Matthew Hutton considers a question which has arisen a number of times recently, and which could be quite a common issue.

As I have been lecturing over recent months, I have come across significant numbers of professional advisers ‘confessing’ that client discretionary trusts hold (as, usually, their sole asset) a non-qualifying life policy. Before I get on to tax, this does of course raise a number of issues on the trust front.

The trust law angle
The trustees may well have power to hold the entire trust fund in a single non-income producing asset, but is this specific asset a sensible choice of investment? Second, if the trust is interest in possession rather than discretionary in form, have the trustees considered their duty to balance the return to the income and capital beneficiaries respectively, even if there is specific provision relieving them from this obligation? They may respond that they are paying ‘an income’ to the life tenant by taking withdrawals from the policy, typically written under 20 segments, and paying these on an annual or monthly basis to the life tenant. However, that is of course a payment of capital rather than income (again, do they have the power to do this?) and this course may be seen to be depleting capital.

The client should have been made aware of any commission paid by the life office to the independent financial adviser who recommended the bond. The fundamental investment question is whether this is going to produce a good overall return to the trust.

What happens if there is a loss?
It is not unknown, on the final chargeable event, for there to be a loss rather than a profit – and the trustees may be disappointed to find that there is no general relief for a loss. Losses can be offset only to the extent that there have been chargeable event gains in an earlier tax year (ITTOIA 2005 s539) – and the logic of that is plain to see. Such a loss can be set against other income charged at higher rates of tax in the year of the final chargeable event, ie with a UK bond achieving relief at 20% (in broad terms).

Why do it?
It has to be said that very often the rationale for such a structure is that the trust fund is relatively low value. If the trust fund is invested rather more conventionally in stocks and shares or unit trusts producing an income, the annual professional fees are often out of all proportion to the income received.

The ‘attraction’ to the client, whether settlor or trustees, is the well-known facility to take withdrawals of capital within the annual 5% limits of the original investment. Clients should of course always be warned that this is not so much tax-free as tax-deferred. However, once a chargeable event occurs, eg on final maturity, there will be a tax charge at typically 20% on either the settlor, if still alive, or the trustees, that is with a UK bond 40% less credit for the 20% treated as paid within the bond or if an offshore bond 40%. The charge may be less than this to the extent that top-slicing relief is available.

Discretionary payments: income or capital?
The technical tax issue I have been pondering with a number of professional colleagues is whether, with a discretionary trust, HMRC could or might allege in the case of regular payments by the trustees to a beneficiary that, even though made out of trust capital, those payments should be treated as income in the hands of the beneficiary. That of course would be fairly disastrous, since it would trigger the obligation for the trustees to make a payment to HMRC and issue a tax deduction R185 certificate to the beneficiary (under ITA 2007 part 9 chapter 7) on the grounds that they are making ‘an annual payment’. So that out of every 100 withdrawn by the trustees from the bond they could pay over only 60 (assuming no brought forward tax pool) and will give the beneficiary a tax deduction certificate for the 40 tax paid.

Happily, the decided cases on the issue (especially Brodie’s Will Trustees v IRC (1933) 17 TC 432 and Cunard’s Trustees v IRC (1946) 27 TC 127, not to mention the more recent decision in favour of the taxpayer Stevenson v Wishart (1987) 59 TC 740) will tend to treat the payment as capital, unless the beneficiary is entitled to a fixed income which the trustees top up through trust capital – not in point here. And the now familiar content of p24 of the tax return guide for 2007/08 provides evidence of HMRC’s relatively relaxed view in not generally treating regular payments of capital by the trustees as income of the beneficiary. Indeed, I have been told in more than one specific case that HMRC have specifically confirmed that they would not treat regular withdrawals from a bond in favour of a discretionary beneficiary as income of that beneficiary.

The particular technical point is that, if such an income tax liability were to arise, there is no credit against the liability under ITTOIA 2005 s467 for the tax paid under the ITA 2007 regime.

Other structures
These and other points should in my view at least form the subject of discussion and consideration among the trustees. One solution might be for them to appoint the bond to the beneficiary before it is encashed so visiting the gain on the beneficiary. Alternatively, instead of buying the bond themselves, they might lend the cash (interest-free, repayable on demand) to the beneficiary, for him to make the investment. Still, the problem with this could be depletion of trust capital, unless perhaps some provision for index-linking were built into the terms of the loan.

Conclusion
While open to the charge of being excessively cautious, in my view discretionary or accumulation trusts (and indeed also interest in possession trusts) should not hold non-qualifying life assurance policies as all or a significant part of the trust fund.

Postscript: bonds held on bare trusts for minors
Traditionally, HMRC have assessed any chargeable event gains on the trustees rather than on the minor. On 14 November 2008 they announced a change of practice from 2007/08, so that the gain will be assessed on the beneficial owner, not on the trustees. However, this will not apply where the funds to buy the bond came from one of the minor’s parents, when the gain will be visited on the parent under ITTOIA 2005 s629: this analysis is being challenged by some professional commentators, including me (since the s629 charge is on ‘income arising’ under the settlement, but the chargeable events regime does not deem the gains assessed to income tax to be income).

Matthew Hutton is the author of Hutton on Estate Planning, which was published electronically and in hard copy (774 pages) in Autumn 2008: www.hutton-estate-planning.co.uk [1]. AccountingWeb subscribers may claim a 10% discount off the published prices for the e-version by contacting mhutton@paston.co.uk [2] and quoting AW.