Investment Bond

Taxation of investment bonds when held in trust

The Trustee Act 2000 (and its Scottish and Northern Ireland equivalents) widened the investment options for nearly all trusts, but at the same time put more responsibilities on the trustees.

They have to seek appropriate advice from ‘suitably qualified individuals’ to make sure of the suitability and appropriate diversification of trust investments.

It has been said that investment bonds could have been designed to sit inside discretionary trusts, as their tax rules can work really well.

But it is important to note that they are taxed under the chargeable event legislation, which means the bondholder is always assessed on gains and subject to income tax and never capital gains tax (CGT).

UK investment bonds suffer corporation tax within the investment fund and because of this, the bondholder is deemed to have paid tax at a rate of 20%. Capital gains within the fund are taxed at 20% but benefit from indexation relief. UK dividend income is not taxed and all other income is taxed at 20%.

Offshore bonds do not suffer any UK income tax or capital gains tax within the fund. Some foreign income and gains may suffer withholding tax that cannot be reclaimed.

Investment bonds are ‘non-income producing assets’ and as such, there is only an income tax charge when there is a chargeable event under s484 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) and those are:

  • the full surrender of the policy (or of individual segments of the policy);
  • the assignment for money, or money’s worth of all rights under the policy;
  • where periodic calculations show gains (when the cumulative 5% annual allowance is exceeded);
  • a death of a life assured which gives rise to a death benefit being payable; and
  • the maturity of a policy.

If the chargeable event gives rise to a chargeable gain, and the policy is written in a bare trust, the gain is assessed on the beneficiary. (Assuming it was not a parental settlement and the beneficiary is aged under 18 and unmarried.)

If it is an interest in possession or discretionary trust, the gain is firstly assessed on the creator of the trust – as long as they are still alive and UK resident in the tax year of the chargeable event. Normal top-slicing rules will apply.

If the creator died in a previous tax year, or is not UK resident, then the assessment will fall on the trustees (as long as at least one trustee is UK resident) at the rate applicable to trusts, currently 45%.

If there are no UK trustees, the gain will be assessed on any UK resident beneficiary who benefits from the trust.

In all cases, if the gain arises under a UK bond, the individual or trustees liable for tax are treated as having paid income tax at 20% on the gain.

Switching funds

Bare Trust

A switch under an investment bond is not a chargeable event, so no tax is payable.

Interest in Possession Trust /Discretionary Trust
A switch under an investment bond is not a chargeable event, so no tax is payable.

Providing a beneficiary with a regular income

Bare Trust

Investment bonds are non-income producing assets and no tax is payable until a chargeable event occurs. Provided the trustees do not make withdrawals and distribute more than 5% of the amount invested each year, no tax arises at that time. (This situation applies until an amount equal to 100% of the amount invested has been taken.)

Interest in Possession Trust

Any income arising has to be distributed to the income beneficiary, and they are liable to income tax dependent on the level of withholding tax and their personal tax position.
The situation with investment bonds is complicated by trust law and practice, although the tax position is quite straightforward. Provided the trustees do not make withdrawals and distribute more than 5% of the amount invested each year, no tax arises at that time. (This situation applies until an amount equal to 100% of the amount invested has been taken.)
But as is commonly known, a withdrawal from an investment bond is not ‘income’ but a ‘return of capital’. This means that it is contrary to a trust provision requiring income to be paid, and an income beneficiary can only indirectly receive investment bond withdrawals if the trustees are allowed to also grant them an advance of capital.
The trustees would have to be satisfied that they were having due consideration to both the income beneficiary and the remaindermen by doing so, and there is another pitfall, that of a court case known as Brodie’s Trustees v IRC (1933).
Following this judgement, there is a danger that Her Majesty’s Revenue & Customs (HMRC) will assess an income beneficiary to tax on capital advances as if it were income, which is very disadvantageous.
Care should be taken, therefore, if this strategy is being contemplated. It may be best to keep an investment bond to one side as a capital asset only, if it is to be part of an interest in possession trust.

Discretionary Trust

Any income arising is subject to income tax in the hands of the trustees at 45% (38.1% for dividends).
A tax credit of 20% for interest income will be available if income is accumulated. If the income is distributed to a beneficiary, the trustees must account for tax at 45%, which will require additional tax to be paid at that stage.
However, the beneficiary will receive the income with a tax credit and may be entitled to reclaim tax as appropriate to their personal tax position.
Provided the trustees do not distribute investment bond withdrawals of more than 5% of the amount invested each year, no tax arises at that time. (This situation applies until an amount equal to 100% of the amount invested has been taken.)

Providing a beneficiary with capital

It is assumed that the trustees will be disposing of trust investments to make an advance of capital to a beneficiary.

Bare Trust

If an investment bond, or policy segments, are fully encashed it is a chargeable event and a chargeable gain may arise – which will be subject to income tax.

The calculation of the chargeable gain will take into account any withdrawals that have been taken previously.

Income tax on the gain is payable by the beneficiary at their marginal rate, which may be determined by using top-slicing relief under s535 to 537 of ITTOIA. If the gain arises under a UK bond, the beneficiary is treated as having paid income tax at 20% on the gain.

Interest in Possession Trust

A capital distribution would not normally take place until after the death of the income beneficiary or until after they have waived their right to their interest in possession.

If an investment bond, or policy segments, are fully encashed by the trustees and the trustees are liable (that is, the settlor has died in the previous tax year or is non-resident), they will pay 45% tax on the chargeable gain (less the 20% credit if a UK bond). The calculation of the chargeable gain will take into account any withdrawals that have been taken previously.

A preferable course of action would be for the trustees to assign the policy or policy segments in specie to beneficiaries, after which they would pay tax on the gain at their marginal rate, taking into account top-slicing relief. A similar result will be achieved if the trustees make an absolute appointment in favour of a beneficiary so that the trust effectively becomes a bare trust.

If they were basic rate taxpayers, after the chargeable gain was added to their other income, they would only pay tax at 20% on the gain, and for a UK bond would be treated as having already paid this.

Discretionary Trust

If an investment bond or policy segments are fully encashed by the trustees, the tax position will be the same as for interest in possession trust above.

Reclaiming the tax paid

If the settlor pays income tax as a result of an investment bond held in trust making chargeable gains, they are entitled to reclaim the amount paid from the trustees under s538 of ITTOIA.

This states that if immediately before a chargeable event the policy was held on non-charitable trusts, the individual liable for tax on the gain from the event is entitled to recover the tax paid in that respect from the trustees.

This briefing note has been prepared for professional adviser use only.

The information regarding taxation is based on our understanding of current legislation, law and HM Revenue & Customs practice as at April 2017. We recommend that investors take their own professional tax advice.

This briefing note can also be viewed as a PDF

This website is for UK professional advisers only and is not approved for use by private customers.

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