Labour’s signature VAT hike on private school fees has moved from being a ‘dog-whistle policy’ to a dreary reality, with the arrival of a new policy paper from the Treasury confirming the move would kick in from 1 January 2025.
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The policy document explained that, from the beginning of next year, ‘all education services and vocational training supplied by a private school, or a ‘connected person’, for a charge will be subject to VAT at the standard rate of 20 per cent.’
It also extinguished any hopes from parents that payments made in advance for next year would be free from VAT – with any fees paid after 29 July subject to the levy.
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While parents will be unable to avoid the higher fees, there are some tax-efficient ways of paying which could help families cope with the higher costs.
Setting up a discretionary trust
‘There’s an awful lot of trusts used to pay school fees,’ says Wilfrid Vernor-Miles, joint head of Hunters’ private client division.
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Discretionary trusts can be a popular option for grandparents. These are sometimes referred to colloquially as ‘educational trusts’, though in practice, nothing legal or technical distinguishes a trust structure used for this purpose.
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Grandparents can offload cash or income-generating assets including company shares to be held in trust, says Haysmacintryre’s private client lawyer Katharine Arthur. A trustee would then manage, invest and oversee these funds, as well as deciding when and how these are distributed to make school fee payments.
Arthur tells Spear’s that when a grandparent or ‘settlor’ sets up a structure, they are able to stipulate the expenses it would cover from the outset – making it a popular option for relatives who are eager to ensure the funds are used for the intended purpose.
‘If it was a discretionary trust, there would be a formal deed, which would dictate how those funds are used,’ she says.
Saving on income tax — and potentially an IHT bill too
Grandparents willing to forfeit their funds to be held in trust could also make a potential inheritance tax saving, with direct gifts becoming tax free after seven years.
The assets held in a trust would be subject to capital gains tax on any new income produced, though once the funds are passed down to children, they will likely be able to make a significant income tax saving.
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Arthur explains: ‘If a trust has money that’s invested in stocks and shares for example, the trust would pay tax on that income and gains, [but] then on distribution to the grandchildren, they would each have their own personal allowance.’
With the personal allowance sitting at £12,750, a substantial sum can be given towards a child’s school fees tax free, assuming they are not receiving money from other sources.
‘That money is taxable in the hands of the infant, who presumably does not have any other income and so wouldn’t have to pay tax on it,’ Vernor-Miles adds.
[See also: Privately furious: Top independent schools braced for Labour’s VAT grab on fees]
Parents should take note that they are unable to offload cash to their children in quite the same way as a grandparent can. ‘There’s an anti-avoidance provision which says that income is taxed in the parents’ hands anyway,’ Vernor-Miles says.
However, where parents do pay their children’s school fees directly, these are usually viewed as costs to take care of a financial dependent, and not as a gift, allowing these to fall outside of the remit of IHT.
According to HMRC, grandparents are also able to make ‘regular payments’ to help with another family member’s living costs, including school fees, which are exempt from IHT as long as these payments are surplus to the income they need in retirement. But anyone making such payments would not make an IHT saving on any funds not handed over at the time of death — underscoring the value of pre-emptive planning and trust structures.
Bare trusts — a simpler option with some drawbacks
Using a bare trust would be a simpler option for a grandparent. This would involve setting up a bank account in a child’s name, operated either by themselves or a trustee, which could be used as they see fit for the child’s benefit. By law, the child would then have access to the remaining funds when they become an adult.
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‘The downside is that with a bare trust, whatever’s left when they become 18 belongs to them. If there’s a lot left in the trust, some people think 18 is quite young to inherit a lot of money,’ cautions Vernor-Miles. ‘But if you structure it right, and put the right amount of money within it, most of it would have been spent on school fees anyway.’
Other ways to pay
When making a direct gift, the tax-free limit before IHT is applied sits only at £3,000. Above this, grandparents will need to be mindful of the usual inheritance tax rules — gifts will become fully tax-free after a seven-year window.
Yet relatives could consider clubbing together to increase the amount that could be passed down each year tax free, says Kevin O’Shea, director, wealth planning at RBC Wealth Management.
‘Where additional costs are met from generous relatives, they should remember that the annual gift allowance is £3,000 per person free of inheritance tax, that could add £12,000 – assuming four grandparents – to the education pot,’ O’Shea says.
Yet this method will only go so far to mitigate the extra cost in fees. ‘Families typically have a finite number of financial planning levers that can be pulled in order to meet additional expenditure’, besides reducing expenditure or earning more money, O’Shea says.
As such, it would be prudent for grandparents interested in helping out with fees to set up structures in advance as part of successful estate planning. It’s also always beneficial to consult a trusted adviser when setting up a structure, according to Vernor-Miles. ‘There are potential IHT charges when money goes into the trust, there are potential IHT charges on the ten-year anniversary, and there are potential IHT charges when money leaves the trust.’
