustees on dividend yielding investments such as equity mutual funds.
One solution might be to hold the investments within an offshore bond wrapper. Dividends and gains could then roll up tax free, and the administration burden on trustees could be significantly reduced. Investments can be switched/ rebalanced within the wrapper without the need to complete tax returns.
At the point of distributing capital, this could be achieved by the assignment of segments to a beneficiary so that when they are cashed-in, any gains would be assessed on the individual. This is especially appealing if the beneficiary is likely to be able to take gains while they are a non-taxpayer, for example to pay university fees, as investment returns would have suffered none of the ‘tax drag’ had they held direct equities.
Trustees have a duty of care to keep the investments they hold under regular review. The changes to dividend taxation provide further reason to ensure that the current investments continue to meet both the aims of the trust and that tax is not being paid unnecessarily.
Source: Standard Life