Kim Jarvis: Income modelling for personal injury trusts

Kim Jarvis looks at personal injury trusts and explains what advisers need to know to help people deal with large sums after sometimes tragic events...

Some compensation awards for personal injury hit the headlines because of the amounts involved.

For example, a multi-million pound compensation for a young child who suffered brain damage due to medical failures during birth or a substantial award for an employee losing an arm and a leg at work.

These personal tragedies are difficult enough to handle for those caring for the beneficiary of the awards, but hopefully, the financial settlement should be sufficient to fund their needs for the rest of their lives.

However, having to manage what can be a huge sum of money and knowing where to invest it for the long term can be a challenge but one that can be handled by a professional adviser.

Personal injury trust

It is quite common for the compensation amount to be allocated to a personal injury trust because it will then be ignored when assessing the entitlement of the beneficiary to means-tested benefits and local authority funded care (assuming the 52-week limit for the trust to be established was not exceeded).

It is important to understand what this 52 week period means. This 52 week period is not a time limit for setting up a trust, it is a period of grace for people already claiming means-tested benefits to sort out their financial affairs and set up a personal injury trust.

In addition, there are practical advantages in that the beneficiary may be very young or mentally incapable and would benefit from trustees handling their financial affairs.

The tax position of trust income and capital will usually be quite straightforward in that it is assessed as if it was the beneficiary’s income and capital.

So for a financial planner, the challenge is in providing a lifetime income from the trust fund with access to capital as and when required. The asset allocation and investment management are crucial, but so is the tax position – which is the main perspective of this article.

Since 6 April 2016, allowances have been introduced for investment income which, when combined with other allowances, can generate a considerable amount of tax-free income.

As an aside, when funds are required it may be prudent to take varying amounts at irregular intervals from the trust to keep below the relevant capital limits for means testing, or the trustees could pay for capital expenditure directly from the trust funds.

One of the drawbacks of using a personal injury trust is that it is not possible to take advantage of the individual savings account (ISA) tax-free allowances, because ISAs must be taken out by an individual. The current annual subscription limit of £20,000 on 6 April 2020 makes that disadvantage even more pronounced.

Income tax allowances

For the purpose of this article, I am assuming that the beneficiary has no other income apart from that available from the trust. That may not always be the case, but it allows us to focus on the allowances available in that situation.
As from 6 April 2020 these are:

Personal allowance £12,500
Personal savings allowance Up to £1,000
Dividend allowance £  2,000
0% starting rate for savings income £  5,000
Total £20,500

 

In addition, there is the £12,300 annual exemption for capital gains. Whilst this is extremely useful, it does depend on the portfolio having accrued sufficient gain in the year concerned. So in the early years, it may be the case that it cannot be fully utilised.

If the trustees need to realise investments and make a capital loss, one solace is that if the capital loss is registered with HM Revenue & Customs within four years, it can be carried forward indefinitely.

So overall, there is the potential for tax-free receipts of £32,800 to be generated every year. And bear in mind that with the CGT exemption at £12,300 – that’s just the gain – they will have the original capital relating to that as well so they can realise a much larger figure.

The personal savings allowance is only available for savings income, as defined by the legislation1. It includes interest from deposit accounts, National Savings and gilts, interest distributions (fixed income) from unit trusts and open-ended investment companies (OEICs) as well as the income content of purchased life annuity payments and gains from life insurance policies (such as investment bonds).

It is £1,000 for a basic rate taxpayer, £500 for a higher rate taxpayer, but zero for an additional rate taxpayer.

Dividend income is also defined by the same legislation2 and as well as equity income, will also apply to dividend distributions from unit trusts and OEICs.

The rule as to when a unit trust or OEIC is a fixed income fund is:

A fund is regarded as a fixed income fund if, at all times in the period covered by the distribution, the market value of the qualifying investments exceeds 60% of the market value of all the investments of the fund.
Otherwise, it will be an equity fund for tax purposes.

Income modelling
When a financial planner is creating an income model, they have to be careful not to let the quest for tax-free income overrule prudent investment management or the trustees’ attitude to investment risk, but these allowances mean that the trustees could potentially hold £100,000 on deposit yielding 1% per annum say, and £100,000 in equity funds yielding 2% per annum; with all the £3,000 income being tax-free.

Which leaves us with £17,500 of allowances available (assuming the personal savings allowance has been used); plus the capital gains tax (CGT) annual exemption of £12,300 available for equity fund disposals.

This could simply be used by increasing the holdings on deposit or in funds, but a more useful holding might be an international investment bond – one issued by a non-UK company in the Isle of Man, Ireland or other jurisdictions.

The old days of hefty investment bond commissions and inflated management charges are long gone, with it now being a versatile tax-efficient low maintenance investment that can be of great advantage to trustees.

The advantages include the provider handling all the portfolio administration and any disposals by the investment manager not being assessed for tax (because the bond is based outside the UK).

The tax position of an investment bond is particular because it is a non-income producing asset and partial withdrawals from the bond are not assessed for tax until they exceed a cumulative annual allowance of 5% of the amount invested.

So in the second year of a bond investment by trustees of £200,000, (assuming no withdrawals in year one) a withdrawal of £20,000 (10%) could be made without any chargeable event arising.

If this sounds too good to be true, it should be noted that when the bond is eventually surrendered all previous partial withdrawals are brought into the calculation of the overall gain and taxed accordingly. So it is a tax-efficient or tax-deferred investment, as opposed to being tax-free, but depending in the policyholder’s tax position and the exit strategy, when an event arises, little or no tax could be payable.

This situation gives trustees an excellent opportunity of managing the tax position of the beneficiary, in terms of using the £17,500 allowance available in this example.

Opportunity 1
If the trustees had made a withdrawal of £37,500 instead of £20,000 from the bond, a ‘chargeable gain’ of £17,500 would have arisen. This would then have utilised the remaining £17,500 allowances because investment bond chargeable gains are savings income.

But please note that this only applies to international investment bonds and, as there is no UK tax deducted within the funds, they benefit from gross roll-up. The tax position of bonds issued by UK companies is different because the investment fund is subject to tax at the equivalent of basic rate (20%) each year on interest and capital gains, however on encashment, although investors get the tax credit for the tax paid within the fund they cannot reclaim the tax paid if they are non-taxpayers.

Even though it falls within the unused allowances, the £17,500 gain is carried forward as a credit until the eventual surrender of the bond, so it will be lost if the investment profit does not reach that level.

Opportunity 2
Other trustees have a £200,000 bond that is now worth £306,000 and they have made no withdrawals. They have capital expenditure which means that they need to raise £50,490 over and above other capital gains using the annual exemption.

Their bond was actually issued as 2000 individual policies of £100 each, which are now worth £153 each. So they surrender 330 individual policies to raise £50,490 with the chargeable gain being £17,490.

As before, this transaction utilises the personal allowance and starting rate for savings income with no tax being payable.

These examples show the advantage of an international investment bond as part of an overall strategy for a lifetime income model for personal injury trusts.

It does all depend on the circumstances and requirements of course, but a combination of types of investment can ensure that the beneficiary enjoys all the income tax allowances available.

Kim Jarvis is technical manager at Canada Life

Section 18 of the Income Tax Act 2007

Section 19 of ibid