Through careful planning involving a discounted gift scheme and an EIS reinvestment relief portfolio service, it is possible for wealthy, older clients to escape the IHT/CGT trap.
Many of you will be familiar with the problems faced by a client holding an asset or assets which have appreciated substantially in value and which the client wants to dispose of for IHT purposes.
If the client merely assigns the assets into trust or to an individual, this will be a disposal for CGT and, subject to certain reliefs and exemptions, these will be chargeable on the donor.
CGT can be held over if a discretionary trust is used but this does not solve the problem on death within seven years – whether CGT has been paid or held over, depending upon the growth of the investments after the gift, the client may be worse off than if he had done nothing.
This is because if an individual retains assets chargeable to CGT on death, they will enjoy an automatic uplift in the value of those assets. However, if transfers of assets to chargeable beneficiaries (that is, not a UK-domiciled spouse or charities) exceed the nil-rate band, then IHT at 40 per cent will be payable on the excess. If the assets had been gifted less than seven years prior to death, the CGT would have been payable on the disposal and the gift would still be chargeable to IHT, with taper relief on any part in excess of the nil-rate band.
However, it is possible to:
Sell a client's entire share portfolio without any CGT charge being incurred.
Obtain immediate IHT benefits, with further benefits after two and seven years.
Subject to survival for seven years and the holding of the investments until death, completely eliminate any CGT or IHT on the value of assets used in the scheme.
Maintain the level of income the client previously enjoyed.
The scheme would work through the sale of assets on which CGT is chargeable, say, a share portfolio. The gain on sale would need to be calcu-lated and total amount realised divided into that part which will be charged to CGT and the original capital increased by indexation and other reliefs. The “chargeable gain” element then needs to be invested in a product which provides CGT deferral and IHT benefits (that is, business property relief after two years).
This is where the EIS reinvestment relief portfolio comes in. This is a stockbroker-managed portfolio of very small companies (less than £15m capitalisation) engaging in “qualifying trades”. Although the scheme was designed to benefit small, high-risk enterprises, many EIS qualifying companies can offer a reasonably high level of property backing. Popular choices include children's nurseries and pub companies.
An investment in a qualifying company provides CGT deferral at 40 per cent and IHT business property relief after two years.
However, advisers should be aware that these shares are very illiquid and, for that reason, coupled with the size of the underlying companies, must be considered higher-risk.
It is also worth noting that business property relief will not be available until all the shares have been invested for at least two years and the stockbroker may take up six months to invest all the funds. Specialist stockbrokers such as Teather and Greenwood and Brewin Dolphin offer these services.
Although the reliefs are lost when the stockbroker sells shares, by reinvesting in a new qualifying company, they are immediately re-established.
If the EIS portfolio is held until death, the deferred gain does not become chargeable and business property relief should be available under current legislation.
At this point, we have beaten both IHT and CGT on the “chargeable gain” portion of the portfolio.
However, the client is now bereft of any income which was previously produced by his share portfolio, as it is unlikely that the EIS portfolio will produce any dividends.
Therefore, a scheme which replaces the client's income in an IHT-efficient manner is needed for the remainder of the funds realised from the sale of the share portfolio.
Provided that the client is in good health at the time,a so-called “discounted gift” scheme might be used. This scheme allows the investor to carve out a stream of payments from a sum of money (which is invested in a single-premium investment bond) while giving away the underlying capital IHT effectively. Not all discounted gift schemes are alike and there are various different types.
These schemes all involve special trusts, to prevent payments to the settlor causing the fund to be subject to a “reservation of benefit” and ineffective for IHT purposes.
Furthermore, because the settlor is likely to receive back a certain amount of his or her original capital as income, the value of the initial gift for IHT purposes is reduced by amount deemed received.
To give a very simple example, if an individual with a life expectancy of 10 years invests £100,000 and elects to withdraw 5 per cent a year, he would receive £50,000 back if he dies at life expectancy.
The amount the settlor will receive back is not a gift for IHT and it falls outside the estate immediately. This is where the phrase “discounted gift” derives from in this context.
However, the Inland Revenue may query any discount based upon the health of the investor at the time that the plan is effected. Medical underwriting is essential to ensure the Inland Revenue agrees the correct “discounted value” if the client dies within seven years of effecting the arrangement.
By combining an EIS reinvestment relief portfolio and an IHT discounted gift scheme, clients can realise assets chargeable to CGT, defer any gain indefinitely prior to elimination on death and make IHT savings immediately (from the discount), after two years (from the EIS portfolio) and after seven years (when the non-discounted element of the discounted gift scheme falls out of account), all while maintaining a regular income.
This approach will not be appropriate for everybody. The investment merits should be carefully considered and the precise amount of the gain as a percentage of the total portfolio.