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Tax-saving strategies for trustees

Jeremy Pearson, technical support manager at Canada Life, details some routes for trustees to consider in light of the increased rate of capital gains tax

Trustees of all trusts, except for bare trusts, have been subject to a flat rate of capital gains tax of 28 per cent since June.

Interest in possession trusts, as well as discretionary trusts, face this increase in CGT rates.

It is obvious that, whatever the colour of the Government, it regards trusts as a tax avoidance exercise that needs to be hammered down. This could not be further from the truth for many trusts, which are set up to protect vulnerable people or to provide security for family members.

Solicitors are already recommending that people review their arrangements and consider if it is worthwhile continuing with their trust. It is also reported that the Law Society fears the move could see the end of trusts.

This may be an over-reaction as there are strategies that trustees can adopt.

But it does seem anomalous that a basic-rate taxpaying beneficiary of a trust would pay 20 per cent on their income and 18 per cent on their capital gains above the annual exemption but could effectively be paying 28 per cent tax on the gains in the trust.

For discretionary trusts the CGT rise is on top of the increased rate of tax on income of 50 per cent that applied from April 6 (42.5 per cent on UK dividend income). This applies when the trust income exceeds the £1,000 standard-rate band.

This means that, for a discretionary trust, income tax has increased by a quarter and the rate of CGT has increased by a half. This will have a significant impact on the overall return available for the beneficiaries.

If the trustees are concerned about this situation, there are strategies they could adopt:

  • Although income is distributed net of tax, if the beneficiary pays tax at less than 50 per cent, as would be likely, they can recover the overpaid tax.
  • Assuming the trust provisions permit and the trustees think it appropriate, a beneficiary could be given a life interest and the income generated would be taxed at the recipient’s rate.
  • Invest for capital growth, although growth is not guaranteed, as the trustees can use their annual CGT exemption of £5,050 and after that pay 28 per cent tax as opposed to 50 per cent tax on income. The annual exemption is sub-divided by the number of trusts created by the same settlor, including life insurance trusts but in any event will never be less than one-fifth of the trustee exemption of £1,010.
  • Use investment bonds as a trustee investment. Investment bonds are a tax-efficient investment for trustees of discretionary trusts for a number of reasons. They do not produce taxable income, they are not subject to CGT in the hands of the trustees and they enable the trustees to draw 5 per cent of the initial investment for 20 years, with no tax charge at that time.

Trustees can switch to their heart’s content without it being a disposal for CGT purposes or a chargeable event and, finally, assignment to a beneficiary can switch the tax point away from the trustees.

Chargeable gains are taxed on the settlor(s) of the trust if they are alive and UK-resident. Otherwise they are taxed on trustees (if UK based) at the rate of 50 per cent (less a 20 per cent tax credit for an onshore bond).

Up to 200,000 family trusts could be affected by the new trustee rate of capital gains tax

If the trustees assign an investment bond to a beneficiary, no chargeable event arises. If a chargeable gain arises thereafter, it will be that beneficiary who is assessed to tax on the gain.

In virtually all cases, you would expect their tax rate to be lower than the trustees’ rate – especially as top-slicing relief is available.

But discretionary trusts are only one of the three generic types, the others being bare trust and interest in possession trusts. Would investment bonds be an advantageous investment for the trustees of those two types of trust?

For bare trusts, all income, capital gains and investment bond chargeable gains are taxed on the beneficiary.

So the considerations as to what type of investment is held in the trust are the same as if the beneficiary was investing direct, albeit taking into account that they may be under the age of majority.

Interest in possession trusts are a bit different, when it comes to considering an investment strategy. By their very definition, all income produced by the trust investments is paid to the life tenant as of right.

Given that withdrawals from an investment bond are return of capital, they do not fit this definition and can only be forwarded to a life tenant if a power of advancement is included in the trust provisions.

The trustees should also be aware of the precedent set by Brodie’s Will Trustees v IRC 1933, which is that anything that looks like income could be taxed as such by HMRC.

So regular payments of a level amount to a life tenant, derived from investment bond withdrawals, are to be avoided.

As the life tenant pays income tax at their appropriate rate on trust income distributed to them, the tax advantage argument in favour of investment bonds is not so strong. It could be strengthened if the interest in possession trusts was generating significant capital gains taxed at 28 per cent.

It is also crucial that the trustees never surrender the bond (and pay tax at 50 per cent), so it should always be distributed to the life tenant or remaindermen before encashment.

The investment bond, of course, still has its usual advantages of tax deferral, investment diversity, administrative simplicity and switching without tax issues.

As with all trust cases, it is a matter of identifying the exact requirements and planning accordingly. Overall, according to the Society of Trust &; Estate Practitioners, up to 200,000 family trusts could be affected by the new trustee rate of CGT. It may be time for the trustees concerned to re-evaluate their investment strategy as their tax bill could increase significantly.


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