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Cascading wealth through the generations

International investment bonds are all about giving choices and being able to adapt to changing lifetime needs and goals. Their tax profile and adaptability means that they could be passed down through the generations and meet a variety of needs, in a tax efficient way.


To illustrate this, let’s look at a case study.


Arthur Jackson wanted an investment that will increase in value by a reasonable amount and that he could ‘dip into’ when he wanted. He did not want to risk his capital too much, so was looking for a portfolio that would be professionally managed to balance risk and return. He was getting on a bit in years and expressed the view that he’d like the investment to be held for his family when he died. It could fund his beneficiaries’ changing needs as they get older, would be tax-efficient and simple to manage.


After considering various options, his professional adviser recommended that he invested £200,000 in an international investment bond The investment would be managed by a discretionary fund manager on a ‘cautious’ basis and to ensure longevity they would have his son, Simon, and his two grandchildren as additional lives assured.
In order to give as much flexibility as possible the bond was set up with 200 individual policies, each with a premium of £1,000.

Arthur lived for a good few years more, taking amounts totalling £50,000 from the bond during his lifetime, but then he unfortunately died. At that time, the bond was worth £300,000 and was transferred into a discretionary trust set up under his will. The trustees, who are his sister Jenny and brother-in-law Bill, become the owners of the bond.


The potential beneficiaries are Arthur’s son (his only child), any spouse of his, any grandchildren and ‘remoter issue’. This phrase means his great-grandchildren and so on. As it is a discretionary trust, it is down to Jenny and Bill as to who gets anything and when. Arthur also left a letter of wishes, which stated that he intended the trust to benefit his grandchildren, when they needed financial assistance, but money could be passed to his son, Simon, if he was in ‘dire straits’.


Tax position
Although the overall gain was £150,000 at the time of Arthur’s death, no chargeable event had occurred because all his withdrawals had been within the 5% tax-deferred allowance and on his death, there had not been ‘a death giving rise to benefits’. This was because Simon and Arthur’s two grandchildren were still alive. As far as inheritance tax (IHT) was concerned, his estate was less than the IHT threshold (including the transferred nil rate band of his late wife) so no entry or exit charges applied to the discretionary will trust for the first ten years.


The bond as a trustee investment
The trustees are pleased to know that the bond is a non-income producing investment so they will not have the stress and hassle of completing annual tax returns unless a gain arises. No tax is paid within the fund and, therefore, any growth in the bond can roll-up. There is also no need to send the form 41G to HMRC, notifying them that tax returns are applicable. They can also appoint or assign bond policies to beneficiaries when trust distributions are made, meaning that the recipient’s tax position will apply to any bond chargeable gains.


Simon says
Although Simon respected his late father’s wishes, he soon informs the trustees that he is more than capable of looking after the grandchildren’s future on his own and they should simply wind up the trust and give him the proceeds.
Jenny and Bill inform him that:

  • They too respect Arthur’s wishes and think the trust should remain in place as he wanted
  • Assigning the bond to him – and assuming he would cash it in – would not allow them to manage the unrealised chargeable gain and make use of the bond’s tax efficiency
  • Simon is currently in the process of divorcing his wife and the proceeds could possibly form part of the financial settlement
  • As Simon was not in ‘dire straits’ they would not be distributing anything to him at present

 

Education fees
Melissa is the eldest of Simon’s children and when she is 18 she starts a three year degree course at York University. University tuition fees in England and Wales can be as high as £9,000 each year, with living costs on top. They are increasing to a maximum of £9,250 in 2017. The trustees would like to make sure she is not burdened with a student loan for years to come and contact their professional adviser to discuss the best way to give Melissa enough money to pay for her tuition fees and living costs.
Their adviser explains that 5% of the total amount invested can be withdrawn each year without an immediate liability to income tax. This is known as the ‘tax-deferred withdrawal’ facility. Where the facility is not used in one year it can be carried over to the next year, so £10,000 each year for a period of 20 years, or 4% for 25 years and so on.


Arthur had taken the maximum allowance up to his death, but as the bond has been in force for two years since then, £20,000 could be taken tax-deferred. However, as Melissa will be at university, and she has no other income, she will have an unused personal allowance of £11,000. In addition, the starting rate for savings income of £5,000 and her personal savings allowance of £1,000 are also available; a total of £17,000. This is an opportunity to realise some of the chargeable gain with no actual tax liability. Investment markets have been mixed over the last two years and the bond is still worth £300,000.


The adviser calculates that the trustees can cash in 22 policies for a surrender value of £33,000 with a chargeable gain of £16,500. (The chargeable gain includes Arthur’s withdrawals as these are added back for tax purposes on encashment.)
But he emphasises to the trustees that they MUST assign the policies to Melissa first and then let her cash them in. That will mean that her unused allowances will apply and she will get the £33,000 tax-free. The trustees like this idea, but they think that £33,000 is far in excess of what she will actually need, and she might fritter away the spare cash, so they just assign 10 policies for £15,000 to her.

 

Chargeable gain calculation

Sum Paid £15,000
Add previous withdrawals £2,500 (50,000 x 10/200)
Less premiums paid £10,000
Chargeable gain £7,500

Note: surrendering 22 policies would produce a chargeable gain of £16,500.
 
The assignment is not a chargeable event, as it was not ‘for money or money’s worth’ and although the distribution was an exit from the discretionary trust, no exit charge is payable in the first ten years as explained earlier.
In the next two years, they assign another 20 policies in total and as before, the chargeable gain falls within her allowances. Melissa graduates without a huge debt hanging over her. Jenny and Bill think that Arthur would be pleased.

 

Funding for a gap year
Melissa passed her degree with flying colours but as she has worked hard over the three years she decides to take a gap year and go travelling. She asks the trustees for some money. They discuss with their professional adviser the most tax efficient way to provide the money. As Melissa is a non-earner they decide to give Melissa 5 policies, which leaves 165 still in the trust. Each policy is now worth £1,800 so she receives £9,000. Melissa, as owner, then cashes in the policies. This chargeable event creates a gain of £4,250 but as Melissa has no other income this will be within her personal allowance.

  

Chargeable gain calculation

Sum Paid £9,000
Add previous withdrawals £1,250 (50,000 x 5/200)
Less premiums paid £5,000
Chargeable gain £5,250


As the trust is discretionary the trustees also need to consider whether there is any inheritance tax payable on the assignment. They are pleased to find out that as the assignment has happened within the first 10 years – and no inheritance tax was payable when the trust was set-up – there will be no exit charge under the relevant property regime.


The other grandchild
Melissa’s sibling, Rob, didn’t go to university but he has been very successful landing a job in the City and earned enough money for his needs. However, a few years later he gets married and then a couple of years later starts a family. He soon finds that he needs to move to a bigger house and rather than take on a bigger mortgage he speaks to the trustees. By this time, Bill has died and been replaced by his son, Roger, as Jenny’s co-trustee.


It is agreed that 35 policies will be transferred to Rob, so that both he and Melissa will have benefitted from an equal number of policies. This leaves 130 policies in the trust. The trustees transfer the policies, making him the owner. As before, the assignment happens within the first 10 years of the trust being created so there is no exit charge.
Each policy is now worth £2,000 so he receives £70,000. However, there is a slight problem; Rob is a higher rate taxpayer. If he cashes them in, he will pay a lot of tax on the chargeable gain. He contacts the professional adviser used by Arthur and the trustees to discuss the best way to manage the tax liability. The adviser realises that Rob’s pregnant wife Jill is off work and going to have little income in the current tax year, so he suggests that Rob assigns his polices to her, before encashment. As neither of these assignments were for money or money’s worth, no chargeable event occurs until Jill cashes in the policies.


This chargeable event creates a gain of £43,750 but as Jill has no other income this will be within her basic rate tax band. And it will be below the £100,000 threshold where she loses her personal allowance.

 

Chargeable gain calculation

Sum Paid £70,000
Add previous withdrawals £8,750 (50,000 x 35/200)
Less premiums paid £35,000
Chargeable gain £43,750


Jill’s tax bill is as below. Top-slicing relief eliminates any higher rate tax liability.

 

Tax bill calculation

Chargeable gain £43,750
Personal allowance £11,000
Starting rate £5,000
Personal savings allowance £500 (as Jill is technically a higher rate taxpayer)
Taxable income £27,250
Tax payable @ 20% £5,450


So the tax bill has been substantially reduced, thanks to the adviser’s recommendation.


10 yearly anniversary
Shortly after the payment is made to Rob, it is the 10-year anniversary of Arthur’s death – and the start of the discretionary will trust. The professional adviser highlights this to the trustees and explains that they must make a calculation to see if a periodic charge is payable.


Firstly, they must calculate the ‘notional chargeable transfer’ on the tenth anniversary. To do this, they must include all the distributions that they have made to beneficiaries and the current value of the trust fund.


Notional chargeable transfer

Melissa year 1 £15,000
Melissa year 2 £16,000
Melissa year 3 £17,000
Melissa gap year £9,000
Rob £70,000
Trust fund £260,000
Total £387,000

 

        
This is then used to calculate the effective tax rate applying to the trust fund. The nil rate band at the time is £354,750.


Tax rate = (£387,000 - £354,750) x 6% = £1,935 / £387,000 = 0.5%

So the actual tax payable by the trustees is:

Tax payable = 0.5% x £260,000 = £1,300
 
Jenny and Roger (the trustees) submit forms IHT100 and IHT100a to HMRC and arrange for payment of the £1,300 by making a withdrawal from the bond, within the 5% allowance. They do this with the assistance of their professional adviser. This exercise must be carried out every ten years. Any future distributions from the trust in the next ten years will suffer an exit charge based on the 0.5% rate.

 

Five years later
Five years later, Melissa and Rob approach the trustees, because they are worried about their father Simon’s situation. His divorce hit him hard financially and his health has deteriorated rapidly; to the point where he needs care services. He has a pension, subject to a pension sharing order, which leaves him £16,000 a year. Apart from that, he has modest wealth.


Individuals with capital above a certain level (currently £23,500 in England) receive no assistance with care costs. So virtually all of Simon’s income could go to pay for care costs. In the circumstances, the trustees agree that his situation falls within Arthur’s letter of wishes and make a distribution to Simon of 10 policies, worth £29,000. There are now 120 policies remaining.


Chargeable gain calculation

Sum Paid £29,000
Add Arthur's withdrawals £2,500 (50,000 x 10/200)
Add the trustees' withdrawal £100 (1,300 x 10/130)
Less premiums paid £10,000
Chargeable gain £21,600


This means that Simon’s total income of £42,600 is below the basic rate tax threshold, so there is no need to consider top-slicing relief – only basic rate tax will apply.
After deducting his personal savings allowance, the tax bill is £4,320. The personal allowance is used by his pension and the savings rate does not apply as that is cancelled by his pension income.


But what about IHT? The nil rate band is now £367,000 so the calculation of the rate is as follows:


Tax rate = (£387,000 - £367,000) x 6% = £1,200 / £387,000 = 0.31%
This is then applied to the amount distributed, but is further reduced by the number of quarters since the last ten-yearly anniversary – that is, 20 quarters (five years).


So the actual tax payable by the trustees is:
Tax payable = 0.31% x £29,000 x 20 / 40 = £44.95


Jenny and Roger submit forms IHT100 and IHT100c to HMRC and arrange for payment of the £44.95 by making a withdrawal from the bond, within the 5% allowance. They make subsequent payments over the next two years to help with Simon’s cost, until he passes away.


Death
When Simon dies, the bond stays in force because Melissa and Rob are still alive – and will be for a good number of years. However, when the last surviving life assured dies, there will be a chargeable event and a chargeable gain arising. So the trustees might want to ensure that over the long-term, the bond and trust fund is gradually paid out.


Helping the next generation
Melissa, like Rob, has children and the trustees can use the policies to help all their children with the cost of education, buying their first home, setting up a business or anything else they think appropriate.


What has been achieved
An international investment bond offers a simple and straightforward, tax-efficient investment solution for those looking to invest a lump sum. In this case study, Arthur has received withdrawals, the bond has been used to assist his family as he wanted, it helped Melissa graduate with no debt, Rob has moved to a larger home and Simon was cared for in comfort.


All of this was achieved with no or relatively little tax applying to the gains made. There are now 100 policies left to help the next generation, with the same tax profile.
But one point is notable, the fact that the family needed the help of a professional adviser throughout, to ensure that they made the correct choices.

  
 
  


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