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General planning issues

The inheritance tax (IHT) nil-rate band has been increased from £242,000 to £250,000.
The increased threshold will apply to chargeable transfers occurring on or after 6 April 2002. The threshold is being increased by £3,000 more than the statutory indexation but it is still estimated that 24,000 estates will be caught for inheritance tax in tax year 2002/03.

Because this was the first Budget of a new term of office and there was a general expectation of tax increases, inheritance tax was a favourite for attack, especially given Labour&#39s past comments on the current favourable system. However, nothing serious materialised.

Although no major changes to IHT have yet been made by this Government, complacency must be avoided. It would, therefore, be prudent to continue planning for the possible changes later in this Government&#39s term of office and so make maximum use of the current rules. Don&#39t forget that some five years ago the Labour Party publicly criticised the lack of bite in the inheritance tax regime.

In very brief terms the main advantages of the current inheritance tax regime are as follows:-

  • a nil-rate band of £250,000 with a flat rate of tax on death (40%)over that amount
  • the potentially exempt transfer rules
  • a 100% maximum level of business property relief and agricultural property relief
  • planning using deeds of variation
  • lump sum inheritance tax schemes that avoid the gift with reservation rules
  • advantageous rules for excluded property trusts.

All of these are areas that may well be targeted for harsher treatment under Labour in the future.

(1) Rates of tax
The nil-rate band has been increased as indicated above. However, bearing in mind the possibility of a change to the IHT regime, individuals who have potential inheritance tax liabilities may be inclined to use their nil-rate band sooner rather than later (see potentially exempt transfers below) and, if they are married, to arrange their asset ownership so that both spouses can utilise their nil-rate band either during lifetime, or on death via their Wills.

If the nil-rate band of the first of a married couple to die can be fully utilised by, say, legacies to children, an IHT saving of £100,000 on the second death can be achieved. If there is concern over continuing access to capital for the surviving spouse a suitable Will trust could be used.
Given the future possibility of change in the nil-rate band, where clients wish to make such arrangements, it may be best to use a wording that gifts the available nil- rate band at death rather than a specified figure equal to the current nil-rate band because, if this figure reduces and no action is taken, future unnecessary IHT liabilities may arise.

It remains to be seen whether Labour will eventually introduce tiered tax rates that increase as the size of the taxable estate increases but this is definitely a possibility and again acts as a stimulant for early lifetime gifts if they can be afforded.

(2) Potentially exempt transfers (PETs)
Gifts that are PETs give rise to no IHT at the time they are made. Moreover, there will be no IHT at all if the donor survives the gift by 7 years. Even if death occurs within 7 years, provided the donor survives for at least 3 years, taper relief will apply to reduce any tax charge. Control over the asset gifted can be maintained by the donor using a trust under which he/she is a trustee.

Labour are thought to regard the PET as a &#34loophole&#34. Therefore, there is a strong possibility that Labour would ultimately wish to remove the PET regime and probably impose an immediate lifetime charge to IHT for all transfers over the nil-rate band. In essence all transfers could then be treated as chargeable transfers for IHT purposes. As mentioned above, it may also be that Labour would consider reintroducing tiered rates of tax for transfers above the nil-rate band – perhaps starting at 30% and rising to, say, 50% or perhaps even 60%.

Anybody contemplating making substantial lifetime gifts in order to save IHT should do so whilst PET treatment is available. All growth in value of the gift will be free of IHT. Gifts to certain trusts count as PETs, for example an accumulation and maintenance trust and a power of appointment interest in possession (flexible) trust. By using a trust, continuing control can be maintained by the donor acting as trustee and, in the case of the flexible trust, maximum flexibility can be included over who will be the ultimate beneficiary under the trust. Life assurance can be effected to cover any potential IHT liability on the death of the donor within 7 years. Careful consideration needs to be given to the capital gains tax (CGT) implications of making gifts and the CGT cost of making a gift balanced against the potential IHT saving.

If cash gifts are to be made into trust, capital investment bonds can be an attractive trustee investment because:-

(a) they are non-income producing and not subject to CGT and therefore reduce trust administration;

(b) they can provide tax deferral especially where the rate of tax paid by the trustees is at a higher rate than that suffered within the insurance company&#39s funds;

(c) the trustees can switch investment funds of the bond without triggering a tax charge; and

(d) if the trustees require cash they can make use of the annual 5% tax- deferred withdrawal facility. It may also be possible to reduce tax on ultimate encashment by assigning individual policies of the bond out of the trust so that adult beneficiaries can make the encashment.

Capital investment bonds will not enable trustees to use their annual CGT exemption of £3,850 in 2002/2003 or make use of a beneficiary&#39s personal income tax allowance. In these circumstances, unit trusts or OEICs may be more appropriate investments.

(3) Deeds of variation
Under current legislation, within two years of a person&#39s death, it may be possible for the beneficiary(ies) of a gift under the Will (or on an intestacy) of the deceased to vary the destination of the gift. Such a variation can, depending on the circumstances, save IHT. It may well be the case that Labour will eventually remove this facility so that if a deed of variation is appropriate, action should be taken sooner rather than later.

(4) Lump sum inheritance tax plans
Retention of the right to income and/or capital will normally mean that the gift with reservation provisions will neutralise any IHT benefit of a gift. A lump sum inheritance tax plan seeks to overcome this problem. These plans, of which there are a number, will often enable an investor to establish a trust and enjoy some form of &#34income&#34 (normally in the form of a capital payment), possibly provide a level of access to capital and provide some control and flexibility via a trust. Ignoring annuity/life assurance (back to back) arrangements, there are four primary forms of lump sum inheritance tax plan, which are all based on the combination of a trust with a capital investment bond:-

(a) The gift and loan (or &#34loan only&#34) scheme – a gift is made to a trust (or a trust declared with no gift) and an interest-free loan, repayable on demand, made to the trustees. The trustees invest in a capital investment bond. Income is enjoyed in the form of tax free loan repayments financed by the trustees making 5% part surrenders from the bond. The investment growth is outside the investor&#39s taxable estate and free of IHT.

(b) A discounted gift plan – a policy is effected subject to a trust where &#34income rights&#34 in the form of payments of capital are retained for the benefit of the settlor (possibly on the maturity of individual policies) with rights on death passing to trustees. Part of the initial investment is regarded as a PET.

(c) A retained interest trust – a capital investment bond is effected subject to a split trust under which a part of the trust is held for the absolute benefit of the settlor and a part on flexible trust under which the settlor is excluded from benefit. The part of the bond initially held on flexible trust is regarded as a PET. The donor can draw down from his side of the trust fund with the 5% part surrender calculation being based on the whole of the initial investment in the bond.

(d) The reversionary interest plan – where, after an initial gift to trust, in successive years amounts revert to the settlor.

There is little doubt of the appeal that lump sum insurance-based inheritance tax schemes have to people who have investment capital and wish to plan to reduce inheritance tax but wish to retain some access to income or capital. It seems that these plans can achieve such objectives but without the application of the gift with reservation provisions. Labour may wish to restrict the effectiveness of such schemes in the future given that three years ago they acted to prevent people using private residences in lease carve-out schemes to avoid inheritance tax. The question of which type of scheme is most appropriate will depend on all the personal and financial circumstances of an investor – not least the age of the investor and the flexibility he or she requires over the future rights to income/capital.

(5) Business/agricultural property relief

Currently certain business and agricultural assets qualify for 100% relief which, subject to certain conditions being satisfied, effectively removes the assets from the inheritance tax net. Labour are concerned that these reliefs may be abused. However, they have stated that &#34they will introduce arrangements to protect bona fide family businesses from being broken up as a result of a more effective inheritance tax regime&#34. Overall, it is felt that Labour would wish, in the main, to continue a reasonably high level of relief on business and agricultural assets although it is not known whether this will continue at 100%.

For persons who desire to make gifts of business/agricultural assets now in order to take advantage of the 100% relief currently available, they may be advised to use a discretionary trust that crystallises a chargeable transfer at the date of gift rather than making a gift that is a PET. Any concern over lifetime gifts subsequently suffering inheritance tax because of a reduction in the rates of relief can be tempered by taking out a temporary assurance policy in trust to cover the &#34at worst&#34 position.

Of course, before a gift of business/agricultural assets is made, the CGT position will need to be considered. Also, for a gift to be effective for IHT potential donors cannot benefit. They should also be satisfied that they have sufficient financial security and, in this respect, a well funded pension scheme can be very useful. In order to avoid the gift with reservation rules, any increased benefits for a shareholding director from the company should be established (preferably by service agreement) prior to the gift.

(6) Excluded property trusts
Where a person who is non-UK domiciled (for inheritance tax purposes) establishes a (normally discretionary) trust and that trust invests in non-UK situs property, under current law the trust will be outside the IHT net forever – even if the settlor later becomes UK domiciled for IHT purposes. This is what is known as an excluded property trust and the trust will not be subject to IHT even if the settlor is a potential beneficiary. Labour may well change the rules on domicile in the future and non-UK domiciled people who are currently resident in the UK may therefore be very interested in establishing such a trust before any possible changes. As such a trust must invest in non-UK situs assets to achieve excluded property status, offshore capital investment bonds or offshore roll-up funds can be ideal investments both from a tax standpoint and as a means of minimising trust administration.


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