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Taxing investment bonds held in trust

This article looks at how UK investment bonds are taxed when they are held inside a trust. It assumes that you have a good understanding of the common types of trusts that hold UK investment bonds.

In this article we focus on three main types of trust:

  • Absolute or Bare
  • Interest in possession
  • Discretionary

Background

The Trustee Act 2000 (England and Wales) and similar legislation for Northern Ireland and Scotland widened the investment options for nearly all trusts. But it also puts more responsibilities on the trustees to: seek appropriate advice from suitably qualified individuals, to review the investments on a regular basis, and to ensure suitability of trust investments and consider the need for diversification.

Trustees and their financial advisers need to understand the tax consequences of investments held within the trust, and the options available to try and reduce the tax burden. The trustee rates of capital gains tax of 20% and income tax of 45% have refocused this need.

This section addresses income tax, capital gains tax and inheritance tax for the trustees and where applicable, the beneficiaries and settlor(s).

The chargeable event regime

Special tax rules apply to investment bonds. The main circumstances which create a tax liability are:

  • when the investment bond (or individual policies within it) is fully surrendered
  • assignment of all of the investment bond for consideration of money or money's worth
  • if withdrawals and/or the consideration for part assignments for consideration of money or money's worth in a policy year exceed either: 5% of the single premium (5% allowance) or the available cumulative allowance (up to the total amount invested)
  • when the investment bond comes to an end because the last of the lives assured dies.

Under the chargeable event regime, gains made by investment bonds are charged to income tax, not capital gains. Therefore any gain will be assessed alongside other income. For age-related allowances and the loss of personal allowance for those with incomes over £100,000, the sum of any chargeable gains is added to their income, not the relevant slice. However, unlike other income producing investments, no tax is due until a chargeable event occurs, therefore there is no requirement for annual tax returns to be completed unless chargeable events occur each year.

For UK bonds, life fund taxation applies which cannot be reclaimed by the settlor, trustees or the beneficiaries. It does, however, provide a ‘tax credit’ equivalent to the basic rate of income of 20%.

Income tax

Absolute or Bare

HMRC’s view is that gains are assessed on the beneficiary of the trust, even where the beneficiary is a minor, and tax is due at their marginal rate of income tax. However, where the trust was created by a parent of the minor beneficiary, under the parental settlement rules the chargeable gain in excess of £100 will be assessed on the parent whilst the beneficiary is an unmarried minor.

Interest in Possession

For Interest in Possession and Discretionary Trusts, it is first important to determine if the trust is UK resident for income tax purposes.

Residency of a trust for income tax purposes

The residency of a trust will depend on the residency of the trustees and in some cases the residency or domicile of the settlor. The residency test for UK income tax will apply each tax year to determine the residency of the trust for UK income tax purposes.

Where all of the trustees are resident in the UK, the trust is UK resident for UK income tax purposes.

Where one or more of the trustees, but not all of them, are UK resident then the trust is UK resident for UK income tax purposes if the settlor was:

  • resident in the UK, or
  • ordinarily resident in the UK, or
  • domiciled in the UK at any relevant time. ‘Relevant time’ means any time a settlor made or is treated as making the trust and any time when a settlor adds property to the trust. Where the settlement arises on a settlor’s death, it means the time immediately before their death.

Where all of the trustees are resident outside the UK, the trust is not UK resident for UK income tax purposes

If the settlor is alive and UK resident, gains will be assessed on the settlor. If the settlor has died, a UK resident trust would become liable, unless the settlor died before 16 March 1998.

If the trust was not UK resident, then any UK resident beneficiary may become liable.

If the settlor died before 16 March 1998 and both the trust and the investment bond were set up before this date and policy benefits have not been enhanced since then, the 'dead settlor' principle would apply. This means no income tax would be payable whilst the trust remains in place.

If the settlor dies after 16 March 1998 and the trust is UK resident, the gain, will be assessable on trust. The trust will benefit from the £1,000 standard rate band (taxed at 20%) for the first £1,000 of income and gains liable to income tax and the rest of the gain would be taxed at 45%. The standard rate band will apply to any earned, savings or dividend income assessable on the trust in the tax year before any remaining standard rate band can be applied to chargeable event gains.

Discretionary

Same position as an interest in possession trust.

Capital Gains tax

Capital gains tax does not generally apply to investment bonds held inside Absolute or Bare, Interest in Possession and Discretionary trusts.

Inheritance tax

Absolute or Bare

Gift into trust would be a Potentially Exempt Transfer (PET) to the extent that it is not exempt. Value of trust assets would be part of beneficiaries’ estate.

Interest in possession

Trust is subject to entry, exit and periodic charges post-22 March 2006.

For existing pre-22 March 2006 trusts the value of the interest is in the estate of the life tenant, as long as no further capital is added to the trust after 22 March 2006, and there was no change to the interest in possession beneficiary after 5 October 2008.

However, where the asset of a pre-22 March 2006 trust is a ‘life’ insurance policy (such as an investment bond) and the change in interest in possession beneficiary was caused by death, the trust will still remain outside the relevant property regime.

Discretionary

Trust is subject to entry, exit and periodic charges. However, there is no value in the estate of the beneficiaries.

Assignments

Where the trustees assign the investment bond, in part or all, to a beneficiary (who must be over 18), under current legislation the assignment is not a chargeable event; any future chargeable event gain will be assessed on the beneficiary at their own tax rates. Given the significant increase in trust taxation, trustees may wish to consider this route if capital is to be distributed to a beneficiary from the trust. This is because the beneficiary’s highest rate of income tax may well be lower than the rate that would be suffered should the gain arise within the trust, or by the settlor as applicable.

Summary

With trusts now being liable to income tax rates of up to 45%, financial advisers should make sure that the trust holds its investments in the most tax efficient manner. Understanding the beneficiaries’ need for income, rights to capital and the investment objectives of the trustees will enable financial advisers to minimise tax and maximise planning and investment opportunities.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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