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Band of hope

Technical Connection’s John Woolley explains the implications of the changes to inheritance tax proposed in the pre-Budget report

Inheritance tax has traditionally been regarded as only affecting the wealthy but times have changed, mainly because the starting point – the nil-rate band – has not kept pace with house price inflation. This means more people are dying with estates that fall into the IHT net.

As IHT is an emotive tax, the Conservative party have used it as a way of hopefully winning votes at the next general election. Their stated proposal is to increase the nil-rate band to £1m. If the £1m nil-rate band applies for each spouse (something we were not certain about) this would mean a married couple could escape IHT on £2m of assets, meaning that many people would be out of the IHT net. The problem with relying on this statement in planning is that:-

  • Many people feel the economic funding behind this proposal has not been considered properly. In particular, it is claimed that the levy on non-UK domiciliaries would not produce sufficient tax to cover the lost tax revenues.
  • Given the anticipated tax revenues from IHT, would the Tories make such a change or would it be watered down?
  • Finally, but most important, this presupposes that the Conservatives come to power and remain in power at the time of an individual’s death.
  • In response, Labour intends to introduce provisions, effective from October 9, 2007, to provide a combined nil-rate band for married couples or couples who are registered civil partners. In effect, this will mean that when the first spouse dies, any of his or her unused nil-rate band will be carried forward and will be available on the death of the surviving spouse. The measure will be retrospective, so a number of widows and widowers will find the potential IHT liability on their death disappears overnight. In extreme cases, this will save up to £120,000.

    Impact on the taxpayer
    Let us assume Tom dies and leaves all his estate to his wife, Fiona. He does not use any of his nil-rate band of £300,000 and so, on Fiona’s subsequent death, she will be entitled to two nil-rate bands, based on whatever the nil-rate band is at the time of her death. If the nil-rate band is then £350,000, the survivor will be entitled to a total nil-rate band of £700,000.

    Had Tom left £150,000 to his children on his death, the percentage of his unused nil-rate band would be 50 per cent. This means that if the nil-rate band is £350,000 on Fiona’s subsequent death, the available nil-rate band at that time will be £525,000, that is, £350,000 plus £175,000. For those who have come through several marriages, the maximum allowable additional nil-rate band will be 100 per cent of the value of the nil-rate band on the death of the survivor. In other words, you cannot multiply the available unused nil-rate band by the number of previous marriages.

    This is an interesting approach by Labour which does not go as far as the Conservative proposal but will undoubtedly now take many married couples, who would not have otherwise used the nil-rate band on first death, out of IHT. Many of these couples may have only had a potential IHT liability because of the value of their home and they will have found the means of planning to use the nil-rate band on first death unacceptable or perhaps they were just not advised.

    Also, it could turn out to be economically clever because many couples could have achieved the same effect by implementing suitable IHT planning on the first death and the cost to the Treasury may not be so great in that it will not lose any more IHT from those couples who have or would plan on the first death.

    For some, there will no longer be a need to consider the comparatively complex will planning necessary to gift an interest in the family home to a will trust on the first death. The more commonly proposed strategy involved creating a tenancy in common and then leaving an IOU or giving a charge on the property to a discretionary will trust established by the first to die.

    However, there will still be occasions when a nil-rate band will trust is needed in relation to the family home. For example:

  • A person who is in a second marriage has a desire for an interest in their property to pass to their children from the first marriage.
  • There is a desire to incorporate planning to avoid the local authority taking account of the house as an asset of the survivor should he or she go into care.
  • There is a desire to transfer half the house to the next generation on the first death because of an expectation that house values will substantially outstrip the increase in the nil-rate band in the future.
  • Impact on the adviser
    For clients with properties valued at up to the combined nil-rate band (currently £600,000), the new rules will help to preserve the house for the next generation without the need for complex will planning.

    But for clients with a house and investments which in total exceed £600,000, the position will be different. There can frequently be a considerable time between the first and second death and, if no use is made of the nil-rate band on the first death, all investment growth will remain in the estate of the survivor nd the investment growth may well outpace the increase in the nil-rate band.

    For such people, a discretionary will trust holding investments will look attractive, particularly as the surviving spouse can be a beneficiary and there is scope to build up debts on his/her taxable estate by the trustees making loans. This will reduce the IHT payable on the spouse’s subsequent death.

    The seven-year cumulation period will still exist so, for those clients with combined taxable estates of more than £600,000 and with investment capital, lifetime gifts still make sense because:

  • If the donor survives more than seven years, the nil-rate band becomes available again.
  • All investment growth is outside the taxable estate.
  • If the client wants continuing control over the gift, a trust can be used and, in single settlor cases, the spouse or registered civil partner can be a potential beneficiary. If the taxpayer needs access or income as well as IHT mitigation, consideration can be given to a discounted gift trust or loan trust, depending on the need for immediate IHT savings balanced against flexibility over access to the investment.

    Death-in-service benefits can, if paid to the surviving spouse, cause that person’s assets to exceed the available nil-rate band. It sometimes makes sense to implement a spousal bypass trust. Any benefit payments to the surviving spouse can be made by loan and so will hopefully be a deduction on that person’s taxable estate on death. Care should be taken over the impact of section 103 Finance Act 1986, which the Phizackerley case was based on. If a discretionary trust is used, the possibility of periodic and exit charges needs to be taken into account and weighed against the savings. In cases where nil-rate planning is undertaken using an immediate post-death life interest trust, with beneficiaries other than the spouse having the interest in possession, consideration could be given to directing death benefits to that trust.

    There will be cases where, despite the potential for IHT on the second death, people do not wish to undertake lifetime planning. A combined taxable estate of £1m could now give rise to a liability of £160,000 (down from £280,000 previously) and a simple solution would be to consider a joint-lives, last-survivor policy in trust. Premiums would be transfers of value but normally fall within the settlor’s annual exemption and/or normal expenditure out of income exemption.

    Whoever wins the next general election, one thing is certain. For some married couples, the impact of IHT will reduce. For many others, the impact will not have changed at all and most of these will be those who, with advice, will have used the nil-rate band on first death anyway. Many of these will be clients of financial advisers.

    Clearly, these changes do not mean that planning is unnecessary. For many, the position will not have changed and this message needs to be made clear to clients. People should also be reminded that because it is the tax rules and rates at the date of death that count, strategies need to be reviewed regularly and carefully. Clients who have excess capital or income should be encouraged to consider taking such steps as are necessary to reduce the future impact of the tax now:

  • Use should be taken of the current favourable potentially-exempt transfer regime.
  • For those who have surplus income, use should be made of the normal expenditure out of income exemption.
  • For those who want to make gifts and keep control, gifts to trusts should be made. A claim for capital gains tax hold-over relief could also be useful.
  • For those who need access to the assets used in planning, discounted gift trusts and loan trusts (and possibly combinations) should be considered.
  • Those who have not yet made a will, particularly married couples and those in a registered civil partnership, should establish an IHT efficient will.
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