The problem: Adviser Sam Davis asked the Smith Jones Financial Planning technical group’s advice about the tax treatment of a bond owned by a trust. Sam’s client, Janet, is a beneficiary of the trust. Sam explained that he was confident about the tax treatment of a bond that is held by an individual but he was unsure how the trustees or beneficiaries would be taxed and therefore he did not know how best to advise the client.
The client’s situation
Sam’s brief summary of the position was as follows. Janet’s parents set up the trust some years ago and the trust assets consist of a UK life assurance investment bond, which he believes is segmented into a large number of policies. The trust is a flexible power of appointment trust of the kind that was very common before 2006. The default main beneficiary is Janet but there is power to appoint to her children or a wide class of beneficiaries.
The value of the bond is about £200,000 and its original value at inception was £120,000. Janet is in her mid-50s and her only child, Peter, is in his late 20s.
She would like to use some or possibly all the proceeds of the trust to help him buy a house. Janet is a higher-rate taxpayer while Peter is currently a basic-rate taxpayer with an income of about £28,000 a year, which is likely to stay at that level for the next couple of years or more. Janet’s mother, who settled the trust some years ago, has since died. Sam would like to understand the tax position on cashing the bond in whole or in part. He can then evaluate the options.
Tax on bonds owned by trusts
Nobody else on the technical comm-ittee can quite recall the detail of the tax position on bonds owned by trusts. Technical support from the life office in question and other insurance companies seems more elusive than in the past. Smith Jones IFAs now sells few, if any, investment bonds and then only on one of the wrap platforms they use, all of which are relatively light on serious technical and tax planning support.
So the technical committee turns to Taxbriefs Advantage which provides them with a full, clear and rapid answer in the section “Taxation of life policies under trust”. The position is as follows.
If Janet’s mother had still been alive and resident in the UK, the gain would have been taxed as if it were part of her income. However, she could have recovered the tax from the trustees.
In fact, the settlor has died well before the chargeable event can take place and at least one of the trustees is UK resident. So under the current rules, the trustees are subject to the tax on the gain at the rate applicable to trusts – a rather penal 45 per cent, less the 20 per cent tax credit because it is a UK bond whose funds have been subject to UK tax. So what to do? Advantage provides some helpful pointers.
The trustees could avoid the potential tax by assigning the investment bonds to one or more of the beneficiaries before the chargeable event takes place. Unlike gifts of mutual funds or shares, the assignment of a life policy does not trigger a tax charge. A crucial condition for this tax freedom is that the assignment is not for “money or money’s worth”. In other words, the trustees do not sell the policy to the beneficiaries.
The beneficiary who received the bond – either Janet or her son Peter – could then encash the policy and would pay tax at the rate that would apply to them. In Janet’s case that would be 40 per cent – so that would be slightly preferable to the trustees’ tax position. In Peter’s case, it might be possible to use top slicing relief (depending on when the bond was first taken out) and the judicious encashment of segmented policies over a few tax years to make sure that there is no tax on the bond.
The final piece of the jigsaw – the dead settlor rule
But as Janet’s adviser, Sam needs to do some more homework on both the bond and the trust. Not only must he check out the potential top slicing position but he also needs to see if an increasingly overlooked tax loophole is available.
This is known as the dead settlor rule, sometimes remembered by experienced advisers but typically unknown to younger advisers and technicians. Originally, the rule was that if a policy was subject to a trust, the person chargeable was the one who created the trust. Then if the person who created the trust had died in the tax year before the year of the gain or earlier, there was no one on whom the Revenue (as it then was) could tax the gain.
The dead settlor rule still works for policies effected before 17 March 1998, where the trust was set up before that date and if the settlor had died earlier. So Sam has some important research to carry out. If the policy can be encashed free of tax in one year, that would be a whole lot simpler and probably cheaper than gradually cashing segments over a period of several years.
Danby Bloch is Editorial Director of Taxbriefs Financial Publishing.
Taxbriefs Advantage is a new online content resource aimed at giving financial advisers, planners and paraplanners a clear business advantage. Advantage provides you with unbiased, independent answers to your technical queries. Marrying Taxbriefs’ quality content with focused functionality, Advantage allows you to build up your own library of regularly updated content to export and share – visit www.taxbriefsadvantage.co.uk and find out more.