The roles and responsibilities of trustees and investment managers in relation to PITs, and a possible investment option to mitigate the tax liabilities

Recent years have illustrated a real awareness by litigators and lawyers alike of the use of personal injury trusts (“PITs”). While this may be as a result of the increasingly litigious society that we are perceived to live in, the benefits of placing a compensation award into trust cannot be ignored.

However, for the purpose of this article, they will be, to a degree. This is not because the debate surrounding the use of PITs is considered of less importance, but rather because the question of whether a PIT is appropriate should also depend upon an individual’s circumstances and longer-term objectives (particularly investment objectives). The legal trust structure can then be used to complement one’s requirements. Where a PIT is required, consideration should be given to the underlying trust assets. The primary focus of this article is to emphasise the need for financial forecasting reports early on in the process, the investment duties incumbent upon the trustees, and our preferred approach to investment with PITs.

The legal duty to invest

In 2005, the Charities and Trustee Investment (Scotland) Act imposed new duties on trustees by increasing the scope of the original governing statute – the Trusts (Scotland) Act 1921 – to accord with modern day thinking. The norm is now that trustees have the widest powers of investment even where the trust deed does not contain particularly comprehensive powers.

The trustees must consider the suitability of any proposed investment, and take into account the need for diversification. To ensure that these requirements are met, the trustees must obtain and consider “proper advice” before exercising the power of investment. While seeking the advice of a financial adviser may not be strictly necessary, in most cases, it would be seen as a prudent course of action.

Benefit of foresight

Where professional advice is sought, the trustees have a duty to ensure that the assets are being invested appropriately according to the predetermined investment objectives and risk profile for the trust. The ultimate purpose of any trust is to provide for the beneficiaries. However, for PITs, these duties are often predicated on the target yield required to meet the beneficiary’s needs for the remainder of his or her life. This can only be calculated by undertaking a detailed cash flow analysis prior to investment.

The purpose of this analysis is to estimate how long the beneficiary will be able to meet his or her anticipated outgoings before the trust assets are exhausted. The report will highlight to the trustees the investment growth required to enable the trust assets to meet the beneficiary’s financial needs for the rest of his or her life. This becomes a vital reporting tool to effectively present the trustees with the “bigger picture” at the outset (the report may also be of assistance to litigators). In addition, the financial report can be recalculated at any time should circumstances change dramatically in the future through depletion of capital to build a property, or increased expenditure, by way of example. Indeed, the report should be reviewed regularly by both the trustees and adviser.

Pitfalls of PITs

A PIT is not a special or unique form of trust. Whatever the legal type of trust structure – bare, liferent, discretionary, or trusts for disabled persons – if it is funded by an award for compensation for an injury which the claimant has sustained, then it can be described as a PIT.

Trusts are not known for their tax efficient nature – quite the opposite, in fact. A bare trust offers a simple, tax-neutral option, but little protection in respect of the trust’s funds. For this reason, a bare trust is often deemed to be an inappropriate structure for personal injury awards. Substantive trusts such as a discretionary trust are often seen as more suitable structures due to their ability to offer both protection and flexibility of the trust funds. However, discretionary trusts should be prefixed with a warning: they come at a cost.

A discretionary trust is subject to the highest rates of income tax (50%) and capital gains tax (28%). Unless the trust falls within the disabled trust criteria, the trust will be subject to possible entry charges, 10-year charges and exit charges for inheritance tax purposes. In addition, annual tax returns will require to be submitted and the trust will be subject to regular accounting periods.

With this in mind, appropriate investment of the underlying trust assets becomes imperative.

How best to invest

The potentially onerous taxation of PITs can leave the trustees with limited cost-efficient options for investment.

A possible solution for trustees can be found by venturing offshore, more specifically in the form of an offshore investment bond. An investment bond is effectively an investment “wrapper” that enables access to a wide range of collectives, as well as various bank and deposit accounts. On a more technical level, an investment bond is a form of life assurance. However, it is the life assurance structure which can offer the trust certain tax and administrative advantages. The ability to hold the funds offshore creates a “haven” for the trust assets since the underlying investments/cash holdings can accumulate free of tax. The trust benefits from “gross roll-up”, and this will often complement the beneficiary’s own lower-rate tax position (particularly for a child beneficiary). The structure encourages active management since there is no need to worry about the impact of tax on any investment changes.

While the money is held within the bond, the trustees can generally avoid the necessity of annual tax returns. Similarly, trust accounts can be kept to a minimum. This clearly helps to save on the costs of ongoing administration. Any potential income tax liabilities on encashment can also be mitigated through careful management of the “exit” strategy. This may be done by utilising a beneficiary’s own income tax position rather than the higher rate belonging to the trust.

The bond also has the ability to pay up to 5% of the original amount invested every year (cumulative), tax free to either the trust or the beneficiaries. This is effectively done by way of a withdrawal of capital, creating further flexibility if required. Admittedly, there are complexities around these structures which require trustees to seek specific and independent investment advice; however the higher set-up costs traditionally associated with these structures are now largely obsolete and the benefits can certainly outweigh any potential disadvantages.

Adding value

For the independent financial adviser, the earlier they are involved in the process (even before the settlement of the award), the more value they can add. The trustees have a duty to ensure that the needs of the beneficiary are met. Every case is different. However, the importance of seeking independent professional advice remains to ensure that the most cost-effective, tax-efficient structure is put in place to meet those needs, both existing and future.

The Author
Alec Stewart is Head of Asset Management at Anderson Strathern Asset Management Ltd 
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