Cut through the cost-of-living crisis
With the cost of living constantly increasing, you may want to plan ahead for school and university fees.
What you can’t do – settlement rules
HMRC recently published that a tax avoidance scheme purporting to allow directors of owner-managed companies to divert dividend income to minor children by having grandparents subscribe for a new class of shares doesn’t work.
The aim of these types of arrangements is to utilise the child’s personal allowance, dividend allowance and basic rate tax band. The income will be subject to less tax (if any) than dividends received by the parents, and can then be used to pay the fees.
In respect of parents and minor children, the rules treat income that exceeds £100 per annum as income of the parent(s) where the assets used to generate it were provided by them.
Rob buys a share portfolio and creates a bare trust arrangement for his son Theo. This is so that Theo is the beneficial owner and entitled to any income. The portfolio produces income of £5,000 in the first tax year. This is treated as a settlement, and Rob will need to include the income on his own tax return for the year.
This only applies to situations where the parent(s) provide the assets. If other family members provide them e.g. uncles/aunts or grandparents, the settlement legislation doesn’t apply unless the parent(s) provided the other family with the assets. From the example above, Rob couldn’t get around these rules by giving his dad, Jeff the cash first to invest in the share portfolio, and then having Jeff declare the bare trust for Theo.
What you can do – safe strategies
The key to successful tax planning for school fees is to ensure that the parents aren’t making any settlement, whether directly or indirectly. The best way to do this with an owner-managed company is to set up the shareholding structure early, when the company is worth little and has no value.
The grandparents, or other family members (excluding the parents) could subscribe for shares at market value, and settle these on trust for the minor children.
What type of company do I need?
A good option might be to set up a family investment company (FIC) if the circumstances are right. These are very specialised, tailored to a family’s needs and circumstances and, due to the cost of setting them up, will be more appropriate if they are used for inheritance tax (IHT) planning, with school fee planning being an added bonus rather than the main motivation.
You have grandparents, parents and minor children. The grandparents introduce cash into the company by subscribing for redeemable preference shares. The parents subscribe for ordinary shares. The minor children could either have the grandparents gift them funds to acquire a different class of ordinary shares (using a nominee arrangement), or the grandparents could subscribe for the shares directly, then settle them into trust for the benefit of the children.
The funds the grandparents use to subscribe for the preference shares could then be used to make investments inside the company, which hopefully make profits.
Companies are generally exempt from tax on dividend income, so shares can be a very efficient option. Dividends can then be paid out, e.g. to the trustees who can pay the school fees.
You will need specialist advice from a corporate solicitor to ensure it is set up to work as intended. An off-the-shelf company will not be suitable.
A simple grandparent trust
You may not want to use a FIC, particularly if it is only school fees being considered.
Could the grandparents simply set up a discretionary trust for the minor children?
This is certainly possible if they have cash or income-producing assets to transfer.
Peter and Wendy have two children. Wendy’s father, Charles, wants to help with the children’s school fees and sets up a trust for their benefit. He puts £300,000 into the trust, which is then used to invest in shares to generate dividend income of approximately 10% per year. This arrangement doesn’t fall foul of the anti-avoidance rules as Charles has provided the funds himself.
A gift of cash or assets into a trust will be a chargeable lifetime transfer (CLT) for IHT purposes but will not attract a charge if the value is below the available nil rate band, or relief such as business property relief applies.
One problem with a grandparent trust is that it will have to pay tax on the income at the trust rates, i.e. 45% or 39.35% (for dividends), subject to a small basic rate band of £1,000.
When the income is paid out to the beneficiaries, the beneficiaries can claim a 45% tax credit. For children, this tends to mean the overall position is tax-neutral due to the availability of their allowances. This however, could have cash-flow implications.
The trust may be subject to periodic IHT charges, depending on the value of assets held. The charge points are every 10 years, and are 6% of the value of the trust assets, less the nil rate band.
As an alternative strategy, the grandparents could invest in offshore investment bonds. There are tax-efficient products that hold a variety of assets that produce income and capital growth. As long as the underlying assets remain in the bond wrapper, they can grow virtually tax free – you would need to talk with your independent financial adviser on the options available before any decision would be made.
You are allowed to draw up to 5% of the original investment each year until such time as all of the original investment has been returned.
Take 5% per annum for 20 years, without incurring an immediate tax liability. This allowance is cumulative, so if no withdrawals are made in the first four years – 25% of the amount invested can be taken in year 5 without triggering a tax charge. This 5% tax-deferred withdrawal can provide a highly tax-efficient source of income to contribute to school fees.
The tax charge eventually comes when the bonds are encashed. The downside is that this is an income tax event rather than capital gains. However, grandparents can avoid tax by placing the bond under a bare trust, naming themselves and the child’s parents as co-trustees and the children as beneficiaries. By assigning the policies to the children, the tax on the gain will be payable by the child and not by the grandparent. Since the gain is likely to be within the child’s personal allowance, it should be tax free.
Naming the parents as co-trustees ensures continuity if anything happens to the grandparents.
A gift from the grandparents
Can the grandparents just pay the fees directly?
The payments will be treated as a potentially exempt transfer (PET) for IHT purposes. As a result, payment of some or all of the fees could be made as part of a wider IHT planning strategy. If the grandparent making the payments survives beyond the 7th anniversary, the gift becomes completely exempt. The strategy here saves tax in the longer run rather than upfront.
To increase the tax efficiency further, the payments could be made from returns on exempt investments, e.g. returns on an ISA or tax-exempt dividends from a venture capital trust. They would also be exempt if they are regular gifts made from surplus income – a strategy often neglected and can involve a simple letter to express what you are planning on doing by gifting your surplus income.
You should speak to your financial advisor accordingly.
Alternative strategies for helping with school fees
What if the grandparents don’t have the income or capital to put the planning into practice or they are no longer alive?
They may be able to access their pension to pay some or all of the school fees. If they are 55 and their scheme permits, they could take a tax-free lump sum of up to 25%.
The good thing about this is that it doesn’t trigger the money purchase annual allowance, so they can continue contributing to their pension scheme with their full annual allowance and claim tax relief. Just make sure that you inform your provider that you are looking to access the lump sum and leave the rest of the savings untouched.
You might even be able to negotiate a discount on the fees in exchange for paying them (the school) in full upfront!
Clare wants to send her daughter to a private school from the age of 13 through to sixth form. Over 5 years this will cost £100,000 if paid annually. Clare negotiates with the school, and the school agrees to reduce the fees to £85,000 if she makes the payment before her daughter starts. Clare or Clare’s mum accesses her lump sum and uses some of this to make the one-off payment.
If you haven’t reached the age of 55, you won’t be able to access your pension savings. However, if you aren’t too far away and own property, you could consider borrowing against it to pay the fees, repaying this once you can access the pension fund.
You should speak to your financial advisor accordingly.
Income tax relief
Another option could be to make investments which attract upfront tax relief, and use the tax savings to pay the fees. The most generous of these are the seed and/or enterprise investment scheme (SEIS, EIS) and venture capital trust (VCT) investments.
Both of these tax-efficient schemes offer a 50% and 30% tax reduction respectively on qualifying investments.
The EIS involves making an investment into a relatively young trading company via a subscription for shares. There is an investment limit of £1 million per year (£2 million for knowledge-intensive companies) for an individual, meaning up to £300,000 of income tax relief.
The problem with EIS investments is that they are inherently risky. If the company fails, the tax relief and loss relief allowed can soften the blow, but you should be aware that there is risk of losing money.
A VCT investment involves buying shares in an approved listed trust. This in turn makes a number of sub-investments into EIS-type companies. This provides an element of “spreading” the risk, and so can be seen as a safer investment than EIS, albeit one that still has more inherent risk than a listed share portfolio.
A qualifying VCT investment also attracts income tax relief at 30%, but the investment limit is £200,000.
An advantage of a VCT investment is that dividends received are exempt from income tax.
You should always contact your financial adviser on anything involving investments.
We have more commentary on EIS here: EIS Deferral Relief
It is still possible to use simple strategies to help pay for school fees in a tax-efficient way. The best methods involve having grandparents putting their wealth to use in generating income for the children. However, if there are no grandparents you can consider other options, such as a pension lump sum or investments that attract income tax relief, to achieve efficiency.