Slash clients’ tax bills using Oeics not bonds in DGTs
Advisers can save their clients considerable amounts of tax by using equity collectives rather than offshore bonds in discretionary Discounted Gift Trusts, argues Mark Green, technical director of T&G Legal Solutions Ltd
Offshore investment bonds have been the traditional tax wrapper of choice for discretionary discounted gift trusts for many years because of the often cited advantage of tax deferral or ‘gross roll up’. But are they really as tax efficient as their promoters would have you believe?
As a provider of trusts and trustee services, we tested the tax efficiency of offshore bonds against UK collective equity investments by carrying out extensive tax comparisons between the two types of investments held in discretionary discounted gift trusts.
We found that UK collective investments in such trusts can prove more tax efficient than offshore bonds by a significant margin – as you can see in the example at the end of this article.
Advisers will be well aware of the rules for calculating chargeable event gains on offshore bonds for discretionary trusts and the fact that the gain is fully taxable on the trustees at the trust rate of 45% in the tax year following the settlor’s death. But the rules for calculating tax on dividend trust income and capital gains on collectives held in settlor-interested discretionary trusts is less well known, so let’s consider this in more detail.
A discounted gift trust is a settlor-interested trust for income tax purposes because the settlor retains a benefit. Therefore, all the trust income is treated as the income of the settlor.
The trustees will be liable to income tax on gross UK dividend income at the dividend trust rate of 37.5%, less the 10% tax credit. The trustees will need to complete a trust tax return and pay the outstanding income tax to HMRC. They will also notify the settlor of the amount of dividend income received and the amount of tax paid in respect of it. The settlor will enter those details in their self-assessment tax return.
A basic rate and higher rate taxpaying settlor can make an income tax repayment claim to HMRC and reclaim the difference between the tax paid by the trustees and the tax assessable on the settlor at their rate of tax. This tax repayment will go back into the trust to be reinvested by the trustees.
Once the settlor dies, the discretionary trust ceases to be settlor-interested and the trust income will be taxed at the trust rate and dividend trust rate depending on the type of income received.
The trustees are entitled to a capital gains tax annual exemption equal to half that of an individual’s annual exemption. Therefore, the trust’s annual exemption could be £5,500 (£11,000/2). But where the settlor creates more than one settlement (i.e. a discretionary trust) the annual exemption for each trust is found by dividing half the individual’s annual exemption by the number of trusts.
So if there were three trusts the annual exemption would be £1,833 (£5,500/3). However, the minimum amount that the trust’s annual exemption can be reduced to is one-tenth of the individual’s exemption for each of them – so for five or more trusts the minimum for each trust cannot go below £1,100.
The capital gains tax rate of 28% applies to gains arising to UK resident trustees and they will be assessed to capital gains tax on chargeable gains in excess of the trust’s annual exemption. Therefore, trust assets should be realised each tax year to use the trust’s annual exemption for maximum tax efficiency.
Following the settlor’s death, the trustees can make an in-specie transfer of units in the collective to the beneficiaries utilising capital gains tax holdover relief and we have found that this route can prove more tax efficient than assigning an offshore bond to a basic rate taxpaying beneficiary.
The promoters of packaged discretionary trusts and offshore investment bonds clearly want you to use their solution but as we have seen, an offshore bond may not be as tax efficient as UK collective investments. So rather than using such a packaged solution, you should consider using a solicitor or trust company to provide the trust and appoint an investment adviser to invest the trust fund.
A UK resident and domiciled settlor who is also a higher rate taxpayer sets up a discretionary discounted gift trust with £300,000 in cash. The settlor is to receive £12,000 a year from the trust. The trustees invest the cash. The underlying investment generates UK dividends of 3% and capital growth of 3% a year.
Offshore investment bond charges and professional trustee fees for administering a collective in trust have been taken into account. The trust’s capital gains tax annual exemption has been reduced to £1,833 to reflect three trusts but will increase each year to reflect annual increases. The trustees pay income tax on the dividend income received each tax year and utilise the trust annual exemption each tax year. The tax paid over the life of the collective investment is included in the figures below. Inheritance tax has been ignored.
The trustees are assumed to fully surrender the offshore bond/fully dispose of the units in the collective following the settlor’s death at the end of, say, years 5, 10, 15 and 20, so the tax paid at the end of these four set periods is:
Tax paid by trustees Year 5 Year 10 Year 15 Year 20
Offshore Bond tax £37,958 £82,330 £132,578 £190,689
Collectives tax £21,512 £43,712 £66,843 £91,240
Extra tax paid £16,446 £38,618 £65,735 £99,449
by the trustees
in respect of the
To contact Mark, email: firstname.lastname@example.org