There are various, potentially adverse, tax implications where an individual settles cash or other assets on trust but is capable of benefitting from the trust. Various anti-avoidance rules exist for income tax, capital gains tax and inheritance tax purposes, which can give rise to unforeseen tax problems for the unwary. For example:
• The ‘settlements’ provisions treat trust income as belonging to the settlor for income tax purposes (ITTOIA 2005, s 624).
• Capital gains tax holdover relief is not available on a transfer of chargeable assets to the trustees if the settlor has an interest in the settlement (TCGA 1992, s 169B).
• The ‘gifts with reservation’ provisions can treat property transferred into trust as remaining within the transferor’s estate for inheritance tax purposes (e.g. if the settlor transfers a property into trust and occupies it rent-free as a beneficiary) (FA 1986, s 102, Sch 20).
With regard to the first bullet point, there has been uncertainty in the past about whether a settlor can be liable to income tax under the settlements provisions on payments that he or she has made to the trustees, such as loan interest or rents.
Payments by the settlor
In Rogge, Kent, Kent Settlement  UKFTT 49 (TC), the tribunal considered whether payments made by a settlor can be taxed as his income, under what is now ITTOIA 2005, s 624(1) (previously ICTA 1988, s 660A(1)).
The tribunal held that previous case law (CIR v Leiner (1964) 41 TC 589 and Ang v Parrish (Inspector of Taxes)  STC 341) supported HMRC’s argument that it is possible for a settlor to be subject to tax on a payment that he himself has made. The tribunal accepted that a literal interpretation of ICTA 1988, s 660A(1) appeared to lead to an “absurd conclusion” when a payment was made to the trust by the settlor, and sympathised with the appellants’ view that this “cannot be right”. However, the tribunal considered that it was constrained by the words of the legislation itself.
In Mr Rogge’s case, he had paid interest to a discretionary settlement, in respect of a loan made to him by the trustees. It was argued for Mr Rogge that a person cannot be both payer and payee for income tax purposes, but HMRC contended that as settlor and a beneficiary, the effect of ICTA 1988, s 660A was that Mr Rogge was liable to income tax on income arising under the settlement.
In the case of Mr Kent and the Kent Settlement, rent was paid to the trustees of the settlement by Mr and Mrs Kent, who occupied property owned by the trustees. Mr Kent also appealed in his capacity as trustee of the settlement, on the grounds that the rental income should only be taxable on Mr Kent under s 660A. Mr Kent was the settlor and had an interest in possession in the settlement. The trustees owned the residence occupied by Mr Kent and his wife, and received rent from Mr and Mrs Kent as tenants.
It was argued for the appellants that s 660A treats the trust income as being that of Mr Kent only, and also that he could not be both payer and payee for income tax purposes, but the tribunal rejected both arguments and dismissed the appeals. The tribunal held “with some reluctance” that as s 660A refers to ‘income’ as opposed to ‘profit’, it must follow that Mr Kent was liable to tax on all of the rent paid to the trustees, without deduction of trust management expenses.
The settlements code in ICTA 1988 (Part XV, Ch 1A) was replaced and is now contained in ITTOIA 2005, Pt 5, Ch 5. The current code includes a specific provision to prevent trust expenses being used to reduce the settlor’s income (ITTOIA 2005, s 624(1A)). However, for the purposes of calculating the settlor’s income, the same deductions and reliefs are allowed as if the income had actually been received by the settlor (s 623), such as property expenses for rental business purposes (although if the trustees make a loss from a property business, HMRC considers that the trustees’ loss cannot be used by the settlor; see TSEM4017). The settlor is entitled to recover from the trustees any tax paid under s 624 (or s 629). On the other hand, a repayment arising to the settlor as a result of those provisions must be paid to the trustees (or any other person to whom the income was payable due to the settlement) (s 646).
The above tribunal decisions bring some guidance on what has been a long-standing conundrum, albeit that the outcome will no doubt seem unsatisfactory and unfair to many settlors. The settlements rules are also particularly complex and potentially confusing from an administrative viewpoint, in terms of how settlors and trustees of settlor-interested trusts report income for self-assessment purposes. The simplification of such requirements for settlors and trustees would therefore be most welcome.
The above article is reproduced from ‘Practice Update’ (March / April 2012), a tax Newsletter produced by Mark McLaughlin Associates Ltd. To download current and past editions of Practice Update, see the Newsletters section.