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Back to the loan trust

Clients know they have to put an inheritance tax strategy in place and loan trusts are the answer

As the dust continues to settle following the Finance Act 2006, more advisers are feeling confident enough to re-enter the lump-sum inheritance tax market.

Discounted gift schemes remain a vital tool in the adviser’s armoury. However, these schemes all rely on the client being happy to give a lump sum away and never be able to access it again but, for many clients, this is not the case.

While recognising that they need to put in place an IHT mitigation strategy, they are not comfortable with losing all access to capital. What is the answer for them? It is time to revisit that stalwart, the loan trust.

Under schemes of this type, the investor establishes a trust, appointing himself and other persons as trustees. The investor (settlor) is expressly excluded from any benefit under the trust. The investor then makes an interest-free loan, which is repayable on demand, to the trustees and they use the loan to buy a single-premium bond. The trustees then take withdrawals from the bond which they pass back to the investor as part repayments of the loan.

Of course, ever since March 22, 2006, the key question when considering any form of IHT planning has been which trust to use. Should it be an absolute trust to take advantage of the potentially exempt transfer regime or should a discretionary trust be chosen to give flexibility to change beneficiaries as and when required?

From an IHT viewpoint, the granting of an interest-free loan, which is repayable on demand, does not give rise to any transfer of value for IHT purposes and thus there will be no initial transfer of value. This would appear to be a big plus for using a discretionary trust as there will only be the 10-yearly periodic and exit charges to consider. At the 10-yearly anniversary, the value of the trust property will be the value of the bond less the outstanding loan. Thus, unless the amount involved is substantial, no 10-yearly charge should arise. Even for bigger amounts, the problem can be overcome by using a series of trusts created on different days as each trust will have the benefit of its own nil-rate band.

On the death of the settlor, any outstanding loan will form part of his estate but the remaining trust property will remain outside his estate.

Of course, as with any type of planning, there are some disadvantages. The investor can only receive “income” in the form of loan repayments. Once the loan is fully repaid, no more payments can be made to them. Conversely, if the investor dies early in the life of the scheme, then very little in the way of IHT reduction will have been achieved. As the trustees are personally liable to repay the loan, problems may arise if they are required to repay the entire loan in the early years, when the value of the investment bond may be less than the outstanding loan. Generally, however, as the investor will usually be one of the trustees, it is unlikely that they will enforce their right against the other trustees.

However, planning of this nature does confer a number of advantages:

The scheme is simpler than a gift and loan scheme as there is no initial gift of cash involved, with no need to segregate or deal with the initial gift.

The arrangement is flexible as the trustees can change the beneficiaries and there are no adverse tax consequences of a potential beneficiary predeceasing the settlor.

Tax-deferred capital payments of up to 5 per cent a year of the total premium paid can be withdrawn by the trustees to pay to the investor as loan repayments.

There is, however, no need to have a set level of repayments at the outset – these can be varied – thus offering flexibility.

Access to capital is available by the investor simply requesting repayment of the outstanding loan.

If the loan repayments are spent when received, there will be a gradual reduction in the investor’s estate for IHT purposes, as the outstanding loan will reduce accordingly.

Any growth in the value of the investment bond will be outside the investor’s estate and therefore free of IHT.

Loan trusts have been around for a long time but they still have an important role to play in IHT mitigation.

Brian Murphy is senior financial planning manager at Axa Sun Life


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