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A stealthy plan

Gordon Brown may have won a reputation for stealth taxation but it was Nigel Lawson who first introduced Peps in the 1986 Budget. They became available from January 1987, with the original inspiration being the Govern-ment&#39s wish to expand individual share ownership. But was there a secondary, more sinister objective?

Peps were replaced by Isas in 1999 but the idea of investing in equities via compliant collective structures has long proven popular with UK investors. In 2000/01, £9bn was invested in Isas and, as at March 2001, a total of £71bn was invested within Pep and Isa structures.

All Pep and Isa investments grow free of income and capital gains tax, and encashments can be made at any time, without fear of tax penalty. So what is the problem?

Advisers are aware that Peps/Isas are non-transferable. This means they cannot be gifted, assigned or held within a trust fund. Quite simply, investors enjoy the advantage of capital gains and income tax freedom while living but pay 40 per cent inheritance tax (less the usual exemptions) on the aggregate value at death. This is a very cunning form of stealth taxation – the more generous the tax breaks while living, the greater the tax take on death.

Interestingly, the respective inheritance tax yields for 1999/2000, 2000/01 (estimated) and 2001/02 (projected) show an upward trend – £2bn, £2.2bn, and £2.3bn.

As there are already Pep/ Isa millionaires, expect the rate of increase to accelerate over the next decade. The question, of course, is how to avoid this inevitable tax.

Clients who are nearing or enjoying retirement will usually take the time to reconsider their financial needs and objectives. Although needs will differ by client, the general objectives for high-net-worth investors tend to be fairly consistent – an adequate and tax efficient income, backed by sufficient capital reserves and a scheme to alleviate the threat of inheritance tax.

To plan for this new challenge, why not consider one of the following two options:

A combination of continuing Pep/Isa funds as a “capital reservoir”, with a life-insurance-based inheritance tax mitigation scheme providing a range of benefits to the client.

There are no tax exit char-ges in moving part of a Pep/ Isa portfolio into an inheritance tax mitigation scheme.

Gross roll-up is available from non-UK-based providers, with the exception of any non-reclaimable withholding taxes and there is a tax-deferred income to supplement retirement provision.

In this context, there are schemes available offering the usual 5 per cent annual all-owance. With this option, discounted gift schemes offer the potential for an immediate discount or reduction (for inheritance tax purposes) in the value of the original gift.

Exact amounts depend on age, state of health and def-ined income stream but red-uctions in excess of 50 per cent of the amount gifted are possible, if death should occur within seven years.

These arrangements all trigger Pets and the full value of the capital investment falls outside the estate after seven years. Any growth is ringfenced from inheritance tax immediately.

Save for limited capital access afforded by the discounted gift scheme, there is no real difference in the underlying tax profile while the income stream continues. The significant difference is a major improvement in the inheritance tax position.

A combination of discounted gift scheme and a loan trust, perhaps even to the exclusion of the existing Pep/Isa portfolio.

The same general benefits accrue to this arrangement, for example, gross roll-up if the underlying life insurance structures are non-UK-based, with tax-deferred income and the inheritance tax benefits of the discounted gift scheme.

Other benefits from the loan trust include annual repayments of the outstanding loan via 5 per cent tax deferred withdrawals.

Assuming that the annual repayments are spent as income, the capital investment is also removed from the taxable estate over a 20-year per-iod. You also have full access to the capital subscription (or the remaining balance thereof)and any growth within the loan trust is outside of the inv-estor&#39s estate and ringfenced from inheritance tax.

It is important for the client to choose an appropriate life insurance structure as part of the overall arrangement.

Today, most European (and, indeed offshore) life insurance structures are des-igned to comply with The Personal Portfolio Bonds (Tax) Regulations 1999. From March 17, 1998, underlying investments must be limited to collectives, cash, and internal life assurance funds to avoid triggering an annual taxable gain equal to 15 per cent of premiums paid (plus previous taxable gains).

In choosing a suitable jurisdiction for the life insurance structure, it is advisable to consider an EU member state ahead of a UK dependency. Quite simply, independent EU states cannot be directly discriminated against by UK legislation.

Luxemburg-based pers-onal portfolio bonds, for example, provide tax deferment in respect of policy gains and accruing income, except for non-reclaimable withholding taxes. UK residents generally pay tax on subsequent policy surrender but the 5 per cent tax deferred withdrawal facility is always available to help match income requirements.

On the death of a single life assured, any life policy gain is chargeable to income tax in the hands of the deceased investor&#39s personal representatives. In most non-UK jurisdictions, this charge can be avoided by naming other lives assured at inception, that is, there is no insurable interest requirement.

The structure must be transferable between EU countries, as greater numbers of high-net-worth investors are likely to consider retiring or spending more of their time (perhaps becoming tax-resident) abroad.

Advisers may grapple with the problem of providing “best advice” in recommending the sale of all/part of a Pep/Isa portfolio.

This said, leaving the client&#39s beneficiaries with an unnecessarily high inheritance tax bill cannot possibly be right and inheritance tax remains a tax easily mitigated.

For investors with significant Pep/Isa portfolios, there must come a point where the threat of inheritance tax conveys a greater detriment than the benefits of complete income and capital gains tax exemption.

At least this stealth tax can be avoided with planning.

Stuart Robertson is retained by Lombard International Assurance to provide technical and legal advice to IFAs

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