What Future Tax Reform Could Mean for Discretionary Trusts

Discretionary trusts have long been a valuable tool for estate planning, offering flexibility, control and a way to manage inheritance tax (IHT) over time. However, the UK tax landscape is now shifting, with changes significant enough to warrant a careful review. The Autumn Budget 2025 has introduced a series of reforms that will change how discretionary trusts are taxed. Importantly, restrictions on Business Property Relief (BPR) and Agricultural Property Relief (APR) will be effective from 6 April 2026, and the IHT reforms relating to pension funds will come into effect from April 2027. In this article, we look at what is changing for IHT, what it means in practice, and why now is the time to seek advice from experienced inheritance tax advisers.

A brief overview of discretionary trusts

A discretionary trust is a legal arrangement where a Settlor transfers assets to trustees, who then hold and manage those assets for the benefit of a defined class of beneficiaries. Unlike a fixed trust, no single beneficiary in a discretionary trust has an automatic right to receive anything. The trustees decide who receives, as well as when and how much. This model makes the discretionary trust structure highly flexible and useful for families with complex circumstances.

Discretionary trusts can run for up to 125 years, and, importantly, they are subject to their own rules for income tax, capital gains tax and inheritance tax. It is these distinct tax rules that are now changing under the proposed UK tax reform. In most respects, it is becoming more expensive. Let’s explore the reforms in detail.

Key UK tax reforms affecting discretionary trusts

1. Income tax

Discretionary trusts currently pay income tax at 45% on non-dividend income and 39.35% on dividend income. Under the reforms, the dividend trust rate will remain at 39.35%, but the trust tax rate on savings and property income will increase from 45% to 47% in April 2027. Practically, this means that trusts that hold savings accounts, investment properties, or bonds will face higher tax leakage on income that is retained within the structure. For trustees with income-generating assets, this makes a review of distribution strategy increasingly important.

Importantly, the 45% rate continues to apply for income that is not dividend, property, or savings income. Current draft legislation suggests the tax credit accompanying an income distribution will remain at the current rate of 45%, which will result in trustees paying more income tax than they can pass on a tax credit to the beneficiaries, with this additional tax appearing to be non-recoverable.

2. Inheritance tax on pension funds

This is arguably one of the most significant changes brought about by this UK tax reform. At present, unused pension funds and death benefits held under discretionary pension schemes do not form part of the deceased’s estate for IHT purposes. This exemption will no longer exist from April 2027. When the exemption falls away, most unused pension funds and death benefits will be included in a person’s estate and potentially subject to inheritance tax at 40%. Furthermore, the responsibility for reporting and paying the IHT will shift from pension scheme administrators to personal representatives. The timeframe for paying the IHT will remain six months from the end of the month of the date of death, and interest will arise where paid late. There is justifiable concern that the cost of administering estates may rise considerably, and personal representatives will also have the added responsibility of collating information from all of the deceased’s pension schemes to be able to complete the IHT account (IHT400).

Additionally, HMRC has confirmed that personal representatives will have the ability to direct scheme administrators to withhold up to 50% of taxable benefits for up to 15 months from date of death, to help meet the IHT liability before the remaining funds are released to beneficiaries. Importantly, where administrators withhold 50% of the funds, beneficiaries will only be able to access the remaining 50% during that period of up to 15 months. There are, however, alternatives. The IHT can be paid from assets held in the deceased’s free estate before obtaining probate, with pension scheme administrators then reimbursing the personal representatives for the IHT paid; this is understood to be the scenario the Government anticipates for most estates. Where the pension beneficiaries differ from the estate beneficiaries, however, the personal representative will need to recover the IHT paid from the estate from the pension beneficiary directly. Pension beneficiaries may also be able to apply to receive gross benefits and settle the IHT liability from their own personal resources. Twelve months after the end of the month in which the deceased died, personal representatives and pension beneficiaries will become jointly liable for any unpaid IHT attributable to the pension funds.

For individuals who have nominated discretionary trusts to be beneficiaries of their pension or death benefits, for example, a spousal bypass trust, which has the effect of keeping pension death benefits outside of the surviving spouse’s estate, the change coming in April 2027 requires immediate attention. Where the objective of such a trust was to bypass the surviving spouse’s estate for IHT purposes, the new rules bringing unused pensions within the scope of IHT may mean it is more tax-efficient to redirect the benefits to the spouse instead, deferring the IHT until the death of the surviving spouse. Death benefit nominations may need to be reviewed, particularly where the nil-rate band of £325,000 could perhaps be used more effectively. Consultation with inheritance tax advisers is essential.

3. Investment bonds

Investment bonds, and offshore bonds in particular, have been a popular tool within discretionary trusts due to their administrative simplicity and the ability to defer tax on gains. However, from April 2027, the savings rate of up to 47% will apply to chargeable gains on offshore bonds when they are taxed on the Settlor or beneficiaries. For onshore bonds, the internal life fund tax rate will rise to 22%, but the corresponding tax credit given to the bondholder is also updated to reflect this, and top-slicing relief will also remain available, subject to updated rules around how this interacts with the new rates. Trustees who rely on investment bonds as a planning tool must review existing arrangements to ensure that this approach remains suitable.

4. Employee Ownership Trusts

For business leaders considering a sale to an Employee Ownership Trust (EOT), the capital gains tax exemption on qualifying disposals of company shares to EOT trustees has been changed from 100% to 50%. This is applicable to all disposals made on or after 26 November 2025. Importantly, 50% of the gain that is not chargeable to CGT at the time of the disposal is held over by reducing the trustee’s acquisition cost and therefore this element will come back into charge on the trustees when they dispose of the EOT shares. EOTs remain a viable succession option for many business owners, but the reduced relief rate does change things. Anyone considering an EOT sale must model the revised tax position carefully before proceeding.

IHT thresholds

At Budget 2025, it was confirmed that IHT nil-rate bands, which were fixed at current levels until April 2030, will now remain at these levels until April 2031. The nil-rate band stays at £325,000, and the residence nil-rate band remains at £175,000. Importantly, this continued freeze, in the context of rising asset values and inclusion of pensions in estates from 2027, means that more estates will be subject to IHT exposure over time.

What does it all mean for trustees and families?

Taken together, these UK tax reforms signify a meaningful tightening of the tax treatment of discretionary trusts. As such, trustees must think carefully about a number of practical questions:

• Is our current investment strategy still tax-efficient given the new income tax rates on savings and property income?
• Should we be making more distributions to beneficiaries before April 2027 to reduce income retained in the trust at the higher rate?
• Have death benefit nominations for pensions been reviewed in light of the IHT changes, and is the nil-rate band being used effectively?
• Are there restructuring options available that could reduce the trust’s future tax exposure?
• Is the trust registered with HMRC’s Trust Registration Service, and are annual reporting obligations being met correctly?

Of course, there is no single answer to any of these questions. Consultation with experienced inheritance tax advisers is essential, and the right approach will depend on the nature of the trust assets, as well as the beneficiaries’ personal tax positions and the long-term goals the trust is designed to achieve.