Case Study: How a loan from a discretionary trust can offset IHT
The problem: In light of the Finance Act 2013’s provisions restricting the ability to deduct liabilities from an estate when calculating inheritance tax, is it ever appropriate for trustees of a discretionary trust to make an interest-free loan to a beneficiary?
The solution: Trustees must first consider their duties and whether such lending is indeed appropriate.
The trust deed will set out the powers and duties the settlor has given to the trustees. These powers will be ‘dispositive’ (how, and in what circumstances, trustees are to distribute trust income and/or capital) and ‘administrative’ (how the trust is to be run). If there is uncertainty, trustees should take legal advice.
Trustees should consider why the trust was established as that will give an indication as to how the settlor wanted the trust to be used and any letter of wishes from the settlor will be of particular interest.
Trustees must act solely in the interest of beneficiaries. A beneficiary has a right to have the trust administered, the trust fund invested and income distributed in accordance with the terms of the trust. It follows that a beneficiary has a right to see the trust accounts and the trust deed and to obtain reasonable information as to the investment and management of the trust fund.
Beneficiaries have no rights to participate in the running of the trust but can make representations to the trustees.
A trustee when exercising a power of investment must have regard to the standard investment criteria set out in the Trustee Act 2000 (or the equivalent Scottish and Northern Irish legislation) and must review the investments of the trust from time to time.
Before making any investment or reviewing the trust investments, the trustee must obtain and consider proper advice, unless it is reasonable to conclude that in the circumstances it is unnecessary or inappropriate.
The objective of trustees investing for the general benefit of the beneficiaries is to obtain the greatest total return in income and capital appreciation, which is consistent with a reasonable degree of prudence. The investment approach should take account of modern portfolio theory, which looks at the balance between risk and return of the whole portfolio rather than of each individual asset. The trustees’ personal preferences (for example personal attitude to risk) should not impinge on this approach.
Is an interest-free loan an investment? In general it is not, since an investment is something from which a return in the form of capital or income is sought. However, modern trusts generally include a specific power to make interest-free loans.
This should be regarded as a dispositive power – it is being used to provide a benefit for a specific beneficiary – rather than an administrative one.
Does granting an interest-free loan save IHT? The initial making of the loan is neutral. The money lent by the trustees increases the beneficiary’s estate but that is offset by the debt incurred.
If the beneficiary spends some or all of the money lent, that will reduce the size of the estate. The beneficiary will remain liable to repay the loan, which will be a deductible debt on death if it is actually repaid. For deaths occurring before 17 July 2013, the debt was deductible regardless of whether it was repaid.
The trustees should consider the interests of the other beneficiaries. An interest-free loan will not generate any growth for the trust fund. Indeed the value of the trust fund will fall in real terms due to inflation.
If in doubt the trustees should seek specialist advice.
Graeme Robb is a technical manager at Prudential