Last month we considered the key tax changes
taking effect from 6 April 2016 and how they affect trustees of the
various types of trust.
To recap, these changes are:
- the introduction of the personal savings allowance (PSA) and
- gross payments of interest from banks and building societies
- the new dividend tax rates;
- the abolition of the dividend tax credits; and
- the reduction in the CGT rates.
Having reviewed the tax and legal fundamentals, this month we
will look at some specific investment strategies for trustees
depending on the type of trust under consideration.
For most private trusts the investment choice will usually be
between collectives and investment (insurance) bonds (simply called
"bonds" in the rest of this article). So let's first remind
ourselves of the key features of each type of investment in the
context of trustee investments.
Bonds as trustee investments
- As these are non-income producing the administration is simple
as there are no ongoing tax liabilities for the trustees and no tax
returns are required until a chargeable event gain arises.
- There is no tax on fund switches or on beneficiaries becoming
absolutely entitled to the trust assets.
- Trustees pay income tax at 25% on onshore bond gains (45% trust
rate less 20% tax credit) and at 45% on offshore bond gains.
- If the trustees are taxed, they can offset the standard rate
band against offshore bond gains.
- They offer the facility to take regular tax-deferred
withdrawals of capital (up to 5% of the original investment each
year for 20 years) which can be distributed to beneficiaries to
supplement income without being taxed as income.
- They may be particularly appropriate for trusts (especially
discretionary trusts) where income and capital gains are to be
accumulated and would otherwise bear tax.
- An assignment of the bond or segments of a bond to a
beneficiary is not a chargeable event, providing the possibility
for tax-effective encashment for the beneficiary who pays tax at a
lower rate than the trustees, with the potential to use the
beneficiary's personal savings allowance (PSA).
Whilst the above could be described as the benefits of bonds for
trustees, there are, of course, also significant drawbacks,
- As the bonds are not subject to CGT, this means there is no
scope to use either the beneficiary's or trustees' annual CGT
exemption or the 20% or 10% tax rate on gains.
- There is no scope to use a beneficiary's dividend
- Bonds are generally not suitable where natural income is
UK collectives as trustee investments
- These provide scope to use the beneficiaries' personal
allowance as well as the PSA (for interest distributions) and
dividend allowance (for dividends) on an arising basis if the trust
is a bare trust or an interest in possession trust (subject to the
parental settlement rules). The position here has improved post 5
April 2016 with the introduction of the PSA and the dividend
allowance and gross interest and dividend payments.
- There is also scope to use the trustees' annual CGT exemption
and 20% CGT rate (except for residential property that is not the
beneficiary's principal private residence where the rate continues
- It is generally easier to strike a balance between capital and
- Trustees of discretionary trusts benefit from the standard rate
income tax band.
The main downside of collectives is the extra administration,
ongoing tax returns and need to account for income tax and CGT
whenever income or gains arise.
So, how are trustee investment choices influenced by the tax
changes which took effect last April? The answer will depend on the
type of trust. In what follows we ignore settlor-interested
With a bare trust, the beneficiary is taxed as if the trust did
not exist, except where the parental settlement rules apply.
For a non-parental trust therefore the tax considerations would
be the same as if you were looking at a direct investment by an
For dividends, as a rule of thumb, when the dividends would fall
within the tax free dividend allowance (i.e. an investor's total
dividends in a tax year do not exceed £5,000) there can be no
income tax benefit in holding the equities producing the dividends
inside a bond. Above that level, though, the tax rates have
increased by 7.5% and so the tax deferment qualities of aUKor
offshore bond might then start to look attractive.
In relation to capital growth, the CGT annual exemption and a
tax rate of 10% or 20% outside of the bond will make it hard to
argue a case for the tax deferment qualities of an onshore bond
unless the investor has used their annual CGT exemption, is a
higher rate taxpayer and the life company concerned reserves for
tax on realised (or deemed realised) capital gains at a rate
substantially lower than 20%.
In short, for a bare trust, unless the dividends exceed £5,000
per annum and capital gains exceed the annual exempt amount, the
tax case for an investment bond may be hard to make.
Interest in possession trusts
Given that income under these trusts is taxed on the beneficiary
entitled to it and it retains its character, that is interest and
dividends are taxed as such, the beneficiary will be able to offset
their personal allowance, as well as the PSA and dividend
allowance, against any income they are entitled to under the trust.
The trustees will have their own annual CGT exemption and the
reduced CGT rate(s). This puts these trusts in a similar position
to bare trusts as far as the choice of investments is concerned,
i.e. on a purely tax basis it would be difficult to recommend
One more issue to consider for trustees of these trusts is the
need to make tax returns and pay tax at the basic rates (20% on
interest and 7.5% on dividends) on any income that they actually
receive. This is something the trustees of these trusts have not
had to do until now when interest and dividends were paid with tax
credits which franked the basic rate. As we know, as a
concession for tax year 2016/17 the trustees do not need to report
any savings income if the total tax liability would be £100 or
If the trustees wish to avoid having to make returns and pay tax
they can ensure that any income is mandated to the beneficiary,
i.e. paid directly into the beneficiary's bank account. This
shouldn't be a problem in principle unless the trustees need some
of the income to cover their expenses and so prefer to actually
receive the income in their own bank account.
Here the position is a little more complex as the trustees do
not benefit from the PSA or dividend allowance; and even if trust
income is distributed to a beneficiary, it will be taxed on the
beneficiary as "trust income", and not as dividend income or
interest, regardless of its source. Indeed, because of the complex
way that income distributions are dealt with, e.g. requiring
any distribution to be made with a tax credit of 45%, which
in practice is likely to require some additional tax to be paid by
the trustees , income distributions from discretionary trusts
are often too complicated to administer and will often be avoided.
Investment in accumulation units or investment in a bond with a
view to a possible advancement of capital may often be more
attractive as long as no exit charges are incurred for IHT purposes
when such advancements take place. Of course, an investment in
accumulation units will still mean tax returns and income tax
liabilities, although only at the rate of 38.1% on dividends (7.5%
within the standard rate band).
So, with discretionary trusts, we have finally arrived at a
point where bonds may well offer an advantage over collectives,
especially where a part of the funds is invested in other funds so
that the trustees can also take advantage of their annual CGT
exemption and the lower CGT rate.
The changes in the tax rates and the recent start to the new tax
year should provide a good opportunity to contact all "trustee
clients" with a view to reviewing trust investments. At the very
least the trustees will need to be made aware of the new tax rates
and existing trust investments should be reviewed taking account of
the new rules. There is clearly plenty to talk about.