Many UK hedge fund investors are unaware that their estate could face effective tax rates of over 60 per cent upon their death, because hedg...

Many UK hedge fund investors are unaware that their estate could face effective tax rates of over 60 per cent upon their death, because hedge funds, unlike many assets, can attract income tax as well as inheritance tax charges, according to private client lawyers, Withers. Hedge funds are often “non-qualifying offshore funds”, which are subject to income tax rather than capital gains tax in the UK. Whilst capital gains tax is not payable on death, hedge fund investments in an individual’s estate will be re-valued at market rates and any gain can be taxed at a 40 per cent income tax rate, according to Withers. This can result in a double tax hit because the investment will still potentially be a taxable asset for inheritance tax purposes. “Only the income tax payable, rather than the full taxable amount, is deducted from the investor’s estate, so inheritance tax can still be due on the remainder,” said Stuart Skeffington, tax and trusts specialist at Withers. He added: “The overall tax burden can therefore exceed the 40 per cent inheritance tax liability one associates with assets falling under the capital gains tax regime, such as shares. Hedge fund investors can therefore face an effective tax rate of up to 64 per cent.” Withers gives the following example: Mr Smith (an unmarried higher rate taxpayer) has used his nil rate band and died holding a single investment in a hedge fund that is a non-qualifying offshore fund, which he purchased for £500,000 ($917,732) and which is now worth £2 million.

• He will suffer income tax on the latent gain of £1.5 million at 40 per cent = £600,000.
• His estate will be reduced from £2 million to £1.4 million for inheritance tax purposes as tax paid is deducted from the estate.
• He will now pay 40 per cent inheritance tax on the residual: £1.4 million x 40 per cent = £560,000.
• His original £2 million estate is now reduced to £840,000.
• Total tax paid = £1.16 million. As a percentage of his overall estate of £2 million, this represents 58 per cent.