As a basic rule, dividends received by the trustees of a discretionary trust are taxed at the additional rate of tax (39.35% for 2024/25) unless they are covered by the trustees’ standard rate band or are used to defray trustees’ expenses (trust management expenses).
Read on for an explanation of the tax rules affecting dividends in a discretionary trust, with examples of how they work in practice.
Standard rate band
Dividends which are covered by the trustees’ standard rate band (SRB) are taxed at the basic rate of tax (8.75% for 2024/25).
Trustees have a standard rate band of £1,000, which is shared amongst all the qualifying trusts which have been created by the same settlor and are still in existence in the tax year. For instance, if the settlor has created four separate trusts, then each will be entitled to an SRB of £250. The minimum SRB for a trust is £200; so if the settlor has created ten trusts, each will still get a £200 SRB.
The SRB is first allocated against non-dividend income and then dividends, so if the other income exceeds the standard rate band, no dividend income will fall into the SRB.
Trust management expenses
Dividend income which is used to defray trust management expenses (TMEs) which are ‘properly chargeable to income’ is also taxed at the basic rate of tax. (Further guidance is available in HMRC’s Trust, Settlements and Estates Manual: TSEM8100.)
To work out the amount which is covered by the TMEs, they are grossed up by the basic rate of tax. For example, if the allowable TMEs were £1,000 then an additional £1,096 would be subject to tax at the basic rate (£1,000 /91.25%). Unlike the SRB, TMEs are first allocated to dividends and then to other income.
Trustees’ tax pool
Income tax payable by the trustees is allocated to the tax pool, with the exception of the tax on the dividends covered by the TMEs.
If an income distribution is made by the trustees, it is deemed to be net of tax already paid at 45%. For instance, an income distribution of £5,500 is deemed to be net of tax credit of tax already paid of £4,500 (this tax may be then reclaimable by a beneficiary).
The tax credit is then deducted from the tax pool and any excess tax pool is carried forward, indefinitely, to be used in a future tax year.
The tax pool cannot be in a deficit. Therefore if the tax credit exceeds the available tax pool, the trustees have to make an additional payment to HMRC to cover the shortfall.
Income account
The trustees can only make an income distribution if they have an available income balance in the income account. The income account is calculated as the net income after the deduction of the income tax liability and the TMEs, less any other income distributions made.
Any undistributed income is carried forward indefinitely to be used in a future tax year, unless otherwise stated in the trust deed, or accumulated by the trustees.
Dividend income inefficiencies
As noted above, any income distributions carry a 45% tax credit. This creates a discrepancy in the overall tax and income positions if the main source of income is dividends, which are taxed at 39.35%.
For example (ignoring for now TMEs and SRB):
If there was dividend income in the trust of £100,000 then the tax payable on this would £39,350.
The tax pool would increase by £39,350 and the net income (income pool) would be £60,650.
When considering distributing income from the trust, the trustees have two main options for making the maximum possible distribution:
- Distribute an amount to use up the tax pool. In this case, an income distribution of £48,094 would carry a tax credit of c£39,350, which would exhaust the tax pool but leave £12,556 in the income pool.
- Distribute the entire income balance. In this case, a distribution of £60,650 could be made to use up the income pool, which would carry a tax credit of £49,633. This would leave a shortfall in the tax pool of £10,283 which the trustees would need to pay to HMRC. This would leave no balance in the income pool or tax pools to carry forward.
These are just two examples of the extremes either way. In practice a combination of income distributions, loans and/or capital distributions can be used to maximise the tax efficiency. This will be unique to each trust’s individual position and bespoke advice should be taken before any distributions are made.
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