A friend told you that she avoided tax on dividends from her company shares by putting them in a trust for her children. Unfortunately, she was light on details of how this worked. Can avoiding tax as she described be that simple?
Parental gifts and tax
HMRC has long been aware of arrangements to divert income from parents to their children to avoid tax. It thwarts these with special anti-avoidance rules (the “settlements legislation” ). This make a parent liable to tax on the diverted income if it exceeds £100. The rule applies in two situations:
- Where the parent keeps an interest in the income or assets generating the income, e.g. retaining ownership of property after giving the rights to the income to their minor child.
- Where a parent doesn’t have an interest in the assets they gifted and the income it generates is paid to their child.
Trusts and parental gifts
Situation 2 suggests that your friend might not be right. Dividends on shares she gifted to a trust will count as her taxable income when paid or treated as paid to her children. Trap. Most types of trust automatically give the beneficiary the right to income as soon as it is received even if the trustees hold it back from the beneficiary (child). Tip. A discretionary trust only gives the beneficiary the right to income when the trustees pay it to them. This means the settlements legislation won’t bite unless the trustees pay income to the child.
Discretionary trust
By giving shares in her company to a discretionary trust with her minor children as beneficiaries your friend won’t pay tax on the dividends generated by the shares. But that doesn’t mean no tax is paid. The trust has to pay tax on the dividends at a special rate equal to the higher income tax rate.
Trap. Your friend must not be a beneficiary or potential beneficiary of the trust as this counts as having an interest in the assets (shares) she gifted; and Situation 1 of the anti-avoidance rules will apply.
Tax frying pan or fire?
By using a discretionary trust it seems that your friend has simply swapped paying tax on the dividends herself for it being paid by the trust. However, the tax-saving plan is a slow burner. Tip. When the children reach 18, or if earlier marry or become a civil partner, the accumulated income (dividends) in the trust can be paid to them without counting as taxable income for your friend. Instead it’s taxable income for the now adult child. This might not appear to have achieved any tax saving, but if the adult child has no or only a small amount of income there’s a tax saving because they receive a refundable credit for the tax paid by the trust.
Example. Jacky is 18 and at university. She earned £1,500 working in the summer break. In 2022/23 she receives a payment of £5,000 before tax from a discretionary trust. It has already paid tax of £1,905 on the income (dividends). Jacky’s total income for 2022/23 is £6,500 which is less than the personal tax-free allowance. The £1,905 tax paid by the trust is treated as paid by Jacky. As she is not liable to tax she can reclaim the £1,905.
In conclusion. Tax can be saved by diverting income-producing assets to your children via a trust. It must be carefully worded to prevent anti-avoidance rules applying and will rely on your children having a period of low or no income after they reach 18. There are also capital tax consequences from gifting shares and we’ll look at these in another article.
Normally, any income derived from gifts made to your minor children is taxable on you. However, tax can be saved by diverting income-producing assets via a discretionary trust but any advantage can only be achieved after they’ve reached 18. The capital tax consequences of transferring assets to a trust must also be considered.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.