Taxation Readers’ Forum: Are withdrawals trust income or capital?

/ 30 January 2023

Terry Jordan

Writing for Taxation magazine’s Readers’ Forum, BKL tax consultant Terry Jordan responds to a reader’s query about a whether discretionary trust withdrawals are trust income or trust capital.

‘A discretionary trust holds offshore life assurance investment bonds. The settlor has always been UK tax resident and is still alive. All the trustees are UK tax resident and have always been. It is therefore a UK resident trust.

If withdrawals are taken within the cumulative 5% limits, are these withdrawals trust income or trust capital? With a ten-year anniversary approaching, the plan was to ensure that the cumulative 5% drawdowns had been taken and paid to beneficiaries in order to reduce the trust capital.

HMRC’s Trusts, Settlements and Estates Manual TSEM3220 seems to indicate it is income for tax purposes, but I understood that the concept of life bonds is that the 5% is a return of capital.

If it is income for tax purposes does that mean that the payment of the 5% drawdowns to beneficiaries is an income distribution and not a capital distribution requiring an exit charge?’ Query 20,073 – Puzzled.

Terry Jordan’s reply: A settlor is charged if gains are realised.

‘Puzzled’s query concerns a UK discretionary trust which holds non-UK investment bonds.

The settlor is living and UK resident. As Kevin Read pointed out in his article ‘In bond we trust’ (Taxation, 8 January 2014), there are many advantages to trustees investing in a life assurance investment bond:

  • easily ensuring that the requirements of the Trustee Act 2000 regarding diversification of investments are met;
  • simplified administration for the trustees; and
  • the ability to switch the underlying investments held in the life assurance tax wrapper without incurring tax charges.

In my experience the taxation of such bonds continues to cause some confusion.

Puzzled refers to HMRC’s Trusts, Settlements and Estates Manual at TSEM3220 and the heading is ‘Capital items that are income for tax purposes: foreign life assurance policy  gain chargeable on trustees’.

Although reference is made to ‘gains’ realised on encashment the charge to tax on ‘chargeable events’ is to income tax and not capital gains tax.

However, the fact that the charge is to income tax does not mean that the 5% withdrawals are necessarily income for trust purposes.

HMRC’s Inheritance Tax Manual at 14250 in the context of the inheritance tax exemption in respect of regular gifts from surplus income includes the following: ‘A person may receive payments from insurance policies in a number of situations; on maturity, by full or part surrender of a policy, by regular withdrawals, by sale, assignment or loan. Some of these payments are chargeable to income tax but that does not make them income. Even if the payments are regular, the character of such payments is usually capital and they cannot be taken into account in calculating the income available to a transferor. A common situation is where a person takes annual withdrawals equal to 5% of the premium from a single premium policy.’

In this case, the withdrawals from the bond must go to trust capital account and if distributed out will trigger proportionate or ‘exit’ inheritance tax charges.

When bonds are held on non-charitable trusts the gains are taxed on the settlor if he is available to be charged. The settlor in this case is available by virtue of being living and UK-resident.

Perhaps counter-intuitively a settlor is charged if gains are realised by the trustees in the tax year of death, even if the settlor is no longer living and it is usually advisable for the bonds to be written on multiple lives.’

The full article is available on the Taxation website.

Our private client tax team have expertise in a range of areas including IHT, wills, trusts and probate. For more information, please get in touch with your usual BKL contact or use our enquiry form.

Terry Jordan

Senior Adviser, Private Client

T +44 (0)20 8922 9360
E terry.jordan@bkl.co.uk

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