The spouse-interest trust is perhaps the ultimate in flex-ible inheritance tax planning, addressing the key planning issue of access to capital or income if the client's circumstances change. But does it work? The Inland Revenue thinks not but its first challenge has failed.
Inheritance tax is said to be a voluntary tax. This is true to the extent that you can afford to make lifetime gifts. No inheritance tax is charged on gifts to an individual (or to a settlement other than one creating discretionary trusts) made more than seven years before death.
But making potentially exempt transfers is not always an option. This is because the general rule is that the gift must have “no strings attached”. If the donor retains some interest, such as the possibility of benefiting from the gifted assets in the future, this is a gift with reservation.
The full value of the gifted property or trust fund at the date of death is then treated as still part of the donor's taxable estate.
You may have clients who are comfortably off and have secure incomes. But with some people now likely to be retired for longer than they worked and with the funding of long-term care costs still largely unresolved, potential access to capital is often a key requirement.
The spouse-interest trust solution
A spouse-interest trust is designed to allow married couples to take advantage of the Pet regime while still retaining the possibility of benefiting from the gifted assets. It has been used for many years by solicitors and has been offered as a packaged scheme in the insurance market since the mid 90s.
The settlor makes a gift to a trust under which his or her spouse has a right to receive income – an interest in possession. Because a person with an interest in possession is treated for inheritance tax pur- poses as the owner of the property producing the income, this is a transfer of assets to the spouse. Such transfers are exempt from inheritance tax.
The settlor may therefore be included as a potential beneficiary without the trust fund being taxed as part of the settlor's estate on death.
Section 102(5)(a) Finance Act 1986 specifically provides that the gift-with-reservation provisions can have no application where the gift is an exempt transfer.
The trustees may subsequently terminate the spouse's income interest in favour of beneficiaries such as children or grandchildren. This is a Pet by the spouse. The entire trust fund can then pass free of inheritance tax to the beneficiaries appointed in place of the spouse if the spouse survives for seven years from the date of termination of his or her interest.
The trustees also have power to appoint part or all of the capital of the trust fund to the settlor.
Does the Inland Revenue accept this interpretation of the legislation? No.
While it accepts that the settlor makes a disposal by way of gift to which section 102(5) applies, it argues that the settlor makes two further gifts – to the discretionary and default beneficiaries. As the discretionary beneficiaries include the settlor, it claims that the gift-with-reservation provisions do apply (to the whole trust fund).
These arguments have now been considered in a hearing before the Special Commissioners. The case concerned a gift of an interest in a house to trustees upon trust to pay the income to the settlor's husband during his life and after his death to hold the capital and income on discretionary trusts for a class of beneficiaries that included the settlor herself.
On the husband's death, his interest in possession in the trust fund was declared in the inheritance tax account and the appropriate amount of tax was paid.
On the subsequent death of the settlor, her estate was assessed to tax on the value of the trust fund at the date of death, by virtue of the gifts with reservation provisions.
The Special Commissioner decided that section 102(5) Finance Act 1986 applied so as to exclude the gift-with-reservation provisions completely and, in particular, that, on the creation of the settlement, the disposal of property was by way of one gift only to the husband.
Although the inclusion of the settlor as a discretionary beneficiary was a reservation of benefit, the estate's appeal against the assessment to tax was successful and the Inland Revenue's arguments were comprehensively dismissed.
The decision of the Special Commissioner is entirely in accordance with the robust and authoritative opinion from leading tax counsel that underpins the life insurance-based spouse-interest plans.
Although the planning in this case was not based on one of the insurance schemes, the decision does deal directly with the underlying legislative basis of these arrangements.
So what now? The Special Commissioner's decision is good news but may not be the final word on the matter. The Inland Revenue has given notice of an appeal to the High Court.
In the meantime, trustees of existing arrangements need not take any special action. In particular, it is important that the spouse's interest in possession is not terminated prematurely. The interest should remain for a reasonable period – a minimum of at least six months is recommended.
Spouse-interest trusts remain as a planning option. There is always a residual risk that tax planning can be defeated by action in the courts or by amending legislation.
But if a start is made on planning there is a possibility that it can be carried through. For many clients, the spouse-interest trust will represent the only acceptable planning alternative to doing nothing.
However, it is important that potential clients and their advisers are fully informed and understand that planning of this type cannot be rushed.
It will often need to take place over more than one tax year and there should be no question of buy now while stocks last.
But where the client requires ultimate flexibility, the spouse-interest trust remains a useful option. After all, the worst-case scenario is that the trustees appoint the trust fund back to the settlor under the revert-to-settlor exemption.