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School fees too much to "bare"?

December 14th 2009

A change in the approach by HM Revenue & Customs in October 2008, towards the tax treatment of bare or absolute trusts, has identified a unique opportunity when looking to make provision for school fees.

 Any gain will be assessed on the beneficiary of the trust, rather than (as was previously the case) the trustees or the person who created the trust (provided it is not the parent of the beneficiary). Funding school fees by combining the tax advantages of an offshore bond with the ability to use a child’s personal income tax allowance could be a very tax efficient strategy.
 
How does it work?
Grandparents often fund their grandchildren’s school fees, but anyone other than the child’s parents can be the ‘donor’. We will assume that the grandparents are the donors in this simple process.
 
1.                The grandparents create a bare trust for the benefit of the grandchild (the beneficiary) for whom the school fees will be payable. The trust allows the trustees, typically the parents, to use the trust funds for the general education, maintenance and benefit of the beneficiary.
 
2.                The grandparents make a gift of capital to the trustees for the purpose of meeting the future cost of the school fees.
 
3.                The trustees choose to invest the capital into an offshore bond that offers a wide choice of investment opportunities and is divided into a number of individual policies or segments for greater tax efficiency. Any growth within each segment is generally tax-free until, for example, a segment is encashed.
 
4.                As fees become payable, the trustees encash individual segments and any gain is assessed on the child, rather than the grandparents or parents. As the child will typically be a non taxpayer and will have a personal income tax allowance of £6,475 (2009/10), it is unlikely that a tax charge will arise.
 
5.                The following example is for illustrative purposes only and does not take into account any charges. All figures are rounded to the nearest pound. Please note that the value of an investment in the bond can fall as well as rise, is not guaranteed and you could get back less than you invest.
 
Example
Paul and Anne, both aged 55 and higher rate taxpayers, are looking to set aside some money to pay for their grandson’s private education. The fees are expected to start in five years and continue for seven years until he reaches 18. The annual fees are currently £10,000 and are expected to increase by 3% each year. They consider investing £90,000 into an offshore bond and encashing individual £1,000 segments each year to contribute towards the fees payable. They expect to remain higher rate taxpayers. Assuming an annual growth rate of 6% for the bond:
 

End of Year
Initial Value Segments
Encashment Value
 
Gain
Tax payable @ 40%
Net Proceeds
School Fees
5
£10,000
£13,382
£3,382
£1,353
£12,029
£11,593
6
£10,000
£14,185
£4,185
£1,674
£12,511
£11,941
7
£10,000
£15,036
£5,036
£2,015
£13,021
£12,299
8
£10,000
£15,938
£5,938
£2,375
£13,563
£12,668
9
£9,000
£15,205
£6,205
£2,482
£12,723
£13,048
10
£9,000
£16,118
£7,118
£2,847
£13,271
£13,439
11
£9,000
£17,085
£8,085
£3,234
£13,851
£13,842
Totals
£67,000
£106,949
£39,949
£15,980
£90,969
£88,830

 

But what if Paul and Anne instead, create a bare trust for their grandson and gift their £90,000 to the trustees, who would invest in the same offshore bond and withdraw the same amount each year as before?

 
End of year
Initial Value of Segments
Encashment Value
Gain
Tax Payable
10
£9,000
£16,118
£7,118
£ 64 (£6,475 x 0% + £643 x 10%)
11
£9,000
£17,085
£8,085
£161 (£6,475 x 0% + £1,610 x 10%)
 
By creating a bare trust, Paul and Anne could save £15,980 in tax, allowing them to contribute more to their grandson’s school fees. Assuming there are no increases in personal allowances, their grandson would only have a tax liability in the last two years of just £225 on total payments of £106,949. The remainder of the bond could then be used to help fund their grandson’s further education.
 
This document is based on our current understanding and interpretation of current legislation in the UK  and HMRC practice, which may change at any time.
 
If you would like to talk to one of our advisers about any aspect of your personal finances please give us a call on 0113 287 8200 or e-mail us on advice@prosperis.co.uk