In this issue, John Woolley looks at tax-effective investment strategies
Trustees of discretionary trusts currently pay income tax at the highest rate that applies to individuals.
This high level of trustee taxation and the recent changes in the tax rules on dividend income and savings interest clearly have an impact on the investment decisions that trustees will need to make because, as is well known, tax efficiency can considerably affect the net returns available for trustees and beneficiaries.
This article looks at the impact of these changes on trustees’ investment strategies as well as some of the important legal aspects of trustee investment.
1 Trust investments – the legal requirements
The Trustee Act (TA) 2000 governs the statutory investment duties of trustees in England and Wales. There are equivalent provisions in Northern Ireland and in Scotland.
Before the TA 2000, trustees only had complete control over trust investments if the trust deed gave them unfettered powers of investment. Now, by virtue of section 3 (and equivalent legislation in Scotland and Northern Ireland) and, subject to satisfying the conditions in 1.2, 1.3 and 1.4 below, trustees are given a general power of investment, which permits them to make investments of any kind.
1.2 Duty of care
Unless the trust deed states otherwise, the exercise of the investment powers by a trustee will usually be subject to the statutory duty of care. (section 1, TA 2000). This means that a trustee must exercise such care and skill as is reasonable in the circumstances, having regard in particular to any special knowledge or experience that he or she has or holds himself or herself out as having; and if he or she acts as trustee in the course of a business or profession, to any special knowledge or experience that it is reasonable to expect of a person acting in the course of that kind of business or profession. The statutory duty of care therefore takes account of the circumstances of a particular trustee.
This statutory duty of care can be overridden by the trust document. However, even if there is a specific exclusion of the statutory duty of care, the trustees will then be subject to the common law duty of care, which sets the test of prudence rather than reasonableness (see Re Whitely (1886) 33 ChD 347).
Income generated from an interest in possession trust will be taxed on the beneficiary entitled as savings income or dividend income, according to its source
1.3 Diversification and suitability
When exercising powers of investment (statutory or otherwise) trustees of all trusts, whenever created, must have regard to diversification and suitability of the proposed investments to the trust. These are known as the ‘standard investment criteria’ (section 4, TA) 2000.
The requirement to consider ‘diversification’ of the trust fund means that, where appropriate, the trustees should use a spread of investments. The requirement can be modified by words in the trust deed.
It is important to appreciate that the requirement to consider the need for diversification does not mean an obligation to diversify trust assets. Clearly, it will depend on the circumstances whether diversification is appropriate. If a trust fund is created with cash, it will usually be appropriate when making investments to diversify the investments in line with modern portfolio theory. On the other hand, where a trust has been created with a particular investment in mind or a specific investment has been transferred into trust, perhaps because of desired tax consequences, it may well not be appropriate to diversify.
‘Suitability’ relates both to the kind of investment proposed and to the particular investment as an investment of that kind. It includes considerations as to the size and risk of the investment and the need to strike an appropriate balance between income and capital growth to meet the needs of the trust. It also includes any relevant ethical considerations.
There is a further requirement for the trustees to keep the investments of the trust under review and to consider whether, in light of the standard investment criteria, they should be varied. There is no fixed period after which a review should take place; instead TA 2000 refers to reviews being carried out “from time to time”. In practice, trustees ought to review the investments at least every time they receive an annual statement.
1.4 Obtaining and considering proper advice
Under section 5 of TA 2000, the trustees must, in general, obtain and consider "proper advice" before exercising their power of investment, as well as when reviewing the investments of the trust.
For these purposes, proper advice would be the advice of a person whom the trustees reasonably believe to be qualified to give it by their ability in, and practical experience of, financial and other matters relating to the proposed investment. Provided that the trustees can show they have sought appropriate professional advice and otherwise acted in accordance with the provisions of the trust, they are unlikely to be found liable for any breach of trust.
This is illustrated by the case of Daniel v Tee 2016 (EWHC 1538 (Ch), where two beneficiaries of a Will trust sued the trustees of the trust for losses resulting from allegedly bad investment decisions. The court found that the trustees, having obtained proper investment advice from a financial adviser, had acted reasonably and fulfilled their duty under the TA 2000.
Capital gains on investments that exceed the annual exemption will only be taxed at 20% as compared to the current income tax top rate of 45%…
It is, however, important to note that even where the trustees instruct a professional, such as a financial adviser, to advise them on investments, this does not absolve them from taking an active part in making decisions.
Any investment advice taken should take account of all the relevant factors including:
- Whether the trustees need to generate income, capital growth or both in order to satisfy the needs of the beneficiaries;
- The timeframe for the payment of benefits – so, for example, if benefits need to be paid out in the near future, speculative investments would not be appropriate, whereas if the trust fund were to be invested for a child/grandchild to vest entitlement at age 25 over, say, a 12-year timeframe, some equity holdings would be appropriate; and
- The tax treatment of the trust – clearly, if investments can be made in such a way as to improve the tax efficiency of the investment, this will improve the investment returns for the trustees/beneficiaries.
2 The taxation of trust investments
2.1 Income tax
The income tax treatment will depend on the type of trust in question as described below. In what follows, it should be remembered that certain anti-avoidance rules will charge income tax on the settlor, where the settlor or settlor’s spouse can benefit under the trust (a settlor-interested trust) or the ‘£100 rule’ applies (the settlor’s minor unmarried child is entitled to income and more than £100 income arises under the trust).
2.1.1 Interest in possession trusts
Income of these trusts will be, in general, taxed on the beneficiary entitled to income. However, the trustees must first have paid (or be deemed to have paid) basic rate tax. As UK dividends are no longer paid with a tax credit, and interest is no longer paid net of tax deducted at source, this means that the trustees have a 7.5% liability on dividend income and a 20% liability on income from other sources in 2018/19. In calculating the beneficiary’s tax charge on the trust income, the beneficiary will get a credit for tax paid by the trustees.
2.1.2 Discretionary/accumulation and maintenance trusts
(a) Standard rate tax band
Trustees of discretionary trusts have a standard rate tax band of £1,000, which is sub-divided by the number of trusts – up to a maximum of five – created by the same settlor. Income falling within the standard rate band is taxed at basic rate (7.5% for dividends and 20% for other sources of income). Trustees are not entitled to a personal savings allowance or the dividend tax allowance.
It should be noted that income can be accumulated within the trust and added to capital, or it can be distributed as income. Whether trust income should be distributed or accumulated and later paid out will depend on the tax position of the beneficiary (and whether the £100 rule or the ‘settlor-interested trust’ rules apply).
(b) Trust rates of tax
Income in excess of the standard rate band of £1,000 is, in 2018/19, taxed at 38.1% (if dividend income) and 45% (if other income).
It is important to bear in mind that where trustees distribute income to a beneficiary, they will be deemed to have paid 45% income tax on the income. In the case of dividend income above the standard rate band, the trustees will therefore need to make a further tax payment of 6.9% of the dividend (45% less 38.1%). When the net income is distributed, the beneficiary will receive a credit for earlier tax paid by the trustees in determining their tax liability and this may well result in a repayment of tax. Any tax repayment to the settlor must be paid back to the trustees. Different rules apply to settlor-interested trusts.
It should be noted that the 10% tax credit that accompanied dividends received by trustees for tax years up to and including 2015/2016 did not form part of the trustees’ tax pool and cannot be ‘flowed’ through to beneficiaries receiving income from the trust.
2.2 Capital gains tax (CGT)
The CGT rate paid by trustees is 20% (but 28% on gains linked to residential property), regardless of the level of other income or gains of the trust.
In most cases, the trustees will only be entitled to an annual CGT exemption that is equal to 50% of the exemption for an individual (£5,850 in 2018/2019 and £6,000 in 2019/2020). The exemption is subdivided by the number of trusts created by the same settlor – see 3.2.
So, in light of the current tax rules, where should trustees be investing? Well, this will depend, at least to a degree, on whether the trust in question is an interest in possession trust or a discretionary trust.
3.1 Interest in possession trust
Although there are various types of interest in possession trust – a fixed interest in possession and a power of appointment flexible interest in possession (frequently called a ‘flexible trust’) – the essence of an interest in possession trust is that a beneficiary (the life tenant) is entitled to the income of the trust fund.
With a fixed interest in possession trust, a person (the life tenant) will be entitled to the trust income, while on his or her death other beneficiaries (the remaindermen or residuary beneficiaries) will be entitled to capital (for example, to my son Bob for life and then to Bob’s children in equal shares). With these trusts, the trustees may or may not have a power to advance capital to the life tenant.
Other flexible interest in possession trusts give the trustees power to appoint capital or income to a range of beneficiaries and, in the absence of any appointment, named default beneficiaries will be entitled to income.
Income generated from an interest in possession trust will be taxed on the beneficiary entitled as savings income or dividend income, according to its source. The beneficiary may therefore be able to use the personal savings allowance or dividend allowance (as appropriate) to reduce tax on the income received from the trust.
For fixed interest in possession trusts, the trustees will usually need to invest in such a way as to produce a reasonable level of income with a reasonable prospect for capital growth. In this way, the needs of both the life tenant (to income) and the remaindermen (to capital) can be satisfied. The choice therefore is to invest the whole trust fund in investments that produce a reasonable balance of income/capital growth – for example collective investments (unit trusts/open-ended investment companies, etc) that distribute income – or to invest a part of the trust fund with a view to generating a high level of income, and a part to produce the prospect for a high level of capital growth.
It is important to note that trustees will only be able to pay capital – such as withdrawals from single premium bonds – to a life tenant if the trust deed contains a specific power enabling them to do so. If the idea is to make such payments on a regular basis, it will be essential that the payments are properly documented as capital appointments or advancements so as to avoid any possibility of them being taxed as income in the hands of the life tenant. This could be a particular issue if the trust deed gives the trustees specific power to appoint capital to top up the life tenant’s income entitlement [see Stevenson v Wishart 1987].
Where there is no power to pay or appoint capital to the life tenant, the trustees will be in breach of trust if such payments are made.
3.2 Discretionary/accumulation and maintenance trusts
The trustees of a discretionary trust could consider the following investment strategies:
3.2.1 Invest for capital growth
It makes tax sense for trustees to consider investing for capital growth rather than income. In this way, the trustees will be able to use their annual CGT exemption against capital gains that arise on a later disposal. Currently, this is £5,850 (£6,000 in 2019/2020) where the settlor of the trust has only established one trust since 7 June 1978. Where more than one trust has been established, the exemption available is divided by the number of trusts (and it should be borne in mind that trusts of non-CGT chargeable assets, such as life policies, also count for this purpose, but not bare trusts or trusts of registered pension plans). However, the trustee annual CGT exemption will never be less than £1,170 (one 10th of the full individual exemption [£11,700 in 2018/19] or £1,200 in 2019/20).
Capital gains on investments that exceed the annual exempt amount will only be taxed at 20% as compared to the current income tax top rate of 45%/38.1% that can apply on income. However, overemphasis on capital growth (as opposed to income - producing portfolios) could introduce a greater level of risk and this needs to be carefully weighed against the tax arguments in favour of growth. There is a clear need for financial advice in this area.
- Distribute income to beneficiaries The trustees could consider distributing income to beneficiaries. The income will be taxed as ‘trust income’ in the hands of the beneficiaries, so they could not use their personal savings allowance or dividend allowance against the income. However, depending on their tax position, they could recover some or all of the tax paid by the trustees. If trust income (by anti-avoidance provisions) is assessed on the settlor, this may also mean a lower tax rate being borne. Where the trustees are certain who should benefit regularly from trust income, it may even be worth considering appointing an interest in possession (right to income) to that beneficiary.
Whether this is possible will depend on the terms of the trust, and there are a number of tax issues that will need to be considered.
3.2.3 Invest in tax-efficient investments
The trustees could consider investing in more tax-efficient (potentially tax-deferring) investments such as single premium bonds.
3.2.4 Advantages of single premium bonds
Income that arises inside a UK insurance company’s investment fund will suffer a lower rate of tax (or nil rate of tax) in the hands of the insurance company than income received by the trustees from directly-held investments.
For example, savings income and rental income suffer 20% tax within a UK life fund, which is lower than the current 45% rate that could apply to direct investments held by a trust. UK dividend income currently suffers no tax within the UK life fund, whereas dividend income from directly-held investments can suffer income tax of up to 38.1%, whether it is reinvested or not.
On encashment of the bond by the trustees, any chargeable event gains will be charged to income tax on either the settlor or the trustees but, either way, there will be a 20% tax credit for internal tax suffered within the UK life fund, so the maximum rate paid by the trustees will be 25% on the realised gains under a UK bond. If the chargeable event gains are taxed on the settlor, the rate of income tax will depend on the settlor’s other taxable income.
Under an offshore bond, other than any unreclaimable withholding tax, there will usually be no tax on underlying income and gains within the life company’s funds. However, there will be no tax credit on chargeable event gains on encashment, so the income tax charge will normally be 45% to the extent chargeable event gains exceed the standard rate band (which also applies to interest in possession trusts in cases where chargeable event gains arise).
Whether an offshore or UK bond will offer the most tax-effective solution will depend on the circumstances, including the composition of the underlying fund and the likely investment term of the bond. Whether a bond is more appropriate and tax effective than a collective investment will, all other things being equal, frequently depend on the composition of the underlying portfolio.
3.2.5 Tax-efficient encashment strategies for bonds
A UK or offshore bond can offer scope for tax-efficient accumulation of investment income, with scope to adjust the assets of the underlying investment fund by switching between funds of the provider with no tax implications. Furthermore, should the trustees need to distribute cash to a beneficiary, they can access the bond by making use of their annual 5% tax-deferred withdrawal allowance. This is, in effect, tax deferment.
If trustees are considering encashing a bond to make a payment to a ‘low-tax’ beneficiary, they could consider making an assignment to that non-taxpaying or basic rate-taxpaying adult beneficiary before the bond is finally encashed. No chargeable event will arise on this assignment and, hopefully, a lower tax bill will result on final encashment, at which point the beneficiary will be assessed to tax (with the benefit of top-slicing relief where relevant).
Alternatively, where the beneficiary is a minor, an absolute irrevocable appointment of benefits under the trust to that minor prior to encashment may be appropriate. Any subsequent chargeable event gain made by the trustees will then be taxed on the minor beneficiary as absolute beneficial owner (unless the minor beneficiary is a child of the settlor, when the £100 rule might apply – see 2.1).
3.2.6 Drawbacks of single premium bonds
Single premium bonds will not be so tax attractive where trustees wish to make regular use of their annual CGT exemption (£5,850 in 2018/19). And, of course, as mentioned above, the current CGT rate of 20% for most transactions is considerably lower than the current 38.1%/45% income tax rates.
Single premium bonds, as non-income-producing assets, may not be as inheritance tax (IHT)-efficient as collectives, where trustees of a discretionary trust wish to make regular distributions to a beneficiary. This is because capital distributions may attract IHT exit charges, whereas distributions of true income will not. Of course, if the size of the trust fund is well below the trust’s available nil rate band, this will not be an issue.
Trustees of discretionary trusts pay relatively high marginal rates of tax and this can have a detrimental impact on the returns for beneficiaries under the trust. Suitable financial advice is essential.
In order to combat the increases in tax rates, trustees of discretionary trusts should consider:
- Reinvestment in tax-efficient investments such as those mentioned above; and
- Distributing income out of the trust to a low-tax beneficiary with a view to recovering the tax at the high rates of income tax the trustees will have paid on receipt of the income.
When selecting investments, trustees will need to consider:
- Whether to invest to produce income or capital growth;
- How to minimise tax;
- Where appropriate (particularly with regard to interest in possession trusts), how to strike a fair balance between the respective rights of the beneficiaries entitled to income and those entitled to capital.
Of course, for all trustee investments, due care and attention needs to be exercised to ensure that the investment is appropriate given the beneficiaries’ requirements in the particular case. The CGT implications of reinvestment will also need to be taken into account. CGT rates are currently reasonably low, so the payment of tax in order to reinvest, although painful, should not be the sole driver of a decision of whether to reinvest or not.