I am a trustee of a small interest in possession trust. We have been using the services of a stockbroker but I am growing concerned about this strategy and wonder whether collective investment vehicles might be more appropriate, particularly bearing in mind the duties placed on trustees following the introduction of the Trustees Act 2000. What are the issues I should be taking into account?
Most trusts have traditionally invested in portfolios of individual securities. This has always been a questionable policy in the case of small trusts, where packaged investment products offer clear advantages in terms of diversification and the availability of ongoing professional supervision at economic cost.
In the light of the duty imposed on trustees by the Trustee Act 2000 to ensure the suitability of investments, the arguments in favour of packaged products are further strengthened because they also offer ways of maximising returns for the beneficiaries by reducing the adverse impact of the recent tax changes applying to trusts, namely:
The introduction of complicated rules for capital gainstax, which impose a heavy additional burden of administrative cost, affecting interest in possession trusts in particular.
Changes to the system of dividend tax credits, which affect discretionary and accumulation & maintenance trusts and result in a serious reduction in net income for beneficiaries who rely on dividend income.
In times of low inflation and low investment yields, additional tax charges and administrative expenses cannot be ignored. As the Financial Times commented in April 2000: “The perception that wealthy investors should build a portfolio of individual shareholdings is not necessarily sound from the tax point of view. The pooled fund structure has very important tax advantages.”
Packaged products offer a number of advantages:
In the words of the Treasury, they “generally entail less risk than direct holdings of securities and offer economies of scale”.
They offer tax advantages, hence the description of tax wrappers. Each product type has its own characteristics and applications but in every case they provide tax advantages over direct investment in securities.
The tax advantages can greatly simplify the administration of investment portfolios and thereby create significant cost savings.
They can be packaged to achieve special investment objectives, such as a consistent high monthly income.
They can incorporate facilities such as capital drawdown, which may be valuable to boost income when yields are low.
They can incorporate capital guarantees to protect the interests of beneficiaries and thereby also protect the trustees.
Unlike investment management services, they are exempt from VAT.
Interest in possession trusts have not been adversely affected by the abolition of advance corporation tax and the changes to tax credits but the changes in the capital gains tax regime will inevitably increase the complexity and therefore the cost of capital gains tax calculations. For trustees with significant shareholdings in quoted companies, who will also have to take account of scrip and bonus issues, the calculations may become too complex to be undertaken manually and may need to be operated through a database which keeps a permanent record of issue values. The result is that the capital gains tax-exempt portfolio structure offered by collective investments such as unit trusts, investment trusts and UK Oeics has become even more attractive compared with direct securities holdings.
These tax wrappers enable trustees to pursue an active investment strategy while building up their entitlement to taper relief until they are ready to crystallise gains and dispose of their holdings. Calculations by Newton Investment Management indicate that, assuming identical portfolios, turnover levels and growth rates, an investor in a unit trust over 10 years may gain an advantage over investors in individual stocks worth around 1 per cent a year in capital gains tax savings alone.
Collectives' exemption from capital gains tax on internal dealings gives them an advantage over investment bonds, whose underlying investments are subject to corporation tax on the total return including capital gains (although because these bonds are outside the scope of the capital gains tax reforms, their underlying funds continue to enjoy the benefit of indexation).
It may be prudent for trustees to invest in a portfolio of collectives. Internal dealings within each fund enjoy freedom from capital gains tax but opportunities may still arise for trustees to take advantage of their annual exemption by periodically harvesting the gains on individual holdings. The 1998 Finance Act provisions, which prevent bed and breakfasting, provide an additional argument against confining a trust's holding to a single collective.
Some collectives offer a choice between income units, which entitle the holder to receive income which is generated, and accumulation units, which make no distributions (although income which accrues is nevertheless taxable in the hands of the holder). It is important that trustees of interest in possession trusts select the income option, even if they intend to distribute capital in lieu of income. The reason for this is that life tenants are entitled to whatever income might accrue but in the case of accumulation units the income is recycled to enhance capital values and becomes impossible to trace. So if the beneficiaries demand the income which is their right, the trustees would have difficulty in identifying this.