Arthur Jackson wanted an investment that could be passed down through the generations and meet a variety of needs in the most tax efficient way.
He expressed the view that he’d like the investment to be held for his family, to fund their changing needs as they get older. Arthur did not want to risk his capital too much, preferring a portfolio that would be professionally managed to balance risk and return.
After considering various options, his professional adviser recommended that he invest £200,000 in an international investment bond. To ensure longevity they include his son Simon, and his children, as additional lives assured.
To provide flexibility, the bond was set up as 20,000 individual policies, each with a premium of £10. At outset the bond was transferred into a discretionary trust, with his sister Jenny and brother-in-law Bill being appointed as additional trustees.
The potential beneficiaries are Simon (his only child), any grandchildren and ‘remoter issue’ (his great-grandchildren and so on). As it is a discretionary trust, it is down to the trustees as to who gets anything and when. However, Arthur writes a letter of wishes stating that the trust is intended to benefit his grandchildren, but money could be passed to Simon, if he was in ‘dire straits’.
Just over seven years later, when the bond value has grown to £300,000, Arthur dies. As Arthur survived more than seven years from making the gift no value is included in his estate for inheritance tax purposes. Also on his death no chargeable event occurs as there has not been ‘a death giving rise to benefits’. This is because Simon, and Arthur’s two grandchildren, are still alive.
Melissa is the eldest of Simon’s children and is starting a three year degree course at York University.
With tuition fees as high as £9,350 each year the trustees would like to make sure she is not burdened with a student loan for years to come and contact their professional adviser.
Their adviser explains that 5% of the total amount invested can be withdrawn each year without an immediate liability to income tax.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.
However, as Melissa has no other income, she has an unused personal allowance of £11,850. In addition, the starting rate for savings income of £5,000 and her personal savings allowance of £1,000 are also available, giving a total of £17,850.
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 3,570 policies for a surrender value of £53,550 giving a chargeable gain of £17,850.
But he emphasises that they should assign the policies to Melissa first and then let her cash them in, enabling her to use her personal allowances, receiving the £53,550 tax-free.
The trustees like this idea, but they think that £53,550 is far in excess of what she will actually need, and she might fritter away the spare cash, so they just assign 1000 policies for £15,000 to her.
Chargeable gain calculation:
Sum Paid £15,000
Less premiums paid £10,000
Chargeable gain £5,000
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, they are pleased to find out that as the assignment has occurred 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.
In the next two years, they assign a further 2,500 policies and as before, the chargeable gains fall within her allowances. Melissa graduates without a huge debt hanging over her.
10 yearly anniversary
Shortly after the last payment, it is the first 10yearly anniversary of the discretionary trust. The 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
Trust fund £270,000
This is then used to calculate whether a charge is applicable. The nil rate band at the time is still £325,000, so no actual tax is payable by the trustees. As no periodic charge is payable there will be no exit charges payable in the next ten years either. However, as the value is more than 80% of the nil rate band the trustees need to report the trust to HMRC.
The other grandchild
Rob didn’t go to university but he has been very successful securing a job in the City and earning enough money for his needs.
He would like to move to a bigger house and, rather than take on a larger mortgage, he speaks to the trustees.
It is agreed that 3,500 policies will be transferred to Rob, so both he and Melissa will have benefitted from an equal number of policies. The trustees transfer the policies, making him the owner This leaves 13,000 policies in the trust.
Each policy is now worth £20 so he receives £70,000. However, as Rob is a higher rate taxpayer, if he cashes them in, he will pay a lot of tax on the chargeable gain.
The adviser realises that Rob’s pregnant wife Jill is off work and has 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 £35,000 but as Jill has no other income this will be within her basic rate tax band.
Chargeable gain calculation:
Sum Paid £70,000
Less premiums paid £35,000
Chargeable gain £35,000
So the tax bill has been substantially reduced, thanks to the adviser’s recommendation.
Five years later
Five years later, Melissa and Rob approach the trustees because they are worried about their father’s health, he has deteriorated to the point where he needs ongoing care services. He has pension income of £16,000 a year and modest wealth.
The trustees agree to make a distribution to Simon of 1,000 policies worth £29,000 to help pay for his care. This leaves 12,000 policies remaining.
The chargeable gain calculation is as follows:
Sum Paid £29,000
Less premiums paid £10,000
Chargeable gain £19,000
This means that Simon’s total income of £35,000 is below the basic rate tax threshold, so there is no need to consider top-slicing relief – only basic rate tax will apply.
When Simon dies, the bond stays in force because Melissa and Rob are still alive – Melissa, like Rob, also has children and the trustees can continue to use the policies to help them all.
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, the bond has been used to assist Arthur’s family as he wanted. It helped Melissa graduate with no debt, Rob 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 10,000 policies left to continue to help the next generation.
But one point is notable, the family benefitted from the help of a professional adviser and paraplanner throughout, to ensure that they made the correct choices.
By Kim Jarvis is a technical manager at Canada Life. She has worked in the life industry arena for over 20 years, with experience in trusts and their taxation, product development, the impact of new legislation on the industry and delivering training. She is an affiliate of the Society of Trusts and Estate Practitioners and a Chartered Insurer.