ABOUT THE AUTHOR: Amanda Edwards TEP is an
Associate at Boodle Hatfield
Attempts by parents to divert income to their minor children so
that the income can be taxed at their children’s own (possibly
lower) rates of income tax have long been caught by anti-avoidance
provisions. These date back to 1991 and are now to be
found in s629 Income Tax (Trading and Other Income Act)
2005 (ITTOIA 2005), the so-called ‘parental settlement
rules’.
A parental settlement for income tax purposes may even arise
inadvertently as ‘settlement’, widely defined in the income tax
legislation to include ‘any disposition,
trust, covenant, agreement, arrangement or transfer of assets’.
One particular trap lies in the making by a parent of a deed of
variation in favour of minor children, as in the following
example.
Example
Joe receives a legacy of GBP250,000 under his father’s will and
wants to make a deed of variation in favour of his two
children (aged four and six), mainly for inheritance tax (IHT)
purposes because he has no need of the money himself. For IHT
purposes this works well as the GBP250,000 will be treated as if
Joe’s father had himself made the gift into trust for his
grandchildren under his will.
However, the ‘writing back’ is only effective for IHT purposes
and for preventing a disposal for capital gains tax (CGT) purposes
(assuming in each case that the deed of variation contains the
necessary election). For income tax, this will be a parental
settlement by Joe. Given the age of Joe’s children, this may not be
appropriate unless the investments can be invested in
low-income-yielding assets. Note that if Joe has retained an
interest in the trust (e.g. because he himself can benefit or the
settlement is revocable), this will be caught by the
settlor-interested rules under s624 ITTOIA 2005 and will be treated
as a settlor-interested trust, rather than a parental
settlement.
Another scenario where a parental settlement can arise
inadvertently is where shares in a family company are held by
parents and also by trustees, on behalf of minor children. If the
parents waive their right to dividends, it may be that the
trustees’ dividend is increased. This will be an ‘arrangement’
sufficient to trigger the parental settlement rules under s629.
The various tax effects of a parental settlement are set out in
more detail below.
The income arising on a parental settlement is taxable on the
(parent) settlor, subject to a GBP100 per annum de minimis limit.
Once the GBP100 limit is passed, the entire income is taxable on
the parent at whatever rate the income would have been charged if
it had actually been their income. This will cover:
- payments of income made to each child under the trust or
settlement;
- payments of capital made to each child, to the extent that they
can be matched against any available undistributed income;
- amounts applied for the benefit of each child (where the
payment is made to someone other than the child but for their
benefit, for example payment of school fees).
Any income that is accumulated in the trust will not be taxed on
the settlor, but it will be subject to the trust rate of income tax
(50 per cent for non-dividend income and 42.5 per cent for dividend
income at 2010/11 rates).
For capital gains tax (CGT), the usual rules apply and the
trustees are liable for CGT on gains above the annual exempt amount
(GBP5,050 in 2010/11). However, holdover relief is
not available on the transfer into the trust.
For IHT purposes, payments into a parental settlement made after
22 March 2006 (with few exceptions) will be a lifetime chargeable
transfer and IHT charges may also arise when assets exit the trust
and on ten-year anniversaries.
Bare trusts for minor children
Although a bare trust is not a trust for IHT purposes, it may
nonetheless give rise to a parental settlement for income tax and
fall within s629(1)(b), in which case the income tax treatment
outlined above will apply. This could arise from a simple parental
gift made, for example, when opening a building society account in
the child’s name.
There are, however, CGT advantages in using a bare trust for a
minor: because the child is absolutely entitled to the assets, a
bare trust is not a settlement for CGT. Any gains that arise are
therefore treated as the child’s gains, to be set against his or
her personal annual exemption (GBP10,100 in 2010/11).
Bare trusts created by parents for minor children may therefore
have a limited use for holding low-income-producing assets, which
may give rise to gains within their annual exempt amounts.