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Advance thinking

What are the tax implications when beneficiaries agree to pay premiums under a trust held for their benefit?

All my wittering on about section167 IHTA 1984 and protection policies over the past couple of weeks has got me to think a little more about the role of protection policies in trust in providing for inheritance tax. I am increasingly thinking that, provided the cost of cover is not ridiculously prohibitive, the protection option deserves to be considered other than as a strategy of last resort.

The qualities of a life policy (probably joint life, last survivor) held in trust to meet the IHT liability are not inconsiderable. One of the many benefits that this solution delivers is the ability for the taxpayer to leave his or her life unchanged, save for the outflow of premiums.

Even this financial disruption could be minimised if the persons who would benefit from the policy, say the children, pay or at least contribute towards the cost of cover. Many potential beneficiaries may see this as only fair, especially when they are of an age to be earning enough to make such a contribution to the cost.

This contribution could somewhat crudely be expressed as a payment of tax in instalments, admittedly in advance. This advance payment plan could carry a significant financial, if not emotional, bonus on the death of the life/lives assured.

Insurable interest with protection policies cannot be ignored but, strictly speaking, needs only to be proved at outset. This means that the policy could be effected initially by the life/ lives assured on an own-life basis in trust. The settlor(s) having paid the first premium, the beneficiaries could then take over premium payments.

Before the new trust alignment rules were introduced with effect from March 22, this strategy would have had no potentially adverse IHT consequences.

The beneficiaries would have been contributing to a policy held in trust for their benefit. The trust is likely to have been either a bare trust for the paying beneficiaries or a flexible trust under which the paying beneficiaries had the interest in possession. The policy will have been in the payer’s estate by virtue of the absolute interest or the interest in possession.

The paying beneficiaries will, by virtue of the premium payments, have been making a disposal from which they could benefit but this will have been in the form of gifts to themselves under an absolute trust or sheltered from a double charge to tax where the trust was one under which they had an interest in possession.

This would mean that the value of the trust property would not be included twice in the estate of the settlor, that is, by virtue of the gift with reservation provisions and by virtue of the capital value supporting the interest in possession being deemed to be included in the estate of the settlor.

This position would not be changed after March 21, for a pre-Budget trust policy provided the beneficiaries were not changed after April 5, 2008, other than as a result of the death of a beneficiary, or the settled property added to, other than as a result of the continued payment of premiums to the pre-Budget trust or any action taken as a result of the exercise of an option incorporated before March 22, 2006 as part of the policy terms – an allowed variation under the legislation.

How about post-Budget trusts? The premium payments will not be gifts if the policy is held in trust for the absolute benefit of the payer but will be if the trust is other than a bare trust. In these circumstances, though, the premiums are likely to be exempt. If the trust is other than a bare trust for their benefit, it will be necessary to consider the impact of the discretionary trust regime.

It would seem that the policy value will be included in the taxable estate of the payer under the reservation of benefit rules and it will also be subject to the discretionary trust regime.

At a superficial level, this seems like a very good reason not to pursue this method of paying premiums but is this a hasty conclusion? The relief from double-tax regulations will be helpful to prevent a double charge in respect of any charge to IHT that could arise on the death of the payer by virtue of the gift with reservation provisions and a charge arising by virtue of the payer’s death within seven years of making a contribution to the plan by way of premium, which will probably be exempt anyway.

However, on the payer’s death, the value of the settled property will be included in their estate under the gift with reservation provisions.

This is no worse than what the position would have been under the pre-Budget regime where, on the payer/beneficiary’s death, the policy value or a portion of it would have been included in that person’s estate by virtue of their interest in possession in it.

Under a post-Budget non-bare trust, there will be the periodic and exit charges to consider. This will be the case, however, even if the life/lives assured pay the premiums under such a trust.

The fact is that all non-bare trusts are afflicted with these charges. In practice, in most cases, save for the serious ill-health of the life assured at the time of the periodic charge, the holding of an undistributed substantial sum assured at that time or, in the case of a non-term insurance, the payment of a substantial premium, there should not be a substantial risk of a charge arising in any event. If there were, there is always Rysaffe, provided the risk of potential charges is anticipated when the policy trusts are established.

It may be more likely that someone paying the premiums under a policy will be happy for the trust to be in non-flexible (absolute) format for their benefit. The policy will, of course, form part of their taxable estate but the periodic and exit charges will be avoided.

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