How is a Bare Trust Taxed?

Bare trusts can be a very useful tool in a number of circumstances. The trustee in a bare trust has no power of choice over the disbursement of the assets, in contrast to, for example, a discretionary arrangement. Rather, the trustee simply holds the legal title to the assets; the beneficiary, previously identified by the settlor, is entitled to the absolute benefit derived from those assets.

This is very useful when an individual wishes to gift money to a child or grandchild; as is explained below, a bare trust is a very tax efficient method by which this can be achieved. It should be noted, however, that bare trusts are irrevocable.

This means that the terms of the trust, including the identity of the beneficiary, cannot be changed. This can be potentially problematic if family circumstances change. Further information on the revocability of trusts is available in an article elsewhere on this site.

Potentially Exempt Transfers

The tax treatment of bare trusts has been a subject of great concern in recent times. The rules regarding the taxation of trusts were changed in 2006, and it appeared that the favourable treatment of bare trusts was to be revoked. Thankfully, after representations to HMRC by solicitors and accountants, this did not actually happen. Bare trusts are most commonly used to transfer assets to minors. The assets are held in trust by the trustee until the beneficiary reaches 18 in England, or 16 in Scotland.

The 2006 revisions suggested that transfers into bare trusts for the benefit of such minors would no longer be treated as Potentially Exempt Transfers (PETs) for the purposes of inheritance tax (IHT). PETs become tax free if the individual making the transfer survives for a further seven years. Thus, after the clarification of the revisions, transfers made into bare trusts can potentially be exempt for IHT purposes.

The most important thing to remember is that the beneficiary is responsible for any tax liability that may arise, as opposed to the trust itself. If, for example, assets are transferred into the trust and the settlor survives for at least another seven years, no IHT charge will arise at any point. When the assets are finally transferred out of trust to the beneficiary, however, the latter may be liable for an income tax charge. Frequently this does not occur; in many cases, the cumulative earnings of the beneficiary in that year will not be sufficient to push them over the income tax threshold. In these circumstances, the assets will be completely tax free.

Trustee Liability

It should be noted that, in some cases, trustees have been liable for tax payments during the lifetime of the trust. In these instances, the beneficiaries can claim a refund from HMRC equivalent to the sum paid by the beneficiaries. It should, however, be possible to mitigate the possibility of such a charge arising at all. This can often be achieved through careful drafting of the trust instrument (that is, the document used to establish the trust), for which expert legal advice will be required.