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9. Inheritance tax

9.1 NIL-RATE BAND

The inheritance tax (IHT) nil-rate band has been increased from £263,000 to £ 275,000 which is more than statutory indexation. The increased threshold will apply to chargeable transfers occurring on or after 6 April 2005.

The threshold is to be further increased to £285,000 for tax year 2006/07 and to £300,000 for tax year 2007/08. The Chancellor stated that 94% of estates will not be subject to IHT. The estimated number of estates that will be subject to inheritance tax in tax year 2005/06 will be about 37,000.

9.2 GENERAL PLANNING

It is perhaps unsurprising that no major changes to inheritance tax have been announced just before the General Election and that the increase in the nil-rate band is relatively greater than in the last few years – inheritance tax and its effect on Middle England voters has recently been much talked about in the press.

On the other hand , there has been considerable activity in combating IHT avoidance schemes, for example the pre-owned assets income tax rules introduced last year and coming into effect next month.

As things stand a number of opportunities for mitigating IHT still exist and so it would be prudent to continue planning to make maximum use of the current rules.

In very brief terms the main advantages of the current inheritance tax regime are as follows:-

· a nil-rate band of £275,000 exists per individual with a flat rate of tax on death (40%) over that amount

· the potentially exempt transfer rules remain on the statute book

· a 100% maximum level of business property relief and agricultural property relief is available, subject to satisfying appropriate conditions

· planning using deeds of variation can still take place

· certain lump sum inheritance tax schemes that avoid the gift with reservation rules and the rules on pre-owned assets can be implemented and

· there are advantageous rules for excluded property trusts.

(1) Rates of tax

The nil-rate band has been increased as indicated above. Individuals who have a potential inheritance tax liability may well be inclined to use their nil-rate band sooner rather than later (see potentially exempt transfers below) and, if they are married, to arrange their asset ownership so that each spouse can utilise their nil-rate band either during lifetime, or on death via their Will.

If the nil-rate band of the first of a married couple to die can be fully utilised by, say, legacies to children, an IHT saving of £110,000 on the second death can be achieved. If there is concern over continuing access to capital for the surviving spouse a suitable Will trust could be used under which capital can be advanced by trustees or loans made.

Given the future possibility of change in the nil-rate band, where clients wish to make such arrangements, it may be best to use a wording that gifts the available nil-rate band at death rather than a specified figure equal to the current nil-rate band because, if this figure reduces and no action is taken, future unnecessary IHT liabilities may arise. However, if the nil-rate band subsequently increases substantially in value, the clause may need review.

(2) Potentially exempt transfers (PETs)

Gifts that are PETs give rise to no IHT at the time they are made. Moreover, there will be no IHT at all if the donor survives the gift by 7 years. Even if death occurs within 7 years, provided the donor survives for at least 3 years taper relief will apply to reduce any tax charge. Control over the asset gifted can be maintained by the donor using a trust under which he/she is a trustee.

Anybody contemplating making substantial lifetime gifts in order to save IHT should sensibly consider doing so whilst PET treatment is available. All growth in the value of the gift will be free of IHT. Gifts to certain trusts count as PETs, for example an accumulation and maintenance trust and a power of appointment interest in possession (flexible) trust. By using a trust, continuing control can be maintained by the donor acting as trustee and, in the case of the flexible trust, maximum flexibility can be included over who will be the ultimate beneficiary under the trust. Life assurance can be effected to cover any potential IHT liability on the death of the donor within 7 years. Careful consideration needs to be given to the capital gains tax (CGT) implications of making gifts and the CGT cost of making a gift balanced against the potential IHT saving.

If cash gifts are to be made into trust, capital investment bonds can be a tax attractive trustee investment because:-

(a) they are non-income producing and not subject to CGT and therefore reduce trust administration;

(b) they can provide tax deferral especially where the rate of tax paid by the trustees is at a higher rate than that suffered within the insurance company’s funds;

(c) the trustees can switch investment funds of the bond without triggering a tax charge; and

(d) if the trustees require cash they can make use of the annual 5% tax- deferred withdrawal facility. It may also be possible to reduce tax on ultimate encashment by assigning individual policies of the bond out of the trust so that adult beneficiaries can make the encashment.

Capital investment bonds will not, however, enable trustees to benefit from taper relief, use their annual CGT exemption of £4,250 (maximum) in 2005/2006 or make use of a beneficiary’s personal income tax allowance. In these circumstances, unit trusts or OEICs may be more appropriate investments.

(3) Deeds of variation

Under current legislation, within two years of a person’s death, it may be possible for the beneficiary(ies) of a gift under the Will (or on an intestacy) to vary the destination of the gift. Such a variation can, depending on the circumstances, save IHT.

(4) Lump sum inheritance tax plans

Retention of the right to income and/or capital will normally mean that the gift with reservation provisions will neutralise any IHT benefit of a gift. The many lump sum inheritance tax plans available seek to overcome this problem. These plans, of which there are a number, will often enable an investor to establish a trust and enjoy some form of “income” (normally in the form of a capital payment), possibly provide a level of access to capital and provide some control and flexibility via a trust. Ignoring annuity/life assurance (back to back) arrangements, there are four primary forms of lump sum inheritance tax plan, which are all based on the combination of a trust with a capital investment bond:-

(a) The gift and loan (or “loan only”) scheme – a gift is made to a trust (or a trust declared with no gift) and an interest-free loan, repayable on demand, made to the trustees. The trustees invest in a capital investment bond. Income is enjoyed in the form of tax free loan repayments financed by the trustees making 5% part surrenders from the bond. The investment growth is outside the investor’s taxable estate and free of IHT. The Inland Revenue has confirmed to the ABI that this type of plan remains effective for IHT and is not caught by the new rules on pre-owned assets (POAT) – see section 9.3 below.

(b) A discounted gift plan – a policy is effected subject to a trust where “income rights” in the form of payments of capital are retained for the benefit of the settlor (funded out of the maturity of individual policies or a 5% withdrawal from the underlying bond) with rights on death passing to trustees. Part of the initial investment is regarded as a PET. As with the loan plans in (a) above, these plans are safe from the POAT charge . See section 9.3. below for more details.

(c) A retained interest trust – a capital investment bond is effected subject to a split trust under which a part of the trust is held for the absolute benefit of the settlor and a part on flexible trust under which the settlor is excluded from benefit. The part of the bond initially held on flexible trust is regarded as a PET. The donor can draw down from his side of the trust fund with the 5% part surrender calculation being based on the whole of the initial investment in the bond. This type of plan should also be safe from the POAT.

(d) The reversionary interest plan – where, after an initial gift to trust, in successive years amounts revert to the settlor. Here, similar considerations may well apply to those mentioned in (b) above.

There is little doubt of the appeal that lump sum insurance-based inheritance tax schemes hold for people who have investment capital and wish to plan to reduce inheritance tax but wish to retain some access to “income” or capital. It seems that some of these plans can achieve such objectives but without the application of the gift with reservation provisions or the POAT charge.

The question of which type of scheme is most appropriate will depend on all the personal and financial circumstances of an investor – not least the age of the investor and the flexibility he or she requires over the future rights to income/capital.


(5) Business/agricultural property relief

Currently business and agricultural assets qualify for 100% relief, subject to certain conditions being satisfied, which effectively removes the assets from the inheritance tax net.

For persons who desire to make gifts of business/agricultural assets now in order to take advantage of the 100% relief currently available, they may be advised to use a discretionary trust that crystallises a chargeable transfer at the date of gift rather than making a gift that is a PET. Any concern over lifetime gifts subsequently suffering inheritance tax because of a reduction in the rates of relief can be tempered by taking out a temporary assurance policy in trust to cover the “at worst” position.

Of course, before a gift of business/agricultural assets is made, the CGT position will need to be considered. Also, for a gift to be effective for IHT purposes, potential donors cannot benefit. They should also be satisfied that they have sufficient financial security and, in this respect, a well funded pension scheme can be very useful. In order to avoid the gift with reservation rules, any increased benefits for a shareholding director from the company should be established (preferably by service agreement) prior to the gift.

(6) Excluded property trusts

Where a person who is non-UK domiciled (for inheritance tax purposes) establishes a (normally discretionary) trust and that trust invests in non-UK situs property, under current law the trust will be outside the IHT net forever – even if the settlor later becomes UK domiciled for IHT purposes. This is what is known as an excluded property trust and the trust will not be subject to IHT even if the settlor is a potential beneficiary. Further details are given in section 15.

Since the Government published a consultation document on residence and domicile in March 2003 , it has been expected that some changes in this area may be announced. However nothing has yet materialised. The existence of excluded property trusts and their effectiveness for IHT was confirmed at para 2.8 of the consultation document mentioned above. This was helpful given the somewhat confused statements from the Revenue on this point in the past. However, there is no guarantee that the rules will not change. Non-UK domiciled people who are currently resident in the UK may therefore be very interested in establishing such a trust before any possible changes. As such a trust must invest in non-UK situs assets to achieve excluded property status, offshore capital investment bonds or appropriate capital growth oriented offshore funds can be ideal investments both from a tax standpoint and as a means of minimising trust administration.

9.3 THE INCOME TAX CHARGE ON PRE-OWNED ASSETS

In the Pre-Budget Report in December 2003 the Chancellor announced the Government’s intention to combat certain IHT avoidance schemes where assets are disposed of but the previous owner continues to enjoy benefit from the asset without making a commercial payment.

The legislation is now in Schedule 15 Finance Act 2004. This imposes an income tax charge on the benefit of a free or low-cost enjoyment of a previously owned “substantial capital” asset (or an asset that had been accrued with funds provided by the person who then enjoyed a benefit), similar to a benefit in kind charge on an employee enjoying the benefit of free accommodation provided by an employer. The main features of the charge are as follows:-

· The charge can apply to both tangible assets (land, chattels) and intangible assets (e.g. life assurance policies)

· The charge can apply regardless of when the property was disposed of as long as it was after 17 March 1986. There is therefore an element of retrospection

· A number of exclusions have been confirmed (many introduced after protests from professional advisers/organisations during the consultation period).

· The exclusions (i.e when the charge will not apply) are as follows

– The property in question ceased to be owned before 18 March 1986

– Property formerly owned by a taxpayer is currently owned by their spouse

– The asset in question still counts as part of the taxpayer’s estate for IHT under the gift with reservation (GWR) rules (e.g the taxpayer is one of the beneficiaries of the trust he established)

– The property was sold by the taxpayer at arm’s length price paid in cash (even if to a connected party)

– The taxpayer was formerly the owner of the asset only by virtue of a Will or intestacy which has subsequently been varied by agreement between the beneficiaries

– Any enjoyment is no more than incidental.

· In the case of tangible assets the former owners will not be regarded as enjoying a taxable benefit if they retain an interest which is consistent with their ongoing enjoyment of the property, e.g. following a gift of a share in the property to a child who lives with them.

· In the case of intangible assets held in a settlement, they will be treated as giving rise to a taxable benefit only to the extent that the taxpayer may derive benefits from them and those benefits would diminish the benefits potentially available to others.

· The Revenue confirmed in correspondence with the Association of British Insurers in September 2004 that IHT schemes such as Loan trusts or discounted gift trusts were outside the POAT charge. This is because the settlor’s rights under such trusts are held on bare trust for the settlor and the settlor is not a beneficiary of the remainder of the trust (which is a settlement).


· Where an existing arrangement falls within the POAT charge taxpayers can elect to instead have the asset treated as part of their estate for IHT purposes. The type of scheme that is caught by the new tax would be, for example, a “double trust” scheme involving the principal residence or an Eversden-type scheme.

· No liability will arise if the value of the benefit (or potential benefit in the case of intangibles) is not more than £5,000.

A number of issues relating to the POAT were not covered in the Finance Act 2004 and given that the new tax becomes effective from 6 April 2005 we have been eagerly awaiting Regulations dealing with the outstanding matters.

PRE-OWNED ASSETS REGULATIONS

While there has been nothing in the Budget itself dealing with this matter, the Inland Revenue issued draft Regulations on 7 March 2005. The following is a summary of the key provisions. We are still awaiting Inland Revenue guidance on Schedule 15.

The proposed Regulations put some flesh on the bones in terms of how the tax charge will be calculated and charged. In particular they make provision for when gifted assets will be valued and the deemed rate of return that will be applied. The primary legislation contains the valuation rules. The value and deemed rate of return will together give a deemed income that the donor enjoys from the gifted asset.

The proposed Regulations result from the issue of an Inland Revenue consultative document on 16 August 2004 and responses to this.

WHAT THE REGULATIONS COVER

The regulations provide as follows:

(i) Valuation date

For the purpose of calculating the value of the gifted asset, the asset will be valued on 6 April or, if later, the beginning of the period for which the asset becomes chargeable.

(ii) Deemed rate of return

Called the “prescribed rate”, and used when the cash value of the benefit of chattels and intangibles (which includes life assurance policies) is being calculated, it will be fixed at the Inland Revenue’s “official rate” which is currently 5%.

(iii) Valuations at extended intervals

Land and chattels will be valued every 5 years. The first valuation year will occur when the asset is first chargeable to the POAT. There will be no adjustment to the valuation in a five year period due to the effects of inflation.

No mention is made of the valuation of intangibles, such as life assurance policies. Presumably these will therefore be valued annually.

(iv) Equity release

Reversion schemes, where the whole of the property is sold to a provider, is clearly outside the legislation. The regulations will cover the position where part only of a property is sold by exempting such a sale if done at arm’s length. For transactions carried out before 7 March 2005 which involve a part sale either at arm’s length or on arm’s length terms, these will be exempted also. Such disposals will also be exempt after 6 March 2005 if they are made for a consideration other than money or readily realisable assets.

WHAT THE PROPOSED REGULATIONS DO NOT COVER

The regulations make no provision in the following areas:

(i) Business protection trusts

Technically the trust of a protection life policy taken out as part of a business protection / continuation arrangement could be a settlement for inheritance tax purposes. This means that if the settlor is a potential beneficiary under the trust the POAT rules could apply.

Although there is nothing in these draft Regulations concerning business trusts, Technical Connection has obtained Revenue confirmation that Regulations are being drafted to address this so that policies held subject to trusts which are bona fide business arrangements will be removed from the POAT charge by the Regulations. Given the stated objective of the POAT charge (to combat IHT avoidance) this seems the only sensible approach.

(ii) Pre 18 March 1986 trusts

Inheritance tax (and the gift with reservation rules) were introduced in March 1986. The new POAT rules apply to all disposals since this date. In other words, at least according to Dawn Primarolo, the Government is not interested in the POAT rules applying to transactions carried out before the gift with reservation rules were introduced.

After all, the POAT rules were introduced to “shore-up” deficiencies in the IHT rules. However, it appears that this is not necessarily the case. Prior to 18 March 1986 life policies could be set up under a trust under which the settlor was a potential beneficiary. But did this mean that where regular premiums were paid after this date, a gift with reservation would arise ? The answer to this is no, provided premiums did not increase over and above a pre-existing optional level. However, the bad news is that because such premiums are paid post 18 March 1986 and are not gifts with reservation, they could be subject to the POAT.

It was thought that the Inland Revenue were sympathetic to this but no exemption has been forthcoming in the proposed Regulations. This means the POAT rules can apply to pre-18 March 1986 arrangements!

(iii) Life policies

The legislation in Schedule 15 deals with the valuation of life policies but does no more than state it is the value at the valuation date. It is clear how one values a single premium bond but what criteria do you take into account in valuing protection policies which do not normally have a surrender value. The market value based on the life assured’s health? If so using what evidence and when?

All these issues still need to be resolved.

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