Failure to notify Discretionary Trust's Income - Correct Tax Paid Overall, but Wrong Procedure. What 's the Likely Outcome?

Trust Woes - Will HMRC Impose a Penalty?

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Five years ago, client inherited £300,000 and by Deed of Variation, diverted it to setting up a Discretionary Trust with herself, her children and grandchildren as beneficiaries.  She wrote to HMRC notifying the existence of the trust and they replied saying no need to register until there was actually some tax liability.  In the five years since then, the trust hasn't paid anything out to anybody, and the capital has grown a bit.  Client had it in mind that the Deed of Variation  was effective for IHT but not for Income Tax and that she remained taxable on the trust's income.  Since her income is modest - only a little over the Personal Allowance - she's well clear of Higher Rates, and the Trust's income of about £5,000 interest and a similar amount of dividends doesn't put her anywhere near Higher Rates either.  So the client hasn't declared the income and she hasn't filed any Trust Returns either.

My understanding is that the Trust should have made annual returns, paid Higher Rate Tax on most of its income and the client (the settlor) should have made personal returns reporting the same income as personal income and reclaiming the Higher Rate Tax, and she should then have paid the refund over to the Trust.

So overall, the right amount of tax has been paid and HMRC hasn't lost any tax, though their Trust division hasn't had the tax in and their Personal Tax division hasn't had to pay it out again.

When I disclose all this, are HMRC likely to impose a penalty?


Replies (3)

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By Marion Hayes
22nd Oct 2016 13:46

AS far as I am aware, as I had a longstanding client in the same position, your client is correct. Deeds of variation are not effective for Income Tax - only IHT and CGT - so if matters have changed I would be grateful if someone could point us to the relevant legislation

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By jlsTax
24th Oct 2016 12:56

I think there could be some confusion in your phases 'is not effective for income tax purposes'.
A Deed of Variation is not effective for IT purposes in respect of income arising prior to the deed itself, it does however normally affect who is taxable on the income from the date of the deed.
You client therefore would correctly be taxable on income from date of death to date of deed.
Thereafter it is the income of the new Discretionary Trust and would normally be declared (and taxed) as such. Of course as you state the trust is settlor interested and therefore the income remains chargeable on your client and the correct tax will have been paid.
Your problem is that HMRC's administrative way of achieving the correct result with a settlor-interested trust is that they expect a return and tax to be paid by the trust and then adjusted in the Settlor's return.
If explained to HMRC I trust they would allow things to be done correctly for the future and leave the past alone, but no guarantees and it may take some explaining.
As an aside have the trustees properly decided to distribute the income to your client?

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By [email protected]
24th Oct 2016 15:46

Many thanks for that. No, the trustees haven't resolved to distribute any income to the settlor or to anyone else, and nothing has been distributed. The income has simply rolled up in the trust's investments. But I appreciate that the settlor should nevertheless have declared it as though she had received it

I would like to think HMRC would take the sensible view you suggest - that they haven't lost out although the correct procedure hasn't been followed. But I'm not confident. Has anyone any experience of HMRC response to this situation?

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