SCHOOL FEES - 24.04.2008

Diverting income for school fees

Wealthy relatives are often the source of funds used for school fee schemes. But what if yours don’t have the cash to set aside the amounts required for school fee investment plans. Is there a viable alternative?

Why use relatives?

Problem. A school charging £10,000 in fees actually requires £16,649 of your earned income, because after tax at 41% this leaves £10,000 net to pay. Ten years of this sort of expense means that you’ll pay £166,491 of your gross earned income per child over the course of their education.

Solution. If you (the parent) set up a trust for the benefit of your own child, the income arising is taxed on you (while the child is under 18), but if another relative sets up the trust, you are not taxed on the trust income or gains. However, the exact tax implications depends on which type of trust you use (see The next step).

The most likely candidates for this role are the child’s grandparents. Cash rich grandparents can simply place a lump sum in trust so the income and capital combined is available to pay the school fees over the course of the child’s education.

Tax saving. Because the money has been placed in trust for the child, it’s treated as if it were their own income, not the grandparents (providing they have excluded themselves from benefiting from the trust). Therefore, the child’s personal allowance and lower-rate band, which for 2008/9 add up to about £41,435 (£36,000 + £5,435), are available to shelter income from higher-rate tax.

Tax avoidance. What if the parents have the capital but the grandparents do not? Could the parents simply give the grandparents the money to fund the trust that pays the school fees? Unfortunately, the money can be traced back to the parents by the Taxman. He uses the case of Furniss v Dawson, which ignores steps inserted for a non-commercial reason, e.g. just to avoid tax.

School fees paid out of dividends

Subscribe for shares. Where the parents own a company that is likely to generate enough cash in the future to pay the school fees, then:

Step 1. The grandparent uses their own funds to subscribe for new shares in the company. These are issued in a different class from those held by the parents, so a separate rate of dividend can be paid without affecting those paid to the parents.

Step 2. Grandparents immediately gift the shares into a trust that will help pay the school fees. (If the value of the shares is within their nil-rate band, there will be no Inheritance Tax to pay on this chargeable transfer.) The company pays dividends into the trust.

Entirely commercial. If the grandparent pays full market value for the shares, there will be no Capital Gains Tax due on the gift to the trust (as long as it’s made within a short period of time). Investing in a small private company is regarded as an intrinsically risky investment, with the result that the dividends can be high in relation to the amount invested and still be regarded as entirely commercial.

Taxman’s view. At present, the Taxman does not appear to be attacking situations even where the grandparent’s payment for the shares is nominal in relation to the income arising. But in the fast changing world of tax law there is no way of knowing how long this situation might prevail.

The next step

For the tax implications of different types of trust, visit http://tax.indicator.co.uk (TX 08.14.03).

If your company is likely to generate enough profits, get the grandparent to subscribe for shares in your company, which they then gift into a trust. The dividends paid on these shares can be used to fund the school fees.

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