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Replies to Queries -- 2 - Settlement complications

06 June 2001
Issue: 3810 / Categories:

Our client set up a settlement (accumulation and maintenance) for the benefit of his children in 1991, to hold shares in a private company. The shares were held by the trustees until they were sold in 1998. Tax returns have been completed declaring the gain on the shares and income subsequently arising on the proceeds of the shares.

Our client set up a settlement (accumulation and maintenance) for the benefit of his children in 1991, to hold shares in a private company. The shares were held by the trustees until they were sold in 1998. Tax returns have been completed declaring the gain on the shares and income subsequently arising on the proceeds of the shares.

The trustees have the power to bring the settlement to an end and appoint the income and capital to the minor children, which is what they would like to do. The funds would be held on bare trusts until the children reach the age of 18.

(1) Currently the settlement has paid capital gains tax of 34 per cent on the gain. However, from the proceeds arising on the sale of the shares the settlor was lent £10,000. This was repaid in 1999/2000. Is there any tax charge on the settlor in connection with this interest-free loan (we realise it was in breach of trust) or does it affect the capital gains tax position on the sale of the shares by imposing a charge on the settlor?

(2) If income was distributed from the settlement, are we correct in concluding that this income would be added to the settlor's income for the year and tax charged accordingly?

(3) If the settlement is brought to an end and a bare trust arises, would the changes brought in by section 64, Finance Act 1999 mean that the income and capital gains arising from that bare trust would be treated as the settlor's? Or is it merely going to be treated as the vesting of the interest in a pre-1999 settlement with the result that the income can be treated as the children's and make use of their personal allowances?

(Query T15,817) – Trusted.

 

From its creation, income of the original accumulation and maintenance trust will have been potentially assessable on the settlor under the anti-avoidance legislation in Part XV of the Taxes Act 1988. As the settlor has created a settlement for the benefit of his infant unmarried children, section 660B of that Act provides that the settlement's income is to be treated as that of the settlor in so far as it is paid to or for the benefit of such a child, and subject to a de minimis lower limit of £100. The settlor has a right of recovery against the trust of tax paid on that income as certified by the Revenue.

The income does have to be paid out or applied for a child's benefit; thus, were the trustees to accumulate the trust's income, the income is not treated as that of the settlor unless and until later paid out.

However, there may be an ancillary difficulty if a policy of full income accumulation has been followed, since the loan to the settlor will be treated as a 'capital payment' to the settlor by the trustees for the purposes of section 677, Taxes Act 1988.

In effect, the amount of the loan will be matched with the undistributed income of the fund and taxed as the settlor's income under Schedule D, Case VI. The sum is grossed up at the rate applicable to trusts, but the settlor is entitled to a credit for tax paid by the trustees. It needs to be appreciated that there is a carry forward of undistributed income over a ten-year period, although once the loan has been repaid there will be no further charge on available income in subsequent years. Where section 677 applies, there is no provision enabling the settlor to recover any tax that he may have to pay from the trust.

It is not thought that a post-1999 appointment/advancement to new bare trust terms will lead to removal of the trust's income from the Part XV régime. To achieve this, the bare trust would need its 'settlor' to be other than the children's parent. Whilst it is the existing trustees who create the new trust, the wide definition of 'settlor' in section 660(G)(2), Taxes Act 1988 is sufficient to embrace the current beneficiaries' father, who provided the original trust assets.

The decisions in Commissioners of Inland Revenue v Buchanan 37 TC 365 and D'Abreu v Commissioners of Inland Revenue 52 TC 352 also seem in point in this respect.

During the period of the trustees' loan, the trust's gains will be assessable as if realised by the settlor rather than the trustees in light of the 'benefit' derived by the settlor from the loan (section 77, Taxation of Chargeable Gains Act 1992). The gain on the sale of the private company shares would be treated in this way if that sale took place in the same tax year as the loan to the settlor.

'Parental settlements' are not caught adversely by the equivalent anti-avoidance provisions for capital gains tax purposes. Indeed, a solution in the current circumstances might be to consider the creation of a new bare trust which invests in non-income producing assets. Thus, zero dividend preference shares following a predetermined redemption schedule would provide the children with regular capital cash from the trust realised tax free through use of their personal capital gains personal allowances available as a result of their absolute entitlement against the trustees pending each eighteenth birthday.

The bare trust will almost certainly be a new trust, the creation of which will involve the 'new' trustees becoming absolutely entitled against the old settlement trustees. Whilst the immediate liability can be held over under section 260, Taxation of Chargeable Gains Act 1992, there would presumably need to be later disposals of existing trust assets to fund the acquisition of the new investments, resulting in the held over gain then coming into charge, albeit now with each beneficiary's full personal allowance being available against his or her share of that gain. – Digby Bew.

 

The former harsh consequences of such borrowing were instanced in the past by the case of Commissioners of Inland Revenue v De Vigier 42 TC 24.

Under the present rules in section 677, Taxes Act 1988, the loan of £10,000 is treated for the purposes of the section as a capital sum paid to the settlor. There is a maximum liability arrived at by treating the £10,000 as income of the client for the year concerned, but this is restricted by reference to the amount of 'income available' within the trust.

In the apparently simple circumstances of this settlement, it seems that income has been retained since commencement (but not capitalised) and such retentions may exceed £10,000. If so, there is no relevant maximum. If the 'available income' falls short of £10,000 in the year of assessment in question, a fresh liability arises in the following year up to the lesser of the remainder of the £10,000 or the income appearing. Unfortunately, it is necessary to have regard to all the (further) income appearing in the year of repayment 1999-2000 even if repayment occurred early in that year.

Distributions of income (presumably only possible for the children's benefit) are taxable on the settlor under section 660B, Taxes Act 1988. – Lane.

 

Extract from reply by 'Robin Hood':

The changes brought in by section 64 only apply to post-1999 settlements or post-1999 funds added to pre-existing settlements. So the income would be treated as the children's and their personal allowances made use of unless the termination of the trust were in itself an act of settlement. This is highly unlikely, as an end is likely to have been brought about by the trustees exercising fiduciary powers.

Issue: 3810 / Categories:
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