With this it will be convenient to discuss the following:
Schedule 4—Amendments relating to the rate applicable to trusts
New clause 1—Repeal of section 677 of Taxes Act 1988
'Section 677 of the Taxes Act 1988 (sums paid to settlor otherwise than as income) is hereby repealed.'.
I suggest to hon. Members that it is probably useful if they include anything that they would like to say on clause 29 stand part now.
I thank you, Mr. McWilliam, for the comments that you have just made, because the territory is very much interrelated. In the course of my remarks, I want to make a point about amendment No. 31, which, for technical reasons, has not been selected, but is a central part of the point here.
Both clause 29 and schedule 4 increase the income tax rates for non-interest in possession trusts—discretionary and accumulation trusts—from 25 per cent. to 32.5 per cent. and for UK company dividend income from 34 per cent. to 40 per cent. That opens up what we perceive as an unfair imbalance in the treatment of UK company dividends. Whereas higher-rate taxpayers are taxed at 25 per cent., the income received by the beneficiary in a non-interest in possession trust will be taxed at 40 per cent. I think that that will also apply to pension-saving arrangements that fall under the funded unapproved retirement benefit scheme, or FURBS.
Next year, the Government are proposing sensible measures for streaming that I describe as automatic look-through. At the least, I ask why the tax is being put up a year ahead of that, which will result in a year of unfairness, and why it would not be more sensible to combine the two in the same tax year and to delay the tax increase for another year.
I had an extraordinary constituency case, where a little girl's father died at 35, leaving her £10,000. Her grandfather put that into a discretionary trust. He was going up the wall because he was already having tax estopped on it and could not get it back from the Revenue. He said, ''I hear that the rate is now going up to 40 per cent. What sort of justice is that? The amount involved is tiny.'' I said to him, ''As I understand it, in another year you would be alright because it would be a straightforward look-through situation, but I am afraid that this year, for some half-baked reason, you will have to pay even more tax, unless we can persuade the Government to coincide the two measures.''
New clause 1 would abolish section 677. We see no need for schedule 4, which introduces consequential amendments arising from the increases to the schedule F trusts rate and the rate applicable to trusts. Moreover, it complicates an already over-complex situation. The essence of the point is that, if we deal with the whole lot together, once we move to stream the higher tax rates, we do not need section 677 or schedule 4.
Certain capital sums paid to a settlor are taxed as income by section 677 when there is undistributed income in the trust. Schedule 4 introduces yet more complex first-in and first-out matching rules to relate the tax credit received by the settlor to the tax paid by the trustees. We would welcome an explanation of the provision, which appears to be a little capricious. Already the problems with sections 677 and 678 are made worse by schedule 4. The explanatory notes have turned up in the past day or two but, when I and others focused on this area, we did not have the explanatory notes to sort out some of the problems.
Section 677 could be repealed given that UK trust income is increasing to the new 40 per cent. rate. The key point is that, once the tax rate has been increased, you do not need all the clutter that section 677 and schedule 4 bring. There will be virtually no accompanying tax revenues once the rate has been upped to 40 per cent. The amount of tax at stake will diminish over the years as the amount of undistributed income that has suffered tax at rates of less than 40 per cent. reduces over that time. The related rules of section 678—capital sums paid by a body connected with the settlement—will become similarly redundant over time.
To sum up, it seems extraordinary that the Government are not dealing with the new tax rate and streaming at the same time. If both were dealt with at the same time, you could simplify an area of taxation that is ludicrously complex, and made more complex by the provisions of schedule 4, for little or no loss of revenue.
I want to address my comments to amendment No. 31. It is a popular misconception that all beneficiaries of non-interest in possession trusts are—
Order. For the sake of clarity, it is not possible to move the amendment, because the amendment is out of order. I accept that it is out of order on a technicality, but I suggested to hon. Members that they should take the group of amendments and clause stand part together. The argument is in order.
I shall therefore proceed to make the argument—[Interruption.] I am willing to give way to the hon. Member for Ealing, North (Mr. Pound), who, if we are very fortunate, might regale us with details of his naval career.
It is a popular misconception that only the very rich are beneficiaries of non-interest in possession trusts. That idea is wrong for various reasons. Often, for example, simple mitigation of tax, with property prices being so high, will involve, on the death of a first spouse, the creation for at least two years of a non-interest in possession trust—a nil rate inheritance tax trust. There could be 10 beneficiaries of that trust, including the surviving spouse, and many of those beneficiaries could be extremely badly off. I do not understand why the Government have a fair system in place for the next tax year and a patently unfair system for this tax year.
It is not just patently unfair, but made more unfair by the increase in the rate to 40 per cent.
That is absolutely right. For that reason I hope that the amendment will be pressed to a Division, unless the Government accept it, because we support it. It is patently unfair to discriminate doubly for one year against many individuals who are low-rate taxpayers, thus ensuring that they pay considerably more tax.
I understand that, but we have to be very careful in the Committee because we might want to keep our powder dry until Report. Nevertheless, I hope that we shall receive from the Paymaster General, who is invariably generous and courteous, some words of compromise and sense.
I hope that in explaining clause 29 and schedule 4 to the Committee, and responding to the amendments, I will also be able to address the specific point about the future changes to trusts, about which the Government are currently consulting, and how they will interact with the clause. I hope that hon. Members will then be satisfied that the calamitous situation that they believe possible will not come to pass.
Clause 29 changes the applicable rate for trusts from 34 per cent. to 40 per cent., and the corresponding schedule F trust rate from 25 per cent. to 32.5 per cent. The rate applicable to trusts has traditionally been set above the basic rate, which
reflects the fact that many—but, as the hon. Member for Arundel and South Downs said, not necessarily all—of the ultimate beneficiaries are liable to the higher rate tax. Higher rate taxpayers still can, and do, achieve an unfair tax saving by channelling their income through trusts. Increasing the rate applicable to trusts ensures that the right amount of tax is paid by the higher rate taxpayer.
The ultimate tax liability of the beneficiaries who receive income from a trust will not be affected by the increase in the rate applicable to trusts. Beneficiaries will continue to get a credit for the tax paid by the trustees so that higher rate taxpayers will not have to pay any more tax when trust income is paid to them. Beneficiaries who are not liable for income tax, or are liable at the starting or basic rate, will be able to claim the repayment, as is the case at the moment.
Clause 29 and schedule 4 are part of a wider package of changes that will modernise the way that we tax trusts.
If the hon. Gentleman will let me finish this point, I shall give way to him. The changes will reduce the compliance burdens faced by smaller trusts. From the tax year 2005–06, there will be a £500 basic rate band for trusts that pay tax at the rate applicable to trusts. Trusts established for the most vulnerable will benefit from the new rules; the trustees will be taxed only at the vulnerable beneficiaries tax rate.
This is a complex area. The Inland Revenue has consulted widely on it, which has been welcome. That consultation continues, and it is designed to ensure that all the details are correct. The provisions will ensure that trusts for the vulnerable do not pay more tax. In many cases, they will pay less, and it will be backdated.
Mr. Flight rose—
I knew that that would be the crucial point. The measures will be backdated to come into effect in 2004, even though we will require legislation in 2005. The reason for that is that although these changes are widely welcomed, there are still more details that we want to ensure are correct. That is the right way to proceed.
The Minister has uttered the magic words.
When I was making inquiries in relation to the constituency case that I mentioned, I was surprised to find that, historically, there seemed to be ludicrous complexity about whether there could be a straight look through. The case is straightforward. There is an orphaned daughter. Money was the father's only savings. The mother is still alive. A trust has been set up in favour of the daughter, and it has been organised by the grandfather to protect her against the possibility of the mother walking off with the money. However, the child has to pay tax on the income on £10,000. It is extraordinary that the rules result in that. I hope that I am right in understanding that once the new streaming arrangements have been sorted out they will give a complete look through.
With your leave, Mr. McWilliam, I will briefly touch on the proposed modernisation. The hon. Members for Arundel and South Downs and for Torridge and West Devon know full well that this is a very complicated area of taxation. All manner of arrangements—to put this delicately—can be found in it, ranging from vulnerable trusts, for which all Committee members want the Government to make the necessary arrangements to simplify the provisions, to extremely creative high taxpayers who seek to reduce their tax unreasonably.
That is unfortunate, and it provides a challenge for the Government. I will explain it by addressing the points that were made about the changes in section 677 of the Income and Corporation Taxes Act 1988. The changes in the arrangements that we are seeking to make are designed to ensure that we meet that challenge. With regard to the operation of section 677 and anti-avoidance, we are still dealing with higher rate taxpayers, and we are also reviewing, updating and modernising trust arrangements and the tax system for trusts so that we pick up the points that the hon. Gentlemen are rightly making.
The new system will involve an irrevocable election made jointly by trustees and the vulnerable beneficiary for the tax paid by the trustees to be based on the circumstances of the vulnerable beneficiary. It is difficult to comment on the constituency case of the hon. Member for Arundel and South Downs, but then I always marvel at the complexity of his casework. No one has visited me in Bristol, South inquiring about an offshore trust and the unreasonableness of the 40 per cent. tax rate.
On the point to which the Paymaster General has alluded, I think that she said that, on the inception of a trust for a vulnerable person, the election would have to be made by the settler trustees and the vulnerable person. I hope that in due course she will reconsider that, if it is so, because sometimes the vulnerable person is not capable of making an election and might refrain from doing so because they would not want the property put in trust.
Mr. Flight rose—
I will just answer that question before I give way to the hon. Gentleman.
I beg your indulgence, Mr. McWilliam, as we are going quite wide of the subject. The points that the hon. Member for Torridge and West Devon raised are precisely those on which we need further consultation, to ensure that we get that balance right. He is right: it is not straightforward. It is simple for a Minister to say that we wish a measure to apply as a principle, but we have to ensure that it is delivered in the circumstances that we seek to achieve.
The hon. Gentlemen will have to be disappointed this year that the provisions are not available in the Bill. I hope that they will look forward with expectation and encouragement to the legislation next year making an appropriate response to these matters.
Mr. Flight rose—
I want to get this matter out of the way so that I do not stray too far from the amendments, so before I give way I point out that the other issues that we are considering are the basic rate band, the £500, and harmonising definitions and tests. There is broad consensus that we should have a common definition of trust income tax and capital gains tax. As the hon. Member for Arundel and South Downs said, there is also the question of streaming income and ensuring that it is right to deliver the things that he correctly identified in circumstances where it would be appropriate.
I do not plan to say anything about next year's Finance Bill. I was trying to be helpful with regard to current consultation in the context of clause 29. I will give way to the hon. Gentleman and then return to the amendments.
Just to put the record straight, the case in question concerned a trust that was entirely domestic, and these measures are essentially about domestic trusts. It was also modest, with only £10,000, and illustrated the correct use of trusts. A grandfather was simply trying to protect what little his deceased son had received for the benefit of an orphaned child.
I think that I answered the hon. Gentleman's point when I said that all the arrangements for all those who benefit from such trusts will be backdated. I hope that that settles the point. We should not stray any further.
Amendment No. 57 would omit schedule 4 from the Bill. That moves to the other half of the challenge that the Inland Revenue faces in dealing with trusts, where avoidance by extremely wealthy individuals may inadvertently occur, to put it delicately. We are seeking, as an ever-helpful Inland Revenue and assisted Minister, to ensure that the clauses continue to work as intended.
New clause 1 and amendment No. 57 would repeal section 677 of the Income and Corporation Taxes Act 1988, which charges tax on capital payments made by trusts to the individuals who put funds into the trust. The amendment and the new clause would create new opportunities for tax avoidance. Section 677 contains anti-avoidance legislation to stop individuals who put funds into a trust avoiding tax when they withdraw funds from it. New clause 1 would sweep section 677 aside, but section 677 is a necessary defence against avoidance. If it did not exist, people could place funds in an offshore trust that paid little or no tax on its income and arrangements could later be made for funds to be returned to them in a non-taxable form, thereby avoiding tax altogether. That is just not acceptable. Such schemes are not caught by any other anti-avoidance measure, and I hope that the Committee will understand why section 677 is a necessary part of the tax system and new clause 1 should be rejected.
Schedule 4 simply ensures that the proposed change in the rate applicable to trusts is taken into account when section 677 operates. In the simplest case, it ensures that a person receiving a capital payment from a resident trust does not get credit for tax paid at 40 per cent. if the trust had paid only 34 per cent. In the worst case, someone could receive a credit at 40 per cent. when no UK tax had been paid. The amendment, by omitting schedule 4, would make nonsense of the tax credit calculation and create a new tax avoidance opportunity for higher rate taxpayers.
I hope that the hon. Member for Arundel and South Downs, who said that sections 677 and 678 are highly complex and capricious provisions, sees that the Government's amendment in the schedule is a necessary consequence of the increase in the rate applicable to trusts. Schedule 4 aims to ensure that the tax credit given to a settlor when calculating their income tax liability on a capital payment from the trust more closely matches the tax paid by the trustees.
The change to section 677 is necessary to ensure that wealthy settlors pay the right amount of tax. I cannot see why that is unreasonable because everyone else pays the right amount—well, I hope that they do. I certainly do. Without the change, the notional tax credit that they receive would be calculated on the wrong basis. These are anti-avoidance provisions and are necessary to ensure that the right amount of tax is collected in all cases. In any case, the tax revenue at stake would depend enormously on behavioural effects when tax planners are ready and willing to exploit any loophole—this would be a large one—for the benefit of their clients. There is an ongoing risk, because trusts that are based offshore pay no UK tax and that could be used to achieve the avoidance.
I hope that the hon. Gentleman accepts my undertakings on trusts for the vulnerable and that he will also, perhaps reluctantly, accept that section 677 is absolutely necessary. If he does not withdraw his amendment, I shall ask my hon. Friends to vote against it.
The Paymaster General has lived up to the billing that I gave her. Softly, gently and subtly, she has won over this Member.
The right hon. Lady frequently seduces me with her words.
I was delighted to hear what she said. She handles the Committee with great expertise, and did so especially in connection with amendment No. 31. I am delighted to hear that there will be no discrimination against some disadvantaged individuals in this tax year, 2004–05.
The Paymaster General has indeed responded to our main concern about the commitment to backdate. On the more technical aspects of schedule 4 and section 677, in a domestic context, I trust that the Minister understands the point that I was making.
I was under the impression that taxation of income from non-UK offshore trusts was done on a look-through basis under other legislation, and that the issue was therefore thoroughly dealt with elsewhere. She is effectively saying that that is not the case, and that there is a reliance on something in section 677. If that is so, I accept her argument. My point was based on the understanding that the section was really about domestic trusts, and did not touch on offshore trusts. On the basis that the Minister knows her stuff—I am sure that she does—I accept the argument that we cannot get rid of section 677 if it is relevant to the offshore territory. I beg to ask leave to withdraw the amendment.
Amendment, by leave, withdrawn.
Clause 29 ordered to stand part of the Bill.
Schedule 4 agreed to.