Here is an outline of the rules that apply to life policies in trust:
Income Tax on Life Policies In Trust
Life policies do not produce income and so income tax rules are not applicable. However, withdrawals from life policies that are in trust are regarded as ‘income’, even though the withdrawal is a withdrawal of capital rather than income. Therefore, a chargeable event may occur on a life policy under trust and thus a chargeable gain can arise.
Policy in Trust
If a policy is subject to a trust, the person chargeable is the individual who created the trust (the settlor), provided he or she is alive and UK tax resident.
A chargeable event gain is taxable on the settlor while alive and UK resident. If this is not the case, a chargeable event gain is taxable on UK resident trustees or, failing this, on UK resident beneficiaries to the extent that they benefit. Here are the scenarios:
Settlor Is Alive and UK Resident
If the settlor is alive (or the chargeable event occurred in the tax year of their death) and UK resident immediately before the chargeable event, the gain is treated as part of the settlor’s income meaning the settlor is taxable on it. Any tax paid can be recovered from the trustees.
Settlor Is Dead Or Resident Outside UK
If the settlor is dead, or resident outside the UK, immediately before the chargeable event and the trustees are resident in the UK, the trustees are chargeable on the gain.
Chargeable Trust Rates
The charge is at trust rates, which are 45% for income above the trust’s standard rate band and 2O% within it.
To the extent that gains exceed the available standard rate band, there is a 25% liability for a UK policy because of the basic rate tax credit.
No tax credit is given in relation to offshore policies, so the effective tax rates are 20% in the standard rate band and 45% thereafter. This tax cannot be reclaimed by the trust beneficiaries, even if they would not have been liable in their own right because they were well below the higher rate threshold.
Trustees Not Resident in the UK
If the trustees are not resident in the UK, they cannot be held liable for any tax but any UK resident beneficiaries receiving a benefit under the trust from the gain will be taxable on that amount at their tax rates (but with no top-slicing).
Note if trustees surrender the policy in the same tax year as the settlor’s death, the tax liability falls on the settlor.