Taxation of bonds held by a trust

This article provides an overview of the tax which applies to bond held within trust. See our chargeable event hub for more detail on the calculation of gain and income tax liability Quilter.com/CEHUB.

The structure of bonds makes them a popular choice for trusts

Investment bonds are a single premium, unit linked, life assurance policy - usually structured as several individual policy segments. Whilst the bond holder chooses the investment funds which the bond is linked to, they do not actually own them. They’re instead owned by the product provider. This structure means that the bond holder is not subject to income tax or capital gains tax on the underlying funds. This can help simplify tax reporting for trusts.

Onshore bonds pay UK corporation tax on interest and gains within the bond wrapper. This is deducted within the bond wrapper by the life company and is not reported or directly paid by the trustees. This internal taxation gives the bond holder a 20% income tax credit against bond gains they trigger. Further details can be found in this document.

Bond holders are taxed under the ‘chargeable event regime’

When a chargeable event occurs, there is a calculation to see if there is a chargeable gain. Chargeable gains are taxed as savings income. Chargeable events include;

• Full surrender of the bond or one or more individual policy segments
• Bond anniversary where part withdrawals exceed the 5% tax deferred allowance
• Maturity - usually the death of the last life assured
• Assignment in exchange for money or money’s worth
  
  

The person or entity liable depends on the type of trust

Absolute  /  Bare trust

The beneficiary is taxable at their marginal rate of tax. If more than one then the gain is divided between them.

Look out for the parental settlement rule

Where a beneficiary is the unmarried minor child of the settlor (the person who created the trust) then the parental settlement rule applies. If the trust income exceeds £100, all income is taxed on the settlor. If there are 2 parents as joint settlors this will be £100 each.

Interest in possession (IIP) and Discretionary Trusts

The settlor is taxable, at their marginal rate of tax if the gain arises either;

• during their lifetime or,
• during the tax year of their death

If the settlor cannot be taxed, then the trust is taxable at the Rate Applicable to Trusts (RAT) - see below.

If there is more than one settlor, divide the gain between them according to their contribution to the trust, this is often simply 50/50. Where one settlor has already died, this can result in a split treatment for trusts.

Look out changes in the trust structure

Some trusts change their definition of beneficiary on the occurrence of a defined event. This can alter who will be taxable.

Contingent interests

Commonly found within a Will. The trust defines one or more beneficiaries, but states that their absolute entitlement is on the attainment of a certain age (e.g. often 21 or 25) or an event (e.g. on event of marriage). There’s usually a clause which states who will benefit instead if the beneficiary dies or the event does not occur.

Whilst the contingency is yet to be fulfilled, then the beneficiary does not yet have a ‘vested’ interest. Bond gains will be taxed at the RAT. On meeting the contingency, the tax treatment can change. If the beneficiary now has an absolute interest in the trust fund, then they will be taxed at their marginal rate.

The Rate Applicable to Trusts (RAT)

The tax-free band

The tax-free band of up to £500 applies only where the trust’s total income from all sources is below £500 in a tax year. If the income exceeds this, then all income is subject to the RAT. The £500 tax free band is reduced if the settlor has created more than one trust. The £500 is divided between them, but with a minimum of £100.

If there is more than one settlor, then it is the settlor who has created the most trusts which is used to determine the tax-free band available.

Trustees report and pay tax to HMRC using the SA900 form.

Prior to April 2024, trustees had a band of up to £1,000 where the basic rate of income tax applied. This band was also reduced if the settlor had created multiple trusts.

Top slicing relief is not applicable where the trust is taxable

However, it can be used where the settlor or the beneficiaries are personally liable for tax on the gain.

Assigning bonds can help with tax planning

Trustees can choose to assign ownership of the bond or individual policy segments to adult beneficiaries. The beneficiary is then free to keep those segments or encash them at their marginal rate. This can be useful where;

• the settlor’s rate of tax is higher than the beneficiary,
• the settlor is deceased and the RAT applies,
• the beneficiary wishes to keep the bond or encash it over a prolonged period.

Assignment of the bond to a beneficiary as a distribution of the trust fund is not an assignment for money / money’s worth.

Appointments can help with tax planning for minor beneficiaries

Where the intended beneficiary is below age 18 it is not possible to assign a bond to them. However, it is still possible to apply their marginal rate through an ‘appointment’. This is an irrevocable declaration by the trustees that the bond, or individual segments within it, will be held specifically for a particular person. This changes the nature of the trust and gives the beneficiary an absolute entitlement. This makes them taxable at their own marginal rate of tax. Legal ownership of the bond remains with the trustees, they will be responsible for the surrender and distribution of the proceeds. This can be useful where;

• the beneficiary is too young for assignment
• the beneficiary would have difficulties in managing the assignment and withdrawal process

Care should be taken where the beneficiary is the minor unmarried child of the settlor, as the parental settlement rule (described above) applies.

Last reviewed: May 2024