Get it right first time

  • Author : Julian Frere
  • Date : April 2012
ABOUT THE AUTHOR: Julian Frere is a Senior Financial Planner of the Professional Planning Services team at AWD Chase de Vere in Bath, UK

Lay and professional trustees have a great deal to consider when fulfilling the duties set out in the trust deed. One area that isn’t always given the required care and attention is setting an appropriate investment strategy. A key part of this is selecting the right investment structures, which typically means the use of collective funds such as unit trusts or open-ended investment companies (OEICs); directly held investments such as equities, corporate bonds and gilts; and investment bonds, both onshore and offshore. Potentially, all these play a role, given the trust’s objectives and appetite for risk. And getting the investment structure right from the outset can ensure tax efficiency during a trust’s lifetime. It can also mean trust assets are distributed in the most tax-efficient way, there are appropriate costs and that reporting requirements are kept to a minimum.

Tax benefits

Unit trusts/OEICs and directly held investments are, in most cases, income producing and attract capital gains. For an interest in possession trust, any income generated can be used against the beneficiary’s personal income allowance. This is also the case for discretionary trusts, although the trustees must direct the income to the beneficiary who effectively reclaims tax paid by the trustees. If, however, the unit trusts generate income within the discretionary trust, the trustees have a standard-rate tax band of GBP1,000 available to use, where income is taxed at either 10 per cent or 20 per cent. For any capital gains generated on the investments, the trustees can use their annual capital gains tax (CGT) exemption. However, unit trusts carry the disadvantage that if income exceeds the GBP1,000 standard rate tax band or cannot be distributed, there is no escaping or deferring additional rates of tax at 50 per cent or 42.5 per cent. These must be accounted for, and tax returns are required.

‘Investment bonds have several advantages, but growth isn’t tax free’

On the other hand, investment bonds are non-income producing investments. This means that any income generated will not be immediately assessable to income tax, which effectively allows the trustees to defer tax to the point of surrender and affords them the control over who is best placed to carry the tax liability in the most tax efficient way at that time. Investment bonds can also allow the trustees to distribute up to 5 per cent of the original investment amount each year without triggering an immediate income tax liability, which means annual tax returns are not necessary and makes them easier to administer. Investment changes can also be made without triggering a liability to CGT for the trustees.

While investment bonds have several advantages, they do not generate capital gains, which can be used against the trustee’s annual CGT exemption. This means any growth on the portfolio isn’t tax free even if it falls within the annual CGT exemption.

Onshore bonds pay corporation tax internally on income and capital gains equivalent to the basic rate, while offshore bonds can benefit from gross roll-up. Although an offshore bond may look preferable, it is important to consider the likely term of the investment as it needs to be held for the long term to reap the benefits of gross roll-up. Not all assets will benefit from this, though. Equities, for example, may be subject to withholding taxes, and capital held within an offshore bond doesn’t have the same Financial Services Compensation Scheme protection as their onshore equivalents and often the costs associated with this type of vehicle are higher.

Investment solutions

Mainly, there will be a requirement for the interest in possession trust to distribute the natural income from the trust assets and, therefore, unit trusts should be used. Although investment bonds can make distributions of up to 5 per cent per annum, these distributions are considered a return of capital and not income. Therefore, investment bonds are not appropriate for trusts where a real or natural income is required.

There are instances where the interest in possession trust deed will have considerable flexibility over the amount and frequency of the income to be distributed. In these situations it will be important to balance the life tenant’s actual need for income and the capital growth potential of the portfolio. When a life tenant has sufficient income from other sources, it may be beneficial to target a more growth-focused strategy for the portfolio, which then generates a low natural yield. However, careful consideration is needed to find the balance between yield and risk.

Discretionary trusts have more flexibility over the choice of investment structure. From a pure tax efficiency perspective, where the flexibility allows, trusts should gear a portfolio for capital growth by using investment structures such as unit trusts that generate capital gains that can be used against the trust’s annual CGT allowance. Gearing a discretionary trust portfolio in this way enables the trust to capture growth, of which at least GBP5,300 will be tax-free each year, if the settlor hasn’t established other trusts. Further, any residual gains in excess of the annual allowance will be taxed at 28 per cent, which compares favourably to the trustees’ rate of income tax. However, structuring a portfolio in this way should be treated with caution and care must be taken to ensure the overall risk of the portfolio remains in keeping with the trust’s objectives.

Cautious approach

Problems could arise when a growth-focused strategy has a cautious approach to investment risk. In these circumstances, it is likely the portfolio will hold high-yielding securities that generate relatively high levels of natural income. These portfolios tend to have lower growth potential and, therefore, the benefit of the CGT allowance is possibly reduced. Also, the higher level of income, if over the standard-rate tax band, will be taxed at the trustee rate of 50 per cent or 42.5 per cent if not distributed out of the trust, which will reduce the benefit of holding unit trusts. In a low-growth, high-yield environment it may be more advantageous to hold the trust capital within an investment bond where income is not immediately taxable and can be reinvested.

‘It is often worth using a combination of unit trusts and investment bonds’

Although capital growth is preferable, if there is the flexibility and the need to distribute income, the trustees could do so by paying the income directly to non- or basic-rate taxpaying beneficiaries. While the trustees will incur income tax at the trustee rate, the beneficiaries can reclaim this to the extent of their income tax rates. Unit trusts are again ideal for this type of planning and where the need for income exists. Also remember that if the trust objectives change, for example if there is no longer a need for income, it is possible to change from unit trusts to investment bonds, where the income will not be assessable. It may also be possible to appoint a ‘right to income’ by effectively creating an interest in possession trust and benefit from a potentially lower rate of income tax, although this is not applicable to settlor-interested trusts.

Where the trustees wish to target a cautious approach to investment risk and benefit from a generous natural yield that does not need to be distributed, or it is believed that growth can be better achieved through reinvesting income, an investment bond is a suitable investment structure. Investment bonds offer an effective way of deferring tax up to the point of surrender. If encashed within a discretionary trust, any chargeable gain will be subject to income tax at the rate applicable to trusts, but it is possible to assign all or part of an investment bond out of the trust and make the encashment in the hands of a beneficiary who may have a more favourable rate of personal income tax. Generally there is no chargeable event on making the assignment, so this can be a valid and useful planning tool.

Given the flexibility trustees have within a discretionary trust to choose the type of investment structure to fit the trust’s objectives, it is often worth using a combination of unit trusts and investment bonds. When choosing to use an investment bond, care should be taken to ensure it is formed to your best advantage and to avoid future administration problems. Considerations may include the number of policy segments used at outset and who should be the lives assured.

As circumstances around trusts are often dynamic and changeable, trustees should ensure their investment portfolios, especially if using investment bonds, are open architecture and transparent in terms of charges. While each trust must be taken on its own merits, objectives and approach to risk, there are some common features of discretionary trusts and interest in possession trusts that better suit certain investment structures. The emphasis has to be on getting the investment structure correct first time, which will save tax, costs and administration for the trustees.


Article Search

Browse jurisdictions by clicking on the map regions below

© 2012 Society of Trust & Estate Practitioners