Patrick Kennedy talks about the role assignment can play as a tax deflecting strategy.
Life assurance policies have many facets and features, although some of them are easy to overlook. Single premium bonds are long-established investment vehicles that have survived the test of time. Where they provide us with an advantage, especially if this potentially offers valuable tax benefits, then they should be uppermost in our minds.
Way back, when they were originally a new breed of investment vehicle, HM Treasury positioned them as a tax privileged arrangement due to how they were structured. The list below shows many of these features still prevail, which is amazing given the economic and tax landscape that they have travelled through.
• Their structure - tax-efficient income by means of the cumulative 5% a year tax-deferred allowance
• The underlying basis of taxation - from a provider's perspective
• The ability to change ownership by means of assignment
This last point, the ability to assign policy benefits (linked to trusts or otherwise), is one of those simple, yet powerful, facets. This must be foremost in the frontal lobe when considering extracting cash from policies in an efficient and tax-beneficial way.
What is an assignment?
Well, dictionaries are often the best reference source to answer this question! They have a tendency to surprise us with what they reveal. The legal definition of assignment states it is a ‘transfer to another of a right, interest, or title to property, or instrument of transfer'. Couldn't have put it better myself!
This mechanism, in our world of life assurance, is a perfect tool to deflect the tax point from the original owner to a new owner. The benefit of being able to assign revolves around the point that the transaction is not subject to a chargeable event, for income tax, provided it is a genuine gift and not being assigned because the policy has been sold.
The objective would be for the new owner to be a lower, or better still, a nil rate taxpayer so that ownership (or ‘title'), rests in their hands. Then they have the authority (backed by a deed of assignment as proof of title along with the policy schedule) to surrender the policy and, crucially, as the new owner, pay tax on the gain, ideally at their lower marginal rate of tax.
There are usually few time constraints on the new owner to surrender the policy. That could play into their hands and turn out to be a good thing. Additional years of top slicing relief could accumulate and potentially mitigate the tax consequence when it is ultimately surrendered. Additionally, the timing aspect, where possible, should focus on the appropriate tax year to surrender so the policy gain can soak up what remains of the new policy owner's personal allowance, but only for offshore policies.
The application of the assignment strategy is not just confined to individuals. It works just as well for trustees and is just as tax beneficial too. The tax deflection might be greater in that trustees can, in some situations, avoid tax as high as 50% in favour of passing it off to the beneficiary at, ideally, a lower rate. There is good news on the horizon! Trust taxation rates are likely to reduce to 45%, from April 2013, following the recent Budget.
The way trust rules are structured means there are tax benefits to be captured, which follow the same pattern for individuals. Similarly, this is all easily achieved by the use of a simple legal document, transferring ownership from one party to another. The point we mustn't underplay is that an assignment is not a chargeable event for the purposes of income tax (and the assignment must not be for money or money's worth). This is what really drives assignments to be a tax-effective tool.
So far, the main inference has been around the assignee being over 18. Ignoring trusts for a minute, it is legally permissible for minors to be party to a contract as well as hold assets. Perhaps a stumbling block would be that they cannot withdraw from the contract until they attain majority, which doesn't provide certainty. In Scotland, the same rules apply but the age of majority is 16.
In reality, would you really want your ‘little darlings' to be able to hold and control assets, large or small, at an age where they couldn't adequately cope with them? Indeed, with some ‘whipper-snappers', you'd perish the thought at 18 or beyond! Thankfully there is legal protection in place to stop youngsters from financial self harm, it's called capacity to contract.
Back to the world of trusts and particularly well-drafted discretionary trusts, it can be said that similar protection, for minor beneficiaries, can now exist here. The different slant is that trustees hold and control assets on their behalf. But, in terms of the tax treatment of life assurance policies, the outcome of the assignment mechanism wasn't that tax beneficial for minor beneficiaries, prior to a rule change a few years ago.
In an interesting u-turn HMRC changed the rules in HMRC Brief 51/2008 (issued on 8 October 2008), which took effect from 6 April 2007. The practice of the settlor/trustees being liable for income tax on policy gains was deemed to be incorrect, as far as bare trusts for minors were concerned.
From 6 April 2007, in line with the treatment of income tax for such beneficiaries, they became the taxable entity for gains arising on life assurance policies held in bare trusts. This means potentially better mitigation, from a tax perspective, because the bare trust beneficiaries are likely to have ample personal allowance (where it is an offshore policy) to soak up any policy gains when a gain is triggered.
Consequently there was little change for parents who set up bare trusts for their children, with life assurance policies as assets, because HMRC didn't scope in the parental settlement rules when they changed their stance in Brief 51/2008. Where the settlor is the parent of the beneficiary (who is a minor, unmarried and not in a civil partnership) and where chargeable gains exceed £100 in the tax year, all gains will be taxed on the parent.
The position is much better where grandparents or other (wealthy) relatives are the settlor. Then the beneficiary will be the taxable entity when chargeable events are triggered.
It is much better for these individuals because it is about being able to deflect the tax point. If they feel so disposed, effective school fees planning can be established, especially where offshore policies are concerned. Further tax advantages can be captured where the settlor and trustees make an appointment of policy benefits from within a discretionary trust to a bare trust specifically for the purpose of shifting the taxable entity to a more tax appropriate individual. The usual words of warning regarding bare trusts still prevail.
So where do discretionary trusts figure in all of this? Simply with an appropriately drafted trust, containing all the requisite powers, it is possible for trustees to execute a power of appointment (similar to an assignment) to create a bare trust. This has the impact of carving out trust benefits for minor beneficiaries in the form of specific policies to the required amount, with the underlying asset being a life assurance policy. The objective, tax-efficient school fees planning would be a perfect fit where the dangers of bare trusts can be avoided.
A sign for the times is that changes in HMRC interpretation of legislation (Brief 51/2008) can, albeit rarely, deliver tax mitigation opportunities. This delivers a strategic planning benefit offering the ability to deflect the tax, by means of assignment. Utilising either the trust mechanism or the plain assignment route should always be uppermost in our minds.
Patrick Kennedy is tax and estate planning consultant at Canada Life
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