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Taxing questions for charitable trustees

Following the introduction of the Trustee Act 2000 in England and Wales on February 1, 2001, trustees of charitable trusts who did not have wide investment abilities were granted increased statutory powers.

Yet the Charity Commission has advised that they should be cautious when investing their funds. This advice is offered in the commissions recent publication, Investment of Charitable Funds: Basic Principles. The guidance provides charitable trustees with a summary of the dos and donts of investing, encompassing legal obligations and good practice. It complements more detailed technical guidance on the subject which has been available on the commissions website for some time.

No doubt the guidance will once again raise the question of the suitability of life insurance policies and capital redemption policies as invest- ments for charitable trustees.

In considering their strategy, trustees need to be mindful of the tax treatment of any proposed investments. The major tax advantage for charities is the exemption from income and capital gains tax for most forms of income and capital gains that are applied for charitable purposes.

A list of investments which constitute qualifying expenditure for charities is set out in Schedule 20 of the Income and Corporation Taxes Act (ICTA) 1988 but this does not include life insurance policies or capital redemption policies. The Inland Revenue has confirmed in Annex VI to the charities section of its website that it will not accept claims by charities for such investments to be treated as qualifying investments.

The effect of this is that if a charity has relevant income of more than 10,000 in a year and invests in life insurance policies or capital redemption policies, either UK or offshore, the exemption from income and capital gains tax on income and gains which exceed 10,000 in that year will be restricted.

Thus, if a charity has income and gains of 80,000 after expenses and invests 50,000 in a single-premium life insurance policy or capital redemption policy, only 30,000 (the first 10,000 plus 20,000) will be exempt from tax.

Furthermore, if a charitable trust invests in a UK policy, the tax suffered on income and gains by the life fund will not be reclaimable, as indeed will be the case for any withholding tax suffered within the fund of an offshore policy.

Although there is a general exemption from income tax on investment income, that exemption does not extend to income taxed under Schedule D Case VI the very way that chargeable gains under life insurance policies and capital redemption policies are taxed.

Thus, on encashment of such a policy, assuming the charity is constituted as a trust, a tax liability could arise which could have been avoided by the use of more suitable investments. This tax liability will be at the rate of 20 per cent for 2005/06 and thus, for a UK policy, there will be no further tax to pay. For an offshore policy, tax at 20 per cent will be payable on the gain.

It can be seen that investment in a life insurance policy or capital redemption policy will be a highly inappropriate investment for a charitable trust to make.

Let us now consider alternatives. Mutual fund investments such as unit trusts and Oeics are permissible investments for charities under Schedule 20 ICTA 1988.

However, trustees should bear in mind that since April 6, 1999, charities, along with other non-taxpaying shareholders, have not been able to reclaim the notional 10 per cent tax credit on UK divid- end income. Charitable trusts may therefore wish to consider investment in unit trusts or Oeics where the emphasis is on capital growth and which pay no income, so that they can realise units or shares to provide the income they require.

As described earlier, charities are exempt from any charge to capital gains tax as long as the amounts received are applied for charitable purposes. In particular, a fund of funds unit trust may be attractive in order to gain access to a large spread of funds without the need for and the costs of constant buying and selling by the trustees.

Charitable trustees, like all other trustees, will be looking for advice and guidance in the future. The life insurance policy or capital redemption policy route remains highly unsuitable but capital growth-orientated unit trusts or Oeics might well be an attractive option for trustees.

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