Trusts, in conjunction with offshore bonds, can provide a powerful tool in financial planning, offering flexibility, security, and tax efficiency. The UK Trust system is particularly sophisticated, providing a range of trust structures suitable for various financial circumstances and goals. Among these, bare gift trusts and discounted gift trusts, set up on a bare and discretionary basis, have garnered significant attention in recent years due to their unique benefits. This essay will delve into the details of these trust structures and their utility when combined with offshore bonds.
Trusts Defined
To begin with, it’s worth clarifying what trusts and offshore bonds are. A trust is a legal entity created by a settlor, who transfers property to a trustee. The trustee then holds this property for the benefit of one or more beneficiaries. Trusts serve a variety of purposes, from estate planning to asset protection and tax planning.
Offshore Bonds
An offshore bond is a type of investment vehicle that is often used for its tax advantages. It is a wrapper held in a jurisdiction outside of the UK, such as the Isle of Man or Luxembourg, which is used to hold a variety of underlying investments. When used correctly, offshore bonds can provide tax-deferred growth, greater investment freedom, and flexibility in the way income and gains are taken.
Bare Gift Trusts
A bare gift trust is one of the simplest forms of trust. It is often referred to as an absolute or fixed trust because the beneficiaries and their entitlements are fixed at the outset. Once the settlor has made a gift into a bare trust, they cannot change the terms of the trust or the beneficiaries. This is irrevocable. The beneficiaries have an immediate and absolute right to the trust capital and the income it generates.
Disocunted Gift Trusts
A discounted gift trust (DGT), on the other hand, is more complex. When a settlor places assets into a DGT, they retain the right to a series of predetermined, usually regular, payments – often referred to as an “income” – for the rest of their life. The remaining trust fund, after making provision for these payments, is immediately outside of their estate for Inheritance Tax (IHT) purposes. This is the “discounted” gift. The amount of the discount is calculated based on the settlor’s age and health, among other factors.
Both types of trusts can be set up on a bare or discretionary basis. A bare trust, as described, is absolute and gives the beneficiaries a fixed entitlement. A discretionary trust, however, provides more flexibility. The trustees have the discretion to decide who benefits from the trust, when, and by how much. This can be particularly beneficial in situations where the settlor’s circumstances or wishes change over time.
Bare Gift Trusts & Offshore Bonds
Using bare gift trusts in conjunction with offshore bonds can be a particularly effective strategy. The bond grows largely tax-free, and any encashment by the trustees will usually result in a tax charge on the beneficiary, who is likely to be a non-taxpayer or basic rate taxpayer, thus reducing the overall tax liability. Additionally, as bare trusts are not subject to the relevant property regime, there are no periodic or exit charges for Inheritance Tax purposes, making them an effective vehicle for reducing potential IHT liabilities.
Discounted Gift Trusts & Offshore Bonds
Discounted gift trusts set up on a bare or discretionary basis also offer unique advantages when used with offshore bonds. The right to a series of payments retained by the settlor can be structured as withdrawals from the offshore bond, leveraging the bond’s tax-deferred growth. Further, the immediate reduction of the settlor’s estate can be advantageous for IHT planning. If set up on a discretionary basis, the DGT provides additional flexibility in terms of the distribution of benefits, accommodating changes in the settlor’s circumstances or wishes over time.
It’s important to note that while these strategies can be highly effective, they also involve complexities and potential risks.
UK Tax on Trusts
The intricacies of the UK tax law surrounding trusts and offshore bonds can significantly impact the overall effectiveness of these financial planning tools. As of 2023/24, basic rate taxpayers are subject to a 20% tax on gains from offshore bonds. However, since gains are generally treated as forming the highest slice of income, a basic rate taxpayer could potentially be pushed into a higher tax bracket. This situation is where the ‘top slicing’ relief may assist in reducing the rate of tax charged by applying a spreading mechanism1.
New legislation from the Spring Budget 2023 is set to introduce several simplifications to the taxation of trusts and estates. These reforms include provisions that trusts and estates with income up to £500 do not pay tax on that income as it arises. Furthermore, the default basic rate and dividend ordinary rate of tax that applies to the first £1,000 slice of discretionary trust income will be removed. These changes will apply for the tax year 2024 to 2025 onwards2.
Trustees of offshore policies under discretionary trusts are liable to a basic rate tax on gains up to £1,000, where this hasn’t already been set against other non-savings income, otherwise the rate applicable to trusts applies (45%). Given this high tax rate, trustees may consider an assignment of the bond or of specific segments to beneficiaries prior to encashment, thereby reducing the tax liability4. Furthermore, a deed of appointment under bare trust may be considered for a minor beneficiary, offering more planning opportunities5.
The discounted gift schemes, often used in conjunction with trusts, have undergone significant changes. As of May 2023, the valuation rate of interest used by HMRC in valuing the retained rights under discounted gift schemes has increased from 4.5% per annum to 6.75% per annum. This valuation rate of interest is crucial for determining the open market value of the retained rights under these schemes, thereby impacting the transfer of value when a person enters into a discounted gift scheme678.
Loan trusts, Flexible reversionary trusts, and Settlor Interested trusts.
Apart from bare gift trusts and discounted gift trusts, other commonly used trusts include loan trusts, flexible reversionary trusts, and settlor interested trusts. Each of these has unique features, benefits, and tax implications, which we will explore in detail.
A Loan Trust is a method by which individuals can retain access to their capital while potentially reducing their Inheritance Tax (IHT) liability. The Settlor loans an amount to the Trust, which is then invested in an offshore bond. The Settlor can withdraw the original loan amount, usually in regular instalments, throughout their lifetime. Any growth on the investment is immediately outside of the Settlor’s estate for IHT purposes, providing potential tax savings. However, the original loan amount remains within the estate until it is fully repaid.
Flexible Reversionary Trusts, on the other hand, are designed to provide the Settlor with a regular income while also offering potential IHT benefits. The Settlor gifts an amount to the Trust, which is then invested in an offshore bond. The Settlor reserves the right to regular withdrawals, which are paid out on specified dates. Any unused withdrawals accumulate and can be paid out at a later date. Like loan trusts, any growth on the investment is outside of the Settlor’s estate for IHT purposes. However, the gift into the Trust is a Potentially Exempt Transfer (PET), meaning it will only be exempt from IHT if the Settlor survives for seven years from the date of the gift.
Settlor Interested Trusts, such as life interest trusts and interest in possession trusts, are types of trusts where the Settlor or another individual retains a right to benefit from the trust assets. With these trusts, the Settlor can still benefit from the income generated by the offshore bond, while the underlying capital can be passed to other beneficiaries, often upon the Settlor’s death. However, because the Settlor retains an interest in the trust, these trusts may be subject to IHT rules.
Trusts, and in particular bare gift trusts and discounted gift trusts, can offer compelling benefits when utilised in conjunction with offshore bonds. However, the complexities of the UK tax system and recent changes to the law necessitate careful planning and advice. As ever, it is crucial to take into account the individual circumstances of the settlor and beneficiaries, and to seek professional advice where necessary. The tools discussed herein offer powerful strategies for effective wealth management and tax planning, but they should be used judiciously and with a full understanding of the potential risks and rewards.