Discretionary trusts ― tax pool

By Tolley
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The following Trusts and Inheritance Tax guidance note by Tolley provides comprehensive and up to date tax information covering:

  • Discretionary trusts ― tax pool
  • Introduction
  • The components of tax reserved in the tax pool
  • Tax credits on payments to beneficiaries
  • Calculation of the tax pool balance
  • The tax pool charge
  • Effect of the mismatch in tax rates

Introduction

The income of discretionary trusts is taxable on the trustees. When income is passed on to beneficiaries, they are treated as receiving it net of tax at the trust rate. The beneficiary receives a credit for the trust rate tax. If his personal rate of tax is lower than the trust rate, he is entitled to claim a repayment of the tax overcharged.

The ‘tax pool’ is a record of the tax paid from year to year by the trustees of a discretionary trust, which funds the tax credits available to the beneficiaries. If the tax credits on distributions to beneficiaries exceed the amount available in the tax pool, an additional charge is made on the trustees.

In principle, the tax pool is a reserve of income tax which is available for credit and repayment when the income is distributed to beneficiaries. However, the concept is complicated by the fact that there is a mismatch between the tax reserved in the tax pool and the tax credited to the beneficiaries. This inevitable mismatch is explained by the nature of a discretionary beneficiary’s income.

For an interest in possession beneficiary, the trust is a conduit through which the income passes retaining its character and tax rate. Interest is received net of 20% tax and is recognised as net interest in his hands. Similarly, dividends are received net of tax. Currently, this would be net of tax paid at the dividend ordinary rate of 7.5%; before 6 April 2016, it was net of a non-repayable 10% tax credit. This ‘look through’ treatment reflects the fact that the beneficiary is entitled to the income as it arises.

By contrast, a discretionary beneficiary has no right to the income of the trust until the trustees decide to pay it to him. The income paid over may have arisen in earlier years and some

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