With the nil rate band remaining frozen and upcoming changes to pensions from April 2027, interest in inheritance tax (IHT) planning solutions is rising – particularly the use of discretionary trusts and bonds.
As investment bonds are non-income producing investments, they are often used with discretionary trusts due to the administrative simplicity and flexibility to assign out to beneficiaries.
However, it should be remembered that the way you set up the bond at the start can have a significant impact on how gains are taxed, not just during the settlor’s lifetime, but on or after their death.
The tax rules
During the settlor’s lifetime, the rules are relatively straightforward.
If the settlor is alive and UK resident in the tax year the chargeable event occurs, the gain is assessed on the settlor. If there is any tax to pay, they reclaim this from the trust. If they don’t, they have a made a gift for IHT.
A trust is deemed to be UK-resident for tax purposes if all the trustees are resident in the UK
If the settlor has died in a previous tax year or is no longer UK resident, and if the trust itself is UK-resident, the trustees become liable.
A trust is deemed to be UK-resident for tax purposes if all the trustees are resident in the UK, or if at least one of the trustees is resident in the UK and the settlor was UK resident when the trust was set up.
The trust rate of tax is 45% and cannot be reclaimed by beneficiaries so should be avoided where possible.
In most cases this can be achieved relatively easily by making use of the bond’s 5% tax-deferred allowance or assigning/appointing segments of the bond to a beneficiary prior to encashment.
Deciding what should happen on the settlor’s death
One of the main decisions when setting up a bond in trust is around what you want to happen on the settlor’s death.
Should the bond be set up with the settlor as sole life assured, with multiple lives assured, or as a capital redemption bond? Each option has very different consequences for when and how gains are taxed.
If the bond has only one life assured, it will come to an end when the life assured dies.
It would be unusual to set up a bond in trust with a sole life assured who isn’t the settlor
Who is assessed on a gain arising from the chargeable event will depend on the process outlined above.
It would be unusual to set up a bond in trust with a sole life assured who isn’t the settlor, as their death during the settlor’s lifetime would require a further investment to be made unnecessarily.
That said, having the settlor as the sole life assured can be beneficial in certain circumstances. If the settlor is the sole life assured, the gain on their death is assessed in the settlor’s final tax return.
This can be advantageous where the settlor is in a lower tax bracket than the intended beneficiary.
Even where the intention is for the trust to continue on the settlor’s death, intentionally triggering a gain on the settlor’s death is potentially a tax efficient strategy. The trustees can then simply reinvest the proceeds.
Joint settlor discretionary trusts
Care should be taken with joint settlor discretionary trusts.
In these cases, chargeable gains are split and it could be the settlor(s) or trustees who are assessed, depending on each settlor’s residence and whether they’re alive in the tax year concerned.
Adding multiple lives assured to the bond, such as children or grandchildren, can delay chargeable events
Normally, both settlors will pass away in different tax years, leading to the increased likelihood of trustee rate of tax on at least part of the gain if the bond continues into a tax year beyond the death of one of the settlors.
Adding multiple lives assured to the bond, such as children or grandchildren, can delay chargeable events as the bond doesn’t end until death of the last life assured.
If the goal is to defer gains beyond the settlor’s death, multiple lives assured can help achieve this and is very attractive where the settlor is in a higher tax bracket than the beneficiaries.
But while using multiple lives assured is sometimes seen as the default option, remember it can also result in a worse outcome.
No thanks will be given to an adviser who stores up large gains for a higher rate beneficiary when it could have been avoided by setting the bond up differently to start with.
Capital redemption bonds
The third option is to use a “capital redemption bond” (CRB). CRBs have no lives assured, but mature after a fixed term, often 99 years.
Similarly to using multiple lives assured this is helpful where you don’t want the gain assessed on the settlor’s death.
CRBs do provide more certainty that a gain won’t arise unexpectedly so are often used where a trust is expected to run for a long period of time, or a chargeable event within the trust would be heavily taxed.
Ultimately, the decision on how to set up a bond in trust should be tailored to the specifics of the case
CRBs are only available “offshore”, which is another factor to consider when determining suitability of the investment for the trust.
When trusts are used as part of an IHT planning strategy, the focus is often on the IHT saving.
This is understandable, but it’s important not to forget about the taxation of the underlying investment.
Ultimately, the decision on how to set up a bond in trust should be tailored to the specifics of the case and likely tax positions of all parties involved. However, as with most things in life, one size rarely fits all.
Neil Macleod is a senior technical manager at M&G
