Money World Guide To

We would like to begin a programme of investments for our grandchildren but are uncertain about the tax implications. Could you offer some guidance?

From an investment point of view, the tax tail should never wag the dog, but on the other hand in the situation you describe it is important to know the basic ground rules which will point you in the direction of the most appropriate type of investments. Taxes you should be concerned about are income, capital gains and inheritance.

As far as income tax is concerned, if you can clearly show the capital invested on behalf of the grandchildren came from you and not their parents, the income would belong to the grandchildren. Similarly, any gain on the sale of the investments would be potentially taxable on them, not on you or their parents.

And as long as the total value of the gifts did not exceed the annual exemption of #3000 per donor, there would be no inheritance tax implications. If the gift exceeded this, any excess would be regarded as potentially exempt transfers (PETs). In the event of your death within seven years, for the purpose of calculating any inheritance tax liability, PETs are added back to your estate.

What is the income tax position with regard to the children?

Each grandchild is entitled to an annual personal allowance of #4195, so any income up to that level is effectively tax-free. If the average gross yield on any investment made on their behalf was, say, 5%, somewhere around #80,000 could be invested on behalf of each child before they would incur any liability.

What about capital gains tax?

Each child will be entitled to the full capital gains allowance - #6800 for 1998-99 - meaning only gains in excess of this would be taxable. So as far as most grandchildren are concerned, investments can accumulate effectively free from income and capital gains tax.

Any potential problem areas?

Look out for the implications of the recent changes made by Gordon Brown to the taxation of dividend income. Before these, non-taxpayers - that is those whose total income did not exceed their personal allowance - could reclaim tax deducted at source, but from April 1999 that will no longer be possible.

What investments will it affect?

The changes relate to the taxation of dividend income - that is income from equities - so the new rules will catch any dividend income whether from collective investments such as unit or investment trusts, open-ended investment companies (OEICs) or individual shares.

Does this mean equity-based investments should be avoided?

Not necessarily, but in the light of the recent Budget changes you do have to look more closely at the appropriate asset mix. Those who have already made investments on behalf of grandchildren should be reviewing them to see if the children's parents will still be able to reclaim tax on the investment income - if not they are not fully capitalising on the fact that each grandchild has a high tax-free threshold.

Are there investments we can make which are not equities but still retain the prospect for capital growth so that the children can use their capital gains allowance?

There are quite a number of investments which have the potential to grow in value but either produce little or no income, or a return which would not be classified as dividend income. We will look at these in the next Money World guide.

n In association with Portfolio & Pension Management, fee-based IFAs, East Kilbride.