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Trust investments in tax year 2016/17

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 dividend allowance;
  • gross payments of interest from banks and building societies and NS&I;
  • 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, namely:

  • 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 allowance.
  • Bonds are generally not suitable where natural income is required.

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 at 28%).
  • It is generally easier to strike a balance between capital and income.
  • 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 trusts.

Bare trusts

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 individual.

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 a bond.

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 less.

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.

Discretionary trusts

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.