In part one of this two-part article, which looks at the opportunities for investing for children, we looked at the background to investing for children and at investments which can be held in the name of a child.
In part two we will look at how investments which cannot directly be held in a child’s name can be arranged and used for the child’s benefit, and the general tax implications for holding investments in that way.
The tax rules briefly described in part one of this two-part article mean that there are opportunities to take advantage of a child’s personal allowances and capital gains tax (CGT) annual exemption when investing for children. However, when parents make gifts for the benefit of their own minor unmarried children, not in a civil partnership, greater care is needed in finding a tax-effective solution given the anti-avoidance rules that exist (where income generated from parental gifts to a minor unmarried child not in a civil partnership, on all gifts from the same parent, exceeds £100 gross in a tax year it will be assessed to income tax on the donor parent– the so-called “£100 rule”).
- ARRANGING INVESTMENTS FOR THE BENEFIT OF A CHILD
There are basically three ways in which investments can be arranged for the benefit of a child:
(a) The investor notionally earmarks the investment for a child’s benefit.
(b) The investor creates a trust for the benefit of a child.
(c) The investor designates an investment for the benefit of a child – although the legal and tax effects of this will depend on the domicile of the investor (the rules in Scotland are different from the rest of the UK).
We will now look at each of these ways in more detail:
The investor makes an investment in their own name. The legal and beneficial ownership of the investment will remain with the investor who will, in their own mind, notionally earmark the investment for a particular child/children. At some future date of the investor’s choosing the investor can transfer the investment to the child, say on the child attaining age 18 or when a specific financial need arises such as the child needing a deposit to buy a house. Alternatively, the investor could encash part of the investment periodically and use the cash to benefit the child.
Regardless of which type of investment is made, the tax implications would be as follows:-
(i) Any income and capital gains will be assessed to tax on the investor.
(ii) As the investment remains in the ownership of the investor there are no inheritance tax issues when the investment is made.
(iii) If the investment is later transferred into the child’s name, this could give rise to a disposal for CGT purposes. There could also be income tax implications, e.g. if the investment consists of shares/units in an offshore non-reporting fund.
(iv) If the investment is a single premium investment bond which is later assigned to a child this would not give rise to a chargeable event at that time.
(v) If the investment, or cash representing it, is later transferred this will be a potentially exempt transfer for inheritance tax (IHT) purposes. No IHT would arise on the gift if the donor survives the gift by 7 years.
The drawbacks to earmarking are as follows:
- No use is made of the child’s personal income tax allowances and annual CGT exemption.
- On future sale, transfer or assignment of the investment there could be a CGT (or income tax) charge.
- If the investment has grown in value since purchase, and it is assigned to the child, the transfer of value for IHT purposes will be the increased value, not the original purchase price as would be the case if the investment had been gifted to the child at the outset – see (b) below.
The advantages of earmarking are that:
- The investor retains full control of the investment and is under no obligation to use it to benefit the child.
- As the earmarking is only notional, any child can be selected to benefit and, indeed, during the course of the investment the investor may change their mind over who benefits.
- No formalities are required until the point at which the child is to benefit.
(b) Using a trust
Although children can own certain assets in their own name this is not usually recommended because they would not be able to validly deal with the investment, e.g. realise all or part of it, or change the investment or funds to which it is linked, until they attain age 18 (age 16 in Scotland).
As a result of this, in most cases when investments are gifted to children a trust would need to be used. Use of a trust has the merit that it can restrict the access of the beneficiary and the investor retains control over the investments in the trust via the trustees of whom they will usually be one.
Trusts can take many different forms, but normally fall within one of the following three types when used to provide benefits for children.
(i) Absolute (Bare) trust
Here both capital and income are held by the trustees for the absolute benefit of the beneficiary (the child). This means that, irrespective of age, the beneficiary is entitled to both the capital and income of the trust.
A feature of this type of trust, though, is that the beneficiaries must be named and their shares specified at outset, with no scope to make any changes in the future. Therefore, the absolute trust is totally inflexible.
The benefits of such a trust are that income and capital gains will be assessed to tax on the child unless the “£100 rule” applies – see above, and the gift into trust will be a potentially exempt transfer for IHT purposes.
The drawbacks to such a trust are that it is inflexible (see above) and the beneficiary can gain access to the trust fund at age 18 (age 16 in Scotland). In common with the other types of trust, for the trust to be tax effective the investor must not be able to benefit under the trust in any way, shape or form.
(ii) Discretionary trust
Under a discretionary trust, the names or classes of person who are potentially to benefit are set out in the trust document. A discretionary trust gives the trustees total discretion as to the use of capital and the distribution of income between these beneficiaries. This means that until the trustees exercise their discretion to distribute or appoint benefits no beneficiary has the right to income or capital.
Income of the trust is assessed to tax on the trustees at 45% (38.1% for dividends) but tax on the first £1,000 of income is charged at 20% (7.5% for dividends). If the settlor (investor) has created more than one such trust the £1,000 limit is reduced proportionately for each trust but can never be less than £200 per trust. If the income is then paid out to a beneficiary it will be taxed as trust income of that beneficiary with the beneficiary normally getting some benefit for the tax already paid by the trustees.
If the investor and/or their spouse can benefit under the trust then all of the income is effectively assessed to tax on the settlor under what is then known as “a settlor-interested trust”.
Capital gains will be assessed to tax on the trustees, normally at 20% after deduction of their annual exempt amount (normally £5,850, although this amount is also reduced proportionately for each trust created by the same settlor subject to a minimum of £1,170 per trust), and the transfer into the trust will be treated as a chargeable transfer for IHT purposes. IHT exit and ten-yearly periodic charges could arise under the trust.
(iii) Interest in possession trust
Under this type of trust, a named beneficiary has an immediate entitlement to any income produced by the trust assets as and when that income arises. Such a trust is used when the investor wishes a beneficiary to have the guaranteed use of income during their lifetime but does not want the beneficiary to have outright access to the capital. The beneficiaries entitled to the capital are named in the trust.
Under a flexible trust (an interest in possession trust which gives an appointor (the trustees or the investor as the settlor) a power to appoint capital and income) the appointor would have the power to appoint the trust capital and/or future income to other “potential” beneficiaries.
The income arising to such a trust, whether it is paid out to the beneficiary or accumulated in the trust, is assessed to tax on the beneficiary. Technically, the trustees are liable to basic rate tax on the income and the beneficiary is liable to higher/additional rate tax if applicable. If the beneficiary is a non-taxpayer, the tax paid by the trustees can be reclaimed. The trustees' liability can be avoided if all the trust income is paid directly to the beneficiary who is entitled to it.
The CGT position under this type of trust is the same as for a discretionary trust (see above), as is the IHT position for such lifetime trusts created on or after 22 March 2006. If the investor and/or their spouse can benefit then the trust will be a settlor-interested trust – see (ii) above.
(c) Designated accounts
Stocks and shares and collective investments (i.e. unit trusts, OEICs and investment trusts) are sometimes held by way of a designated account. A designated account enables investments to be bought by an adult (such as a parent, guardian or grandparent) and the investments are designated in the name of the child. When the investment is made, on the application form the investor states the initials of the designated person (the child) or identifies the designated person in some other way e.g. X (investor) for the account of Y (the child).
Under English law, and if there is nothing to the contrary stated, such an arrangement will normally constitute a bare trust under which the investor i.e. the purchaser of the shares/units, will be the trustee and the beneficiary (beneficial owner) will be the designated child. It is essential that it is intended that beneficial ownership is vested in the child. For example, if grandfather designates an account for a grandchild and grandfather enjoys any income generated on that account then a bare trust would not exist. In the HMRC Capital Gains Tax Manual at CG11730 it is stated that ‘it is the beneficial ownership (not legal ownership) which the tax principally follows. In its Trusts, Settlements and Estates Manual at TSEM 9150 HMRC clearly recognises that legal and beneficial ownership can be separate – for example where property is held in the name ‘A as nominee for B’, A is a bare trustee, and A is the legal owner and B is the beneficial owner. Because there is no formal trust (and so no specific provisions), the trust will be governed totally by the Trustee Act 1925 and the Trustee Act 2000.
From a tax standpoint, the designated account should enjoy the same tax treatment as an absolute (bare) trust – see 3(b)(i) above. This treatment is supported by the following.
- An earlier HMRC Guidance Note ‘Savings Income From UK Authorised Investment Funds (UK Authorised Unit Trusts (AUTs) and Open Ended Investment Companies (OEICs)’, included the following comment:‘Many UK AIFs allow children to hold units or shares in a designated account. This simply means that the units or shares are held in the name of the parent or guardian but designated with the child’s initials. The units or shares and any income still belong to the child. The £100 rule for savings income applies’.
- In private correspondence, HMRC has confirmed that a gift into a designated account will be treated as a PET. In particular, one letter confirmed the following:‘Thus the usual situation would be that when parents or grandparents purchase unit trusts on behalf of their children/grandchildren that such would be held on bare trust (either implied or constructive). So in most cases such a purchase would be a PET. I say in most cases because, as you are aware, every case must be judged on the facts at the time’.
For absolute certainty as to the tax treatment individual investors should ideally complete a written declaration of intent (a simple signed and dated letter will suffice) or execute a formal express absolute (bare) trust – see 3(b)(i) above.
It should be noted that some investment application forms (or surrounding literature), particularly in Scotland, state that a designation of a beneficiary on the application form does not create a bare trust. In such a case, unless there is separate written evidence of an express trust, no trust will exist.
The reason why designations don't work in Scotland in the same way as in England is that Scots law does not distinguish between legal and beneficial ownership.
The advantages of a designated account over an absolute trust are:
(i) It is simple to set up and there is no need to inform HMRC of its existence.
(ii) There are no legal fees.
(iii) No tax returns are required (subject to the £100 rule) until such time as income/capital gains result in a tax charge on a beneficiary.
The disadvantages of a designated account compared with an absolute trust are:
(i) A designated account is generally only suited to holding stocks and shares and collectives.
(ii) The trustees will lack the authority to apply the investments in a certain way – for example school fees provision.
- For investments falling under heading 3(a), income tax and capital gains will be taxed on the investor.
- For investments falling under heading 3(b), the beneficiary or trustees can be taxed on income and capital gains, depending on the circumstances. If the “£100 parental settlor rule” applies income will be taxed on the parent.
- For investments falling under heading 3(c), income tax and capital gains will be taxed on the child unless the “£100 parental settlor rule” applies (for income).