In previous articles, we explored Qualifying Non-UK Pensions and Portuguese-compliant investment bonds as potential investment strategies. This week, we turn our attention to another important financial planning tool—trusts. In this article, we will discuss the advantages and drawbacks of using trust structures to manage investments.
Are trusts right for you and your family
By Portugal team
This article is published on: 1st October 2024
Please note that the following analysis assumes UK domicile and it is important to understand that you can have a UK domicile as a Portuguese tax resident.
What is a trust?
A trust is a legal arrangement in which ownership of assets—such as cash, property, or investments—is transferred from one individual (the settlor) to trustees. These trustees then become the legal owners of the assets, managing them for the benefit of the settlor’s chosen beneficiaries.
A typical example might involve parents or grandparents aiming to reduce the size of their estate for inheritance tax (IHT) purposes. However, they may not feel comfortable gifting directly at this stage due to, for example, the beneficiaries being minors or not being mature enough to receive gifts direct. So the trust allows them to gift the assets now, but retain control over the timing and distribution of assets to the beneficiaries.
Trusts may also be used to safeguard assets for vulnerable beneficiaries or protect family wealth in the event of divorce.
Trusts can be created during a person’s lifetime or incorporated into a will.
Benefits
One of the key advantages of a trust is the control it offers. The settlor can dictate when and how assets are distributed to beneficiaries, which is particularly useful if the beneficiaries are not ready to manage large sums of money.
In addition to control, trusts offer substantial IHT benefits. Once assets are placed into trust, they are removed from the settlor’s estate, potentially resulting in a 40% tax saving—provided the settlor survives for seven years following the gift. This can significantly reduce the tax burden on beneficiaries when the settlor passes away.
Another practical benefit is that assets held in trust bypass probate, which can speed up the process of settling an estate and distributing assets to beneficiaries.
When is a trust most effective?
A trust is most effective when the settlor does not need access to the assets or income from the trust.
If the settlor or spouse retains any benefit from the assets within the trust, this is treated as a “gift with reservation of benefit” (GWR or GROB) meaning that the value they thought they had given away actually remains in their estate for tax purposes.
We commonly see parents gifting their main home to their children, or to a trust though which their children can benefit, thinking that this gift removes the value of their home from their estate on the basis they are no longer the legal owners. However, by continuing to live in the property they have fallen foul of the GWR rules and have defeated the purpose of the planning.
Tax implications
While trusts can deliver IHT savings and offer control over asset distribution, they can be quite costly from a tax perspective.
Upon creating a trust, the settlor must pay a 20% IHT charge on any amount exceeding the available nil-rate band (£325,000 for the 2024/25 tax year). For example, a £1 million gift into trust would result in a tax bill of £135,000 on the excess £675,000.
If the gift involves non-cash assets, capital gains tax (CGT) may apply, as the transfer is treated as a disposal.
Lastly, trusts are effectively additional rate taxpayers in the UK. They therefore pay income and capital gains tax at the highest rates on any income received and gains made annually. The trust also pays an inheritance tax charge of 6% every 10 years on the trust value.
Trusts and Portuguese Law
As a civil law jurisdiction, Portugal does not recognise trusts legally but it does tax income deriving from trusts and this applies irrespective of whether the trust has increased in value or not i.e. any distributions would be taxed at 28%, or at 35% if coming from a blacklisted jurisdiction, on both capital and gains.
Alternatives to trusts
If trusts are expensive from a tax perspective, not to mention the costs of appointing and running trustees, what at the alternatives?
‘Bare’ trusts
These are simpler than discretionary trusts and do not carry the 20% entry or 6% periodic tax charges. However, bare trusts have a significant limitation: once the beneficiary turns 18, they automatically gain full access to the assets, which may not be suitable for every family.
Contract based solutions
There are financial products that offer similar benefits to trusts—such as “gifting with control”—without the hefty tax costs associated with trusts. These may be worth exploring as an alternative.
Conclusion
There is no “right” or “wrong” in relation to trust planning – the suitability of different trust options will really depend on each family’s position and objectives.
For example, if you need access to either the capital or income from the underlying assets, trusts may not be appropriate. Or if you are uncomfortable gifting directly to your beneficiaries now, then a trust may be a redundant step in the financial planning process, and it may be better to consider various ways and allowances for making direct gits to your beneficiaries.
We would also advise a word of caution against companies cold-calling offering trust solutions to “Labour proof” your finances, and to always ensure you use caution and do your due diligence.