Do Discretionary Trustees Need To Act On Undistributed Trust Income?

Discretionary trustees should consider whether it would be advantageous to distribute trust income that has arisen more than five years before the next inheritance tax ("IHT") ten year anniversary of their trust. The reason for this is that the Government is going to change the way in which the IHT ten year anniversary charge applies to undistributed income that, as at the ten year anniversary, has been in the trust for more than five years. The change will apply in respect of ten year anniversaries occurring on or after 6 April 2014.

Under English trust law discretionary trustees have power to apply the trust income for the beneficiaries or formally to accumulate such income by resolving to hold it as part of the capital. Accumulated income is treated for tax and trust purposes as capital.

Under current law if trustees neither apply the income for the beneficiaries nor formally accumulate it but simply retain it as undistributed income its IHT status is unclear. If distributed in the future, is it taxed as an income distribution or as a distribution of capital, liable to an IHT exit charge? If retained in the trust at a ten year anniversary is it taxed as part of the capital? HM Revenue and Customs ("HMRC") might argue that undistributed income retained in the trust is deemed to form part of the capital after a period of time - but how long must it be held in the trust before this treatment applies? The position is unclear and might moreover depend on the circumstances of particular trusts.

As part of its longer-term project to simplify the IHT taxation of discretionary trusts the Government will be legislating to treat "old" undistributed income (that is, income that has been in the trust for over five years) as part of the capital at a ten year anniversary falling on or after 6 April 2014. Moreover there will be no reduction in the rate of IHT (as there is at present) to take account of the fact that...