Discretionary Trust et al - The choice of trust Trusts continue to play an important part in any estate-planning strategy for high net worth individuals, and most financial planners offering investment advice are aware of the added value that a "packaged" arrangement involving a trust may give. Most clients and their advisers are also aware of the benefits of trusts when used with pure life assurance protection arrangements.

Whilst under English law an individual is pretty much free to declare any terms of a trust that they wish (as long as they are not illegal), in practice most settlors, as well as trust draftsmen, use "standard" precedents. The fact that life assurance companies have offered "standard" trust forms, for what seems like forever, has benefited both advisers and policyholders. Now, though, the new breed of trust forms to assist with estate planning available with investments held on many platforms requires some further considerations.

Will the same trust be suitable for a lifetime gift of, say, investments of a substantial value and a gift of a pure term assurance policy?

What should influence the choice of trust in any particular case? Is the choice of investments relevant? What about the tax rates?

Life policy trusts

Since the inheritance tax (IHT) treatment of trusts was "aligned" in 2006, many if not most of the life offices offering trusts with their life policies have redesigned their trust packages. Where flexibility over the choice of beneficiaries is important to a client (the settlor of the trust), so that an absolute (bare) trust is inappropriate, the preferred choice would now be a fully discretionary trust. After all, the logic goes, if you must be subject to all the awful charges that apply to discretionary trusts, you might as well benefit from the full discretionary powers and flexibility that a discretionary trust provides.

Until the alignment in 2006, the most common type of trust in use was the flexible power of appointment interest in possession trust. Such trusts (if created before 22 March 2006) are not subject to the "relevant property regime".

Will all potential settlors of life policy trusts be happy to have total discretion over the choice of beneficiaries, especially for this power to continue after their death? Perhaps not, but remember that with a fully discretionary trust the appointor (either the settlor or the trustees) can always exercise their power to make whatever appointment of benefits is appropriate. In effect, it is always possible to restrict the discretion if that is what is desired.

Discretionary plus flexibility or Bare plus certainty?

The most important thing with any trust is to consider the precise objectives and wishes of the individual creating the trust, i.e. the settlor. While many will welcome the flexibility of a fully discretionary trust, on the other hand there are no doubt individuals who prefer to define the beneficial rights under a trust for their intended beneficiaries in a more precise fashion. There will, however, be relatively few people happy to settle for a "bare" trust. Remember that under this type of trust, there is no flexibility whatsoever. The intended beneficiaries, and their shares if more than one, must be named at outset and cannot be changed. So when asking a prospective client whether they are certain as to who should benefit from the policy in trust, it is not just the "certainty now" that matters. The client must be certain not only of their intended beneficiaries but that they will never want to change their mind about them.

Default provisions v. Positive action

A flexible trust may also be attractive to those individuals who prefer greater certainty over the choice of beneficiaries. After all, with a fully discretionary trust, a prior appointment by the trustees is necessary for a beneficiary to become entitled to anything under the trust, i.e. this requires a positive action on the part of the trustees. Some settlors might prefer the option of a flexible trust under which there is a default beneficiary entitled to income from the trust without the trustees having to do anything positive. Under a flexible trust, positive action on the part of the trustees would only be necessary if it is desired to appoint income or capital to beneficiaries other than those named by the settlor.

Relevance of tax rates

As long as an ordinary life assurance policy is held in trust, the nature of the trust for IHT purposes is going to be less significant than when other assets of substantial value are held in trust. Granting a right to income to a beneficiary will only have practical implications where there is a trust asset which actually produces real income for that beneficiary.

With a life assurance policy, therefore, a prospective settlor will need to consider the likely objectives of the trust once the policy proceeds have been paid out, say on the death of the settlor. Once substantial assets are held by the trustees, this is when other taxes will become relevant, namely income tax and capital gains tax (CGT).

Trusts for collectives

mentioned above, in recent years an increasing number of investment houses and platforms have started providing trusts and trust packages for use with collectives. The usual suite of trusts on offer would include a bare gift trust, a loan trust, a discounted gift trust and a discretionary gift trust. A more recent innovation, presumably as a result of the complex income tax treatment of discretionary trusts, has been the re-emergence of a life interest trust or a flexible trust. However, this new choice itself can cause problems when considering the choice of investments for the trust in question.

For a lifetime gift of substantial value, the main benefit of a bare trust (the gift to the trust will be a potentially exempt transfer (PET) for IHT purposes), will be more important than when considering pure life cover, However, even here not many investors interested in long-term estate planning are prepared to make the once-and-for-all decision to gift assets absolutely to named individuals. Where any kind of flexibility is required until recently in most cases the only "standard" trust on offer, i.e. where the investor is reluctant to seek advice on a bespoke trust (which would normally involve a substantial fee), would be likely to be a discretionary trust. These days, it is more likely that there will be a choice of a fully discretionary trust and a flexible (interest in possession) trust.

So, how do you help your client choose out of these two the most suitable trust for their needs?

First, the IHT implications of both will be the same, although clearly where the amounts involved are comfortably within the nil rate band, the IHT relevant property regime is not going to cause too much of a headache.

The difference is mainly in the income tax implications.

With a fully discretionary trust, the trust rates currently in force are 50% for interest and 42.5% for dividend income. These are due to reduce to 45% and 37.5% respectively from 6 April 2013.

Tax has to be paid by the trustees even if all the income is accumulated in which case the trustees don't actually receive any income with which to pay the tax. Not only does this mean that the trustees will need to find cash to pay the tax but, since 6 April 2010, the trustee tax rates are higher than those applicable to the vast majority of individual taxpayers, as the equivalent rates only apply to individuals with taxable income in excess of £150,000. Is there any way to avoid these higher income tax rates?

Well, with an interest in possession trust, the trustees, generally speaking, have no liability, with all the trust income being assessed on the beneficiary entitled to income, ie. at the beneficiary's marginal rate(s) of income tax. As indicated above, unless that individual has taxable income in excess of£150,000, the maximum rate of income tax would be 40% or 32.5% for dividends, whilst basic rate taxpayers will have no further tax to pay in respect of dividend income and interest.

It should be noted that we are not looking at trusts which are settlor-interested trusts, where the tax assessment would be on the settlor (in the case of a discretionary trust, in addition to the assessment on the trustees). In such a case, if the settlor is not an additional rate taxpayer, he/she will be able to reclaim the excess tax paid by the trustees (which has to be paid back to the trust).

As well as avoiding the need to pay the higher rates of tax, having an interest in possession trust will also avoid having to complete tax returns (unless other events take place that require reporting to HMRC). From an income tax standpoint, therefore, a trust with an interest in possession should be the preferred option.

The choice of investments

Of course, with an interest in possession trust, it is important that the investments of the trust fund reflect the beneficiary's entitlement to income and the fact that the trust income is assessed to tax on the beneficiary. For example, whilst it is not essential that income is paid out to the beneficiary, if an income does arise it is essential that it is ring-fenced and kept for that beneficiary. Therefore the income must be identifiable. For this reason, investment in accumulation units/shares where the accumulation of income is reflected in the unit/share price (rather than by the purchase of additional units/shares) will not be appropriate for an interest in possession trust. In short, for a flexible trust, the only investments that are suitable are funds which distribute income.

Clearly, it may be that a cost/benefit exercise will be necessary to establish whether paying more income tax under a discretionary trust is a price worth paying for the ability to accumulate income, with perhaps a wider choice of investments.

On the other hand, there may well be circumstances where being able to pay out some income to the beneficiaries may be just what is required. For example, annual payments to a minor beneficiary may well be desirable. In addition, if the beneficiary is not a minor unmarried child of the settlor, the likelihood is that much, if not all, of the trust income would fall within the beneficiary's personal allowance. In such a case, although the tax credit on dividend income is not reclaimable, any tax deducted at source on interest can be reclaimed on behalf of the beneficiary.

Finally, on the subject of tax, it should be added that for CGT purposes there is no difference between a flexible interest in possession trust and a discretionary trust; in both cases the trust rate of 28% will apply.

Retail Distribution Review (RDR) implications

With effect from 1 January 2013, there is a new potential issue to consider in the context of trusts holding investments, and that is the question of fees payable to financial advisers in the circumstances where commission payments will not be possible. The choice of underlying investments (i.e. collectives or a bond) as well as the nature of the trust (i.e. whether a discretionary or not) will both be relevant.

In most cases the fees will have to be paid out of the trust capital and this would normally require the trustees en-cashing some of the trust investments unless there is cash already available (the latter normally a possibility with investments held on a platform), with the usual tax implications (i.e. potential CGT implications for collectives or a chargeable event for income tax in the case of insurance bonds). Alternatively, the settlor of the trust may undertake to pay the on-going fees, but this will have its own tax implications. Some financial product providers will facilitate collection of the fees on behalf of the adviser and different taxation implications will apply depending on the process adopted.

Conclusion

Especially given the income tax rates payable by the trustees of discretionary trusts, it seems that there is a place for both flexible and discretionary trusts when considering estate planning as well as wider tax planning. However, clearly there are many issues to consider before a recommendation of a particular trust and investment combination can be made.