Peter Rayney reviews the current income tax regime for discretionary trusts.
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For more in depth discussion on this, please see our new tax report ‘How to Use Trusts to Reduce Property Taxes. Save 40% Today.
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The Autumn Budget 2025 introduced various income tax increases, most of which apply from April 2026.
Many business owner-managers are now using trusts to implement succession planning and it is therefore important for them to understand the current income tax position of discretionary trusts and the extent to which the tax rises have affected their ‘family’ trusts.
Income tax treatment
For income tax purposes, ITA 2007, s 479 requires that income received by discretionary trusts be taxed at the special trust rates, or in the case of dividend income, the dividend trust rate. This is subject to the overriding rule relating to settlor-interested trusts (see below), which requires the trust income to be taxed on the settlor.
The special ‘discretionary trust’ tax charges arise on income that is either accumulated or payable to the beneficiaries at the trustees’ discretion (ITA 2007, s 480). This contrasts with interest in possession trusts, where their life-tenant beneficiaries enjoy an absolute right to the income.
There are broadly two main aspects to discretionary trust tax. First, there is the tax charge arising on the trust income. Second, in some cases, an additional tax charge may arise when the trust distributes income to a beneficiary (where the trust has paid insufficient tax to ‘frank’ the 45% tax credit that attaches to the income distribution).
Discretionary trust tax
For 2026/27, discretionary trusts are taxed as follows:
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Discretionary trusts no longer have a ‘standard rate band’ (SRB), and hence no part of their income is taxed at the basic rates. The SRB was removed from 6 April 2024. |
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All trust income is now taxed at 45%, with a special 39.35% rate applying to dividend income (remember the recent dividend tax increases do not apply to the ‘top rate’ and the trust dividend rate therefore remains the same at 39.35%.) The trustees cannot claim the benefit of the personal savings allowance or the paltry £500 dividend ‘nil-rate’ band. |
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Trust management expenses properly chargeable against income can be deducted in computing the trust tax (ITA 2007, s 484). Trust expenses are set against dividend income before other income (ITA 2007, s 486). |
A worked example showing the tax liability calculation for a discretionary trust in 2026/27 is shown below.
Example 1: Discretionary trust income tax computation
The trustees of The RV Williams Family 2022 Discretionary Settlement received the following income during the tax year 2026/27.
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Dividend from 20% holding in The Lark Ascending Ltd (net of trust management expenses) |
£15,000 |
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Net rental income (after deducting property expenses) |
£24,700 |
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Bank interest (paid gross) |
£2,900 |
The net income is accumulated within the trust.
The trust’s tax liability for 2026/27 would be calculated as follows:
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£ |
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Net property income |
£24,700 |
x 45%* |
11,115 |
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Bank interest |
£2,900 |
x 45% |
1,305 |
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Net dividend income |
£14,030 |
x 39.35% |
5,521 |
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Total tax liability |
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17,941 |
* Increases to 47% from 6 April 2027
Discretionary trust distributions
Income distributions made by the trustees are deemed to have suffered tax at 45%. The trustees will provide the recipient beneficiary with an R185 certificate stating the net distribution and the grossed-up amount (with the tax credit of 45%). Beneficiaries will pay income tax on the ‘gross’ distribution and will often be able to claim a repayment where the 45% tax deemed to have been suffered exceeds their actual tax liability.
The underlying income from which the distributions are made effectively loses its original character. Thus, for example, where the trustees distribute dividend income, this is simply treated as a trust distribution (non-savings income) in the beneficiary’s hands. Consequently, since this is taxed as ‘trust income’, it does not attract personal dividend tax rates or benefit from the dividend nil-rate band.
The legislation provides a mechanism to enable the trust distributions to carry a tax credit of 45% in the beneficiaries’ hands. This has to be matched by the tax paid by the trustees, which is tracked by the ‘tax pool’. The tax pool will contain the cumulative total of the tax paid by the trustees. When the trustees distribute income, they must deduct the 45% tax credit attaching to the distribution from the tax pool. The tax pool, therefore, represents the total of tax paid by the trustees during the lifetime of the trust, less the amount of tax credits used to frank distributions.
If the tax pool exceeds the 45% tax credit, no further action is required. On the other hand, if the balance on the tax pool is insufficient to cover the 45% tax credit, then the trustees are required to pay a further amount of tax to cover the shortfall (ITA 2007, s 496). This calculation is illustrated in the example below.
From a conceptual viewpoint, unless the trustees have sufficient capacity in the tax pool, the full distribution of dividend income that has been taxed on the trust at 39.35% (from April 2022), will inevitably lead to an extra 5.65% (i.e., 45% less 39.35%) tax being paid under the ITA 2007, s496 charging procedure (see example below).
Example 2: Section 496 tax charge arising on trust distributions
On 31 March 2027, the trustees of The No 1 Tallis Family Settlement 2018 made a cash distribution (on income account) of £55,000 to one of its beneficiaries. At that date, the balance on the trustee’s tax pool was £38,000.
The tax credit attributable to the distribution is £45,000 (i.e., £55,000 x 45%/55%) and the gross distribution is £100,000.
However, since the balance on the tax pool is only £38,000, the trustees must pay a further £7,000 (i.e., £45,000 less £38,000) tax to HMRC (under ITA 2007, s 496).
Assuming the recipient beneficiary’s marginal rate of tax is (say) 40%, they will be able to reclaim a tax repayment of £5,000 (i.e., £100,000 x 40% = £40,000 less tax credit of £45,000).
Settlor-interested and parental trusts
Some very important anti-avoidance rules effectively take precedence over all the other trust provisions. Where they apply, the trustees are not taxed on the income since the income is deemed to be the income of the settlor (i.e., the person who created the trust) for tax purposes (see ITTOIA 2005, Pt 5, Ch 5).
Common examples where this legislation can apply include trusts from which the settlor or their spouse or civil partner can benefit, or trusts which provide income for the parents’ (unmarried) minor children. Where these anti-avoidance rules apply, the settlor must report the relevant income on their own personal tax return (even though it is received by the trust). This income is taxed under the normal rules, although the settlor can frequently apply to be reimbursed for the tax from the trustees (ITTOIA 2005, s 626).
Practical tip
Provided the parental settlement rules can be avoided (e.g., where children are over 18 years old), discretionary trusts remain efficient vehicles for funding school and university fees and so on.
