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Don’t just grin and bare it

Friends Provident life technical manager John Hendry says despite

Gloom abounded as Budget Note 25 rolled off the printers on March 22. The news that new trusts, other than bare trusts, would generally be subject to the relevant property regime, previously confined to discretionary trusts, meant that several popular inher- itance tax planning tools needed urgent re-evaluation.

Six months on, it is clear that there are still plenty of opportunities to help the 75 per cent of the population who, according to a recent Friends Provident survey, aim to leave an inheritance to their children or family.

There are essentially three consequences of a trust falling into the relevant property regime.

First, gifts into trust are chargeable lifetime transfers unless they qualify for other exemptions. Second, trust funds are subject to a periodic IHT charge on the value of the trust fund at each tenth anniversary, with proportionate charges on funds leaving the trust between periodic charge points. And third, each trust has its own nil-rate band independent of the settlor except chargeable transfers made by the settlor in the seven years before creating the trust are deducted.

Protection products were typically written under power-of-appointment interest in possession trusts. Some providers have recently begun offering straightforward discretionary trusts instead as the IHT treatment is now precisely the same.

Premiums for protection products written under trust will usually fall within the standard IHT exemptions or be within the available nil-rate band. Only exceptionally will payment of a premium give rise to an IHT charge.

Most of the time, protection products have no market value so no possibility of a periodic charge arises. But if a life assured is seriously ill at a periodic charge point, a big protection policy could have a significant value subject to the periodic charge. Also, if the trustees still hold the reinvested claim proceeds of a policy at a periodic charge point, the trust fund suffers the periodic charge.

Loan trusts are perhaps least affected by the Budget. The initial transfer of value – the amount invested minus the loan – is zero so there is no IHT liability when the trust is established.

Periodic charges are based only on the policy value less any outstanding loan. Unless this amount exceeds the nil-rate band available to the trust, the periodic charge will be zero. A typical loan trust, with £100,000 invested by someone who has made no significant chargeable transfers, will probably never suffer periodic charges although any outstanding loan at the settlor’s death forms part of his taxable estate as it has always done.

Retained interest trusts are treated for IHT in the same way as standard discretionary or interest in possession trusts except that the settlor’s retained interest – usually expressed as a fixed cash amount – remains part of his personal estate and is not relevant property.

On creation of the trust, there is a chargeable transfer of the gifted interest, which is the excess of the amount invested over the retained interest. If this transfer exceeds the settlor’s avail- able nil-rate band after deducting his chargeable transfers in the previous seven years, IHT is due at 20 per cent on the excess.

At a periodic charge point, the relevant property is the policy value minus the current value of the retained interest, which will be the original retained interest amount less any capital withdrawals taken by the settlor. Unless the value of the relevant property exceeds the trust’s available nil-rate band, no periodic charge will arise. If there is an excess, IHT at 6 per cent is charged on it.

Under discounted gift trusts, the settlor’s retained interest is expressed as a right to receive regular capital payments of a specified amount for life. The initial chargeable transfer equals the discounted gift – the total invested less the actuarial value of the settlor’s right to lifetime capital withdrawals. If the transfer exceeds the settlor’s available nil-rate band, IHT is due at 20 per cent on the excess.

When a periodic charge is due, the relevant property is the policy value minus the actuarial value of the future stream of capital withdrawals earmarked for the settlor, unless the settlor has already died in which case the whole policy value is relevant property. Once the relevant property is identified, the periodic charge is calculated as for retained interest trusts.

Even before the 2006 Budget, many providers offered bare or absolute trusts in favour of a single beneficiary or a few beneficiaries in specified shares. These were little used as they provided no flexibility and no IHT advantages over flexible interest in possession trusts.

Since the Budget, these are almost the only trusts available for gifting outside the relevant property regime, with the initial gifts still potentially-exempt transfers and the funds in them not subject to periodic charges. They are therefore well worth considering by clients prepared to set in stone who will eventually benefit, especially where there is a danger of the gift being chargeable or the trust fund suffering periodic charges if the trust is on any other basis.

Several providers now offer versions of their loan trust and discounted gift plans where the gifted element is held on bare rather than flexible or discretionary trusts. This avoids the gifted element being taxed as a chargeable transfer at the start and the risk of periodic charges later but, again, with loss of all flexibility.

The 2006 Budget certainly hamstrung trust-based IHT avoidance by the super-rich. But huge numbers of middle-net-worth individuals whose lifetime gifting capacity is well within the nil-rate band should still consider trusts as a suitable mechanism.

The IHT countback period is only seven years so high-net-worth individuals can make chargeable transfers totalling over £1m into trusts in a period of just over 21 years without personal liability to IHT. With each trust having its own nil-rate band, the potential for periodic charges can be reduced, if not eliminated.

The message is not to leave IHT planning until the grim reaper is breathing down the client’s neck.


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