Income or Capital - Trusts and Bonds

Suppose the trustees of a discretionary trust invest trust assets in an investment bond.

If the trustees then withdraw 5% of the initial capital value each year that will (within the first 20 years) be taxed as a return of their initial capital, which is to say, not taxed.

If those trustees then distribute those receipts to a beneficiary is that also a distribution of capital (failing which, can the trustees resolve to treat it as a distribution of capital)? If so presumably it is untaxed on the beneficiary too - not being income in the beneficiary’s hands.

Is that analysis correct?

I believe it is.

The downside is that if/when the trustees exceed the 5% (perhaps because 100% of the principal has been repaid) and have to pay income tax, the distributions are still capital. The consequence is that the trustees pay the trust rate of income tax but the beneficiaries do not receive a tax credit and so basic/higher rate taxpayers cannot recover any tax.

Yes it is. The 5% is in effect a partial return of the premiums paid and there will usually be just a single one. IHT RPT charges will apply but not CGT. As regard income tax in strict theory the nature of the receipt determines its status as income or capital not the source of the payment but I am not aware of HMRC seeking to tax regular distributions of 5 per cents as income.

Nor is there a charge under the special “chargeable event” rules (see generally IPTM and ITTOIA Part 5 Chapter 9) on a gratuitous distribution of the policy itself, which can be made to beneficiaries jointly. In fact many policies are are written as several underlying sub-policies, greatly facilitating this exercise. When the policies are later encashed or mature it is the beneficiaries’ own rate of income tax that will be charged on any gain. Policies are often written for a long fixed term to avoid automatic maturity charges rather than managed whole or part surrenders, though the 5% per annum allowance cease to cumulate after “insurance year” 20.

It is good practice for trustees to assess whether to encash and pay any tax at the trust rate (or the settlor’s!) or transfer the policy or sub-policy itself for the beneficiary to encash it.

The 5% works on a cumulative basis so if 15% is first encashed after 3 “insurance years” and then distributed it will not be a chargeable event as there is not an “excess event”. If 20% was encashed there would be a charge on the excess.The 5% amounts historically withdrawn reduce the amount of the original premium deductible later from the policy proceeds of a later whole or partial surrender or final maturity, increasing the taxable amount. So it is not strictly a tax-free allowance but rather a deferral of the charge. Where there are sub-policies trustees should assess whether it is better to withdraw 5% from each or a full surrender of one or more. See IPTM3505 and 7615.

In a DGT the 5% amounts will belong to the settlor until death or earlier full utilisation (as the original premium is initially held on a bare trust for the settlor) and any undrawn surplus, including the right to any remaining unused 5% amounts, is held on a DT (or pre-2006 IIP trusts).

Jack Harper

Hi Andrew

We would often recommend the use of on an investment bond.

The bond is typically broken down to a number of smaller segments and it is worth considering the number of segments in order that you can have more flexibility when encashing part or whole segments.

It is also worth understanding that the adviser charges will reduce the 5% allowance.

Should the beneficiary need monies then consider assigning segments rather than the trustees encashing them themselves as this is often more tax efficient.

It might even be worth having more than one bond within the trust.

Best wishes

Clive Perks CFP

Supportive Financial Planning


Excellent answers. Thanks so much, @andrew.goodman, @jack and @cliveperks.

@jack in response to the aside in your your answer, in what circumstances would the settlor’s tax rates or allowances be pertinent? Is that only where the tax would otherwise fall on the settlor, e.g. where there is a reservation of benefit, or a spouse or minor child benefits?

If IHT is in point as discretionary trusts are usually relevant property, then distributing out the 5% as cash may well trigger IHT exit charges so assigning a few segments to the beneficiaries, if the deed allows, for them to encash, as mentioned in other responses, will avoid this issue.

@Max thank you. I haven’t come across that distinction before - are you saying that an appointment of cash would be an exit charge but that an appointment of some segments of a bond of equivalent value would not be an exit charge? What’s the distinguishing factor?

Yes, that is what I am saying.
I’m not sure of the exact technical reasoning - no doubt someone more learned can explain, however assigning uncashed segments to a beneficiary is a tax nothing for both parties and no value is attributed to it for IHT purposes.

For the benefit of anyone following this discussion, the answer to the question I addressed to @jack above is that chargeable event gains on assets in trust are in general assessed on the settlor while living (or, apparently - which I haven’t come across before - in the tax year of death, even if arising after the death).

There is more detail at IPTM3250 and the pages linked from it: IPTM3250 - Person liable to charge: summary of the position in relation to trusts - HMRC internal manual - GOV.UK (

The rules identifying the person liable to tax are set out in ss464-472 ITTOIA 2005. In a UK resident trust the settlor is taxable, as having “created” the trust, while alive whether he retains an interest or not:s.465 (3). The trustees are chargeable only if he is (delightfully) an “absent settlor”, most commonly if he has died or is non-resident: s467(3) and (4).

IPTM3240: "When a chargeable event occurs after a UK resident settlor’s death, but before the end of the tax year, the gain will be chargeable as part of the total income of the deceased settlor for that tax year.

Where the gain arises on an event after the end of the tax year in which the settlor died, the trustees will be taxable on the gain, subject to the transitional provision for policies in existence before 17 March 1998".

Where the trustees are non-resident, or the beneficial owner is, the transfer of assets abroad rules apply with modifications.So ss. 720,727,or 731 ITA 2007 are relevant in determining the person liable and the exemptions in ss736-742A are theoretically available but in practice, per, HMRC actually “never, well hardly ever”.
A policy issued by a UK resident company is treated as having had income tax deducted at basic rate but this is not repayable: s530 ITTOIA. This needs to be borne in mind when assigning to a minor. A policy issued by a non-resident company is taxable at all rates, which may suit a minor. The insurance company may or may not have suffered tax in the UK or elsewhere so when comparing the returns that should be taken into account with other relevant factors. Note that this does not affect the person chargeable. UK resident trustees can own foreign policies and non-resident trustees UK policies.
Gratuitous assignments to beneficiaries are often used to avoid the tax charge on the settlor and if dead on the trustees to secure lower rates of tax though beware s530 (tax credit at BR non-repayable).
For IHT any distribution from an RPT of cash after surrender or maturity or of a policy itself is liable to tax. If the settlor is liable to income tax as the person who created the trust despite having no interest it can still avoid being a GROB.
Although the policy gain is not income the Pre-Owned Asset Nonsense cannot be ignored in a settlor-interested trust because the test is whether any income would arise to be taxed on the settlor even though if the bond is the only trust asset and does not produce income: para 8(1)(a) Sch 15 FA 2004 and IHTM44009.
Jack Harper

Very useful. Thank you, @jack.

@Max I dont think that is correct. Assigning a segment out is not a Chargeable Event, i.e. does not crystallise a gain chargeable to income tax, but it is a distribution of capital from the trust and therefore subject to any exit charge that may apply.

Following extract from Standard Life’s Techzone for financial advisers:

@KarenThomas My understanding is the same as yours.

Paul Davidoff
New Quadrant

1 Like

I agree

Simon Northcott

I will add an observation to my post by saying that I do recall seeing some investment bonds written in trust from before March 2006 where there trusts were not relevant property trusts: some form of IIP for the intended beneficiary/beneficiaries (often an absolute defeasible interest). In such a case, the assignment of the bond segments to the beneficiary/beneficiaries in the same proportions as their respective shares of the IIP would not trigger an exit charge as it would be “a tax nothing” for IHT purposes. The same is true now of advancements / appointments to life tenants of “qualifying” IIP trusts (ie not relevant property), including also non-relevant property “absolute defeasible interests” where the advancement is to the person with that absolute defeasible interest.

Paul Davidoff

I can confirm from personal experience that Paul Davidoff is exactly right.

Unless the bond prohibits it as a matter of contract, there is no general law against making a legal assignment of a thing in action especially as the assignor is the person required to give notice to the insurance company. The assignee is not required to do anything to validate this and can sue for the policy proceeds in any way a minor is generally permitted: S136 LPA 1925 and s.3 Policies of Assurance Act 1867

Jack Harper

1 Like

I would warn against investment bonds. Don’t think you’re not going to be taxed on the 5% withdrawals. Eventually the bond will be surrendered or reach maturity and the total gain (including the withdrawals) will be taxed as trust income which is at 45% for discretionary trusts with no top slicing relief or relief for beneficiaries because it is still capital for them.
If instead the trust fund is in conventional investments and makes capital withdrawals there is likely to be no CGT to be paid by the trust even with the reduced tax free band (and no tax by beneficiaries). If CGT has to be paid it will be at just 20%.
It’s also worth remembering that discretionary trusts have to pay out real income to beneficiaries after 21 years so bonds will in due course have to be surrendered since they don’t pay true income in the hands of beneficiaries.
As a trustee I learnt all this to considerable cost to the trust when our fund was put into an investment bond on bad advice from our FA.

I was recently involved with an IOM Bond. 3 Beneficiaries and 10 segments. Trustees assigned one segment to 3 jointly. If you do not have enough full segments to assign to best advantage you can spread more tax efficiently by tailoring joint assignments.

As Richard Bishop has indicated a full surrender usually results in a better outcome than partial surrenders of one or more bonds.

Jack Harper

1 The deferred charge to tax can often be minimised if not entirely avoided by gratuitous assignments to beneficiaries whose income tax liability will be less than that of a living settlor or the trustees

2 A discretionary trust can now be drafted to allow income to be accumulated until the end of the perpetuity period which is now 125 years: ss 5 and 13 Perpetuities and Accumulations Act 2009. The Act came into force on 6 April 2010.

It can apply to trusts taking effect before then: ss15 and 16. The abolition of the rule against accumulations applies to older trusts unless they are contained in a Will executed before the above date or by the exercise after that of any power of appointment created before it

The Explanatory Notes are exceptionally helpful

Jack Harper

  1. If a bond’s assured life is not the settlor (say in a Will Trust)., then there is no practical way of avoiding most of the tax while maintaining the value of the fund, particularly as the date of death of the assured is an unknown. Yes, payments to beneficiaries should be made by assignment but that cannot be done after the death and trustees should be mindful of the fax bill on that final “chargeable event”.

  2. Bonds make more sense in settor-life-assured trusts because then there is top slicing relief at his/her rate on the death.

  3. Regarding accommodations, I stand corrected by Jack Harper and the now 125 year rule. In my case the 21 years was in a Will of 2001 and so remains in force (I think).