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Discretionary tips

It is quite a common event for parents or grandparents to put money aside for new born or young children. Some go further and specifically set aside funds to pay for further education in the expectation that the child will attend university. The question is what is the best method of holding investments for up to 18 years?

The most practical approach can often be to use a trust. However, if you are in the process of using a trust as a gift for a child’s future, you should be aware that HM Revenue & Customs recently issued an announcement about the tax basis of investment bonds held under bare trust where the beneficiary is a minor.

It is also important to consider whether a bare trust is the best strategy to use.

A bare trust is commonly used because the gift is usually an absolute gift of modest amount and simplicity is of the essence.

But this means that when a sole beneficiary attains age 18, they effectively own the trust fund outright. To reflect this legal position, for many years, HMRC had a clear practice on the taxation of chargeable-event gains that arise under a life insurance policy held subject to a bare trust.

This was as follows:

  • If the beneficiary is an adult, chargeable-event gains are taxed on that adult beneficiary

  • If the beneficiary is a minor, chargeable-event gains are taxed on the creator of the trust (if the settlor is not alive or not a UK-resident, the trustees are taxed instead)

    However, HMRC has now changed its view on the taxation implications after taking legal advice. This is covered in its Revenue & Customs Brief 51/08, titled, Life insurance policies held on bare trusts for minors.

    HMRC’s opinion is now that chargeable gains should always be taxed as the income of the beneficiary, irrespective of the beneficiary’s age.

    The one exception is where a parent made the settlement. In these circumstances, the parental settlement provisions for general income tax purposes in s629 Income Tax (Trading and Other Income) Act 2005 will apply.

    So the revised tax position, as seen by HMRC, is:

  • If a bare trust was established by a parent, chargeable gains are taxed on that individual

  • In all other cases, chargeable gains are taxed on the beneficiary

  • Chargeable gains that arise after a parental settlor’s death will be taxed on the beneficiary (assuming they are a minor unmarried child of the settlor)

    HMRC has also said it intends to apply this interpretation from tax year 2007/08 onwards, effectively backdating the change.

    Where a grandparent or other person makes the settlement and not a parent, this change in practice will provide scope for using minor beneficiaries’ personal allowances to offset chargeable gains.

    For example, excess withdrawals or segment surrenders could be taken from an offshore bond to fund school fees, ensuring that the resultant chargeable gain is within the child beneficiary’s personal allowance so no income tax will arise on the profit made.

    An offshore bond is used in this example because there is no tax on the underlying fund (except for non-reclaimable withholding tax on some equity funds) unlike a UK bond. All well and good, but there are some drawbacks to using a bare trust and you may actually find that a discretionary trust is a more suitable alternative.

    Some of the drawbacks include:

  • The child may not actually go to university and the donor may want their share of the investment to be kept for the future

  • The child may be aware – or be told – that they can get their hands on all the money at age 18 and demand that the trustees pass it over

  • If there is more than one child, they could do different courses and one might need a bigger trust than the other – which is impossible to predict in advance

  • The parents may have more children and not want to invest further funds but include the new children on to the existing arrangements

  • Lastly, and although unlikely, the child may die before age 18 and the investment would revert to the parents by dint of intestacy, which may not be what the settlor wants.

    All these drawbacks can be overcome by the establishment of a discretionary trust as opposed to a bare trust. These are not always considered because the settlement is a chargeable lifetime transfer. But provided that the investment, together with any other CLTs in the last seven years, is reasonably less than the nil- rate threshold of £312,000 (£325,000 from April 6, 2009), lifetime IHT can easily be avoided.

    However, it is important to take care if other estate planning has taken place, as the interaction between different trust arrangements can prove costly.

    The other drawback is that you will be losing the initial point of using a bare trust – that chargeable gains are now taxed on the beneficiary for non-parental settlements.

    It is possible to get the best of both worlds by making a simple power of appointment under the discretionary trust of specific policies (to the required amount) into a bare trust for the relevant child.

    Any decent standard discretionary trust should allow the trustees to do so in its trust provisions. The policies can then be cashed in and benefit from the new bare trust income tax rules.

    If a client is planning for educational fees or other child benefits, a discretionary trust can provide all of the tax and strategic benefits.

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