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Discretionary Trusts - Key Tax Implications

Author: Aoife Walsh

As accountants, it is unlikely that you will be drafting trusts but at some stage, you will probably be asked to comment on the tax implications of a trust. This may be required at drafting stage; when it is being reviewed; or after a person’s death.

Trusts can be created during a person’s lifetime or they can be created by will, taking effect after a person’s death. Tax implications can arise on set up of the trust; during the life of the trust; when appointments are made from the trust; and on final distribution of all the trust assets.

In addition to the usual tax heads that may apply during the course of a trust, in the case of a “discretionary trust”, discretionary trust tax may also apply.

Discretionary trust tax was introduced because the Revenue Commissioners were dissatisfied with the way in which discretionary trusts were being used. Assets were being tied up long term for generations enabling trustees to do some creative tax planning. The Exchequer was losing out on capital acquisitions tax, which is only payable by the beneficiary of a discretionary trust when an appointment is actually made.

The definition of a discretionary trust in the Capital Acquisitions Tax Acts is different to and more encompassing than the legal definition. We will first look at the tax definition of a discretionary trust; secondly, the application of the tax; and thirdly, the exemption that applies to such trusts set up for incapacitated persons.

DISCRETIONARY TRUSTS

A discretionary trust is broadly defined, for legal purposes, as one where the trustees have a wide discretion to apply income or capital for the benefit of certain beneficiaries. The beneficiary of a discretionary trust does not have the right to receive any benefit from the trust unless and until the trustees make an appointment to that beneficiary.

However, the definition of a discretionary trust for tax purposes is much more encompassing. The definition is set out in S 2 Capital Acquisitions Tax Consolidation Act 2003 (“CATCA 2003”).

““Discretionary trust” means (a) any trust whereby, …, property is held on trust to accumulate the income …, or (b) any trust whereby, …, property (other than property to which for the time being a person is beneficially entitled for an interest in possession) is held on trust to apply, or with a power to apply, the income or capital… of the property for the benefit of any person … whether at the discretion of trustees or any other person and notwithstanding that there may be a power to accumulate all or any part of the income.”

In general, a discretionary trust is defined as one where the trustees have the power to accumulate income. However, there is no discretionary trust if there is an interest in possession e.g. a life interest.

DISCRETIONARY TRUST TAX

Discretionary trust tax consists of an initial levy and an annual levy. There is an exemption for trusts created exclusively for incapacitated persons. There is no relief for business assets, agricultural assets or government stocks or securities held in such a trust. Discretionary trust tax, if it applies, will apply to the entire value of the fund.

Initial Levy

The initial levy was introduced in 1984. It is a once off charge and applies to the trust fund at a rate of 6%. The initial levy applies to discretionary trusts on the latest of the following dates and must be paid within 4 months of the relevant date:

• The date on which the property becomes subject to the discretionary trust; or • The date of death of the settlor; or • The date of the youngest principal object’s 21st birthday (25th birthday where the property became subject to the trust on or after 25th January 1984 and before 31 January 1993)

It is important to note that a “principal object” is defined as:

• The spouse of the disponer, • The children of the disponer; and • The minor children of a pre-deceased child of the disponer.

A grandchild (unless a minor child of a deceased child) or a niece or nephew are not principal objects.

Therefore, when looking at a discretionary trust in order to determine whether there is a charge to discretionary trust tax, you must ask yourself the following questions and if the answer to any of the questions is YES, there is no charge to discretionary trust tax… yet!

• Is the settlor is still alive? • Is there is a principal object under 21 years of age? • Is there is a direction to pay the income of the trust to one or more beneficiaries i.e. a life interest.

Refund

There is a refund of half the initial levy if the trust is wound up within 5 years of the initial levy. This relief must be claimed; the Revenue Commissioners will not automatically make the refund. In practice, if it is intended to wind the trust up immediately, the Revenue Commissioners will accept payment of only 3%. If the trust does receive the 3% refund and this is paid out to a beneficiary, capital acquisitions tax will be due on this payment.

The recent case of Revenue Commissioners v Christie and Others centered around the point in time at which assets passing to the trustees of a discretionary trust will become chargeable to the initial levy. This date also affects the date on which the refund is due. The legislation states that the date in question is the date of death.

It was held that under general law the assets were vested in the executor until the administration of the estate was complete. On completion of the administration of the estate, the assets were then held by trustees upon discretionary terms. The Judge then stated that having established this position under general law, the charging provisions in relation to discretionary trust tax should then be construed. The judge determined that the assets did not become subject of the discretionary trust until the residue of the estate was ascertained. The decision was not appealed by the Revenue Commissioners and was given a legislative footing in the most recent Finance Bill.

Annual Levy

The annual levy was introduced in 1986. It is an annual charge and it applies to the trust fund at a rate of 1%. The annual levy commences the year after the year in which the initial levy is charged: for example, if the initial levy occurs on 6 May 2007, the annual levy will apply on 31 December 2008. The annual levy is charged on 31 December every year (previously 6 April – changed in Finance Bill 2006) and should be paid within 3 months of that date.

Many clients contemplating setting up a trust for their children are shocked to discover that discretionary trust tax is charged when the youngest principal object, usually a child, is 21. With the increase in property prices and personal wealth, people’s estates are more valuable than ever. Many parents do not feel that their children are mature enough to receive the trust property at that age. In addition to a fear of alcohol or drugs, there is also a fear that access to such wealth will diminish their children’s ambition. However, neither the courts nor the Revenue Commissioners see it as their function to protect wealthy young adults.

The trustees of a discretionary trust are then faced with the difficult choice between distributing assets to children prior to their 21st birthday to avoid tax or retaining assets in the trust and suffering discretionary trust tax.

There have been petitions to increase the age limit from 21 to 25 to reduce the pressure on trustees to distribute before beneficiaries are ready to deal with assets responsibly. Conversely, there have been rumours that it will actually be reduced to 18, the age of majority, in line with other legislation.

It is important to note that a trust set up exclusively for persons under 18, even if they are not principal objects, will be exempt from discretionary trust tax. A minor is accepted as being a person with incapacity for the purposes of the exemption in S 17 CATCA 2003.

DISCRETIONARY TRUSTS FOR INCAPACITATED PERSONS

S 17 CATCA grants an exemption from discretionary trust tax where the discretionary trust is set up exclusively for one or more incapacitated persons. The section defines an incapacitated person as one who is “because of age or improvidence, or of physical, mental or legal incapacity, incapable of managing that individual or those individual’s affairs.” This includes a minor, even if that minor is not a principal object.

The exemption will only apply where the discretionary trust has been exclusively set up for the incapacitated person and no other persons. It is possible, though, to include as a beneficiary the institution caring for the incapacitated person. If, however, there is an incapacitated child with siblings who are not incapacitated, all children cannot be included as beneficiaries of the trust; a separate trust must be set up for the incapacitated child.

The definition of an incapacitated person has been subject to much argument with the Revenue Commissioners. For example, a drug user could be said to be incapable of managing his affairs but the Revenue Commissioners will not accept a drug user as being incapacitated for the purposes of the relief.

It is important to note that while there may be an exemption from discretionary trust tax, this exemption does not necessarily extend to income tax, capital gains tax or capital acquisitions tax. There are specific tax implications for both trustees and the beneficiary in relation to the trust income and gains and any appointments made. In addition, any appointments from the trust may impact on any State Benefits received by the beneficiary.

CONCLUSION

Discretionary trusts are not as popular as they once were due to the introduction of discretionary trust tax in 1984 and 1986. Despite this, you will still encounter them in a variety of situations:

• Discretionary trusts set up for minors or incapacitated persons; • Discretionary trusts created in a person’s will prior to the introduction of discretionary trust tax; and • Discretionary trusts created unintentionally.

When reviewing a person’s will from a tax perspective it is important to ensure that a discretionary trust is actually necessary. At drafting stage, ensure that the trustees’ powers are wide enough so that future beneficiaries may be able to avail of various reliefs e.g. dwelling house relief.

The trust may have been created when the client’s children were a lot younger and there may no longer be a need for the trust and thus the charge. If the trust is necessary, it is important to brief the client on the potential charges. You should also ensure that you log future relevant dates in your calendar so that tax effective appointments can be made, if appropriate, given the circumstances of the beneficiary at that time.

If the trust is one created for an incapacitated person or persons, it is important to ensure that for the discretionary trust tax exemption to apply, the trust has been created exclusively for that person or persons’ benefit and that the group of named persons does not include a person that is not incapacitated.

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Discretionary Trusts - Key Tax Implications

Author: Aoife Walsh

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