Writing for Taxation magazine’s Readers’ Forum, BKL tax consultant Terry Jordan responds to a reader’s query about inheritance tax on insurance bonds in a discretionary trust.
‘I am dealing with a discretionary trust, which holds an investment in an insurance bond. A partial withdrawal has been made and a chargeable event gain has arisen. As the settlor is still alive it is my understanding that the chargeable event gain will be taxed on the settlor, not on the trustees.
The amount withdrawn has been paid to a beneficiary (not the settlor), which has raised a number of questions:
- Is the beneficiary liable to income tax on the chargeable event gain? I believe not, since it has been taxed on the settlor.
- Does IHTA 1984, s 65(5)(b) mean that no inheritance tax (IHT) liability can arise, since an income tax liability has already arisen in the hands of the settlor, so that there is no exit charge?
- If the point above is correct, what happens at the next ten-year anniversary? Is the transaction just ignored?
Depending on the answers to the above three questions, would the tax situation for the beneficiary, and from an inheritance tax point of view for the trust, have been different depending on whether the funds were paid directly to the beneficiary or were first paid into the trust bank account and subsequently paid to the beneficiary?
I cannot think that this would make a difference but I would welcome views from readers on this point as well.’ Query 19,739 – Trustworthy.
Terry Jordan’s reply: The settlor has a right of reimbursement against the trustees for the tax paid
‘Trustworthy is dealing with a discretionary trust and a chargeable event gain has arisen on a partial withdrawal from an insurance bond. The trust is not charitable, and the settlor is available to charge by virtue of being living and UK resident. Accordingly, the settlor is liable to income tax on the chargeable event gain under ITTOIA 2005, s 465. In my experience this often comes as a surprise to the trustees and the settlor. There can be an advantage if the settlor can benefit from ‘top-slicing’ relief which is not available to trustees. The settlor has a right of reimbursement against the trustees for the tax paid under s 538.
- A payment has been made to a beneficiary by the trustees. As Trustworthy surmises, the beneficiary is not liable to income tax as the settlor is chargeable.
- The trust is within the inheritance tax relevant property regime and a proportionate or ‘exit’ charge arose under IHTA 1984, s 65 on the payment to the beneficiary. The proceeds from the withdrawal are trust capital and the distribution is of capital not liable to income tax in the hands of the beneficiary (See Stephenson v Wishart [1987] STC 266).
- The value appointed will be aggregated on the next ten-year charge in accordance with s 66(5)(b).
Trustworthy asks whether the situation would be different had the beneficiary received the proceeds direct or if the trustees had paid them into the trust bank account and then out to the beneficiary. I think the answer is no. The trustees could have assigned part of the bond to the beneficiary which, provided was done for no consideration, would not have triggered a chargeable event. The beneficiary could then have encashed with the potential benefit of top-slicing relief (which depends on the age of the bond, not the length of ownership by the beneficiary). That might have led to a lower liability depending upon the relative circumstances of the settlor and the beneficiary.’
The article is also available on the Taxation website.
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