I have seen a number of articles in the press recently about inheritance tax schemes. I am interested to know what schemes are available. How do they work and what benefit would they be to me?
Life insurance companies have developed a variety of schemes designed to reduce an individual's potential IHT liability while at the same time maintaining or increasing their income.
One of the most interesting (and possibly controversial) is the Clerical Medical scheme, known as the Family Wealth Trust. You should note, however, that the Inland Revenue is renewing its efforts to clamp down on inheritance tax avoidance by wealthy individuals using this particular type of trust planning. In a recent hearing (the Eversden case), the Revenue's argument that this type of trust was being used as a tax dodge was dismissed by a Special Commissioner but the Revenue will appeal against the decision in a High Court hearing in the spring.
IHT schemes are not suitable for everyone but in the right circumstances they can solve the classic dilemma in IHT planning – extracting capital from an estate while generating sufficient lifetime income. Certainly, it is possible for substantial savings to be made.
These schemes consist of an annuity, which normally reduces the value of an estate but provides a regular income. Part of this income is used to fund a life insurance policy written in trust with the aim of providing funds to replace the money used to buy the annuity.
Back-to-back schemes are particularly attractive when the general level of interest rates is high and the investor is elderly as subsequent annuity income will be higher. A possible disadvantage could be the higher cost of life insurance.
Here, you establish a trust, for example, by investing a modest amount into a single-premium bond. Additional trustees are then appointed to whom an interest-free loan is made. The trustees use this money to effect another single-premium bond as an additional asset of the trust fund.
You receive regular tax-efficient income in the form of loan repayments using the 5 per cent withdrawal facility associated with the second single-premium bond. There are several advantages with this type of scheme:
The initial payment into the trust is classed as an exempt or potentially-exempt transfer.
All growth on the investment bonds will be outside the estate and free of IHT.
As the interest-free loan is repayable on demand, it is not treated as a gift although any outstanding sum due at death will be part of your estate.
Assuming loan repayments are spent as income, your taxable estate will gradually reduce.
Retained-interest trust schemes
These schemes involve investing in a unit-linked single-premium life insurance bond written under trust. The trust is split so you retain part of the trust fund, from which withdrawals are taken to provide an income. The balance is gifted for the benefit of your chosen beneficiaries. Attractions of these schemes include:
You can take an income of up to 5 per cent each year of the total original investment (not just the donor's part) free of any immediate personal tax liability for 20 years.
Growth on the gifted part is outside your estate.
The trustees (including yourself) retain control over who benefits from the gifted portion.
A Pet is made.
Discounted gift schemes
This is an innovative concept designed to reduce your IHT liability while offering a combination of benefits, including increasing net spendable income. You can gift capital while retaining access to regular distributions, which can be used to supplement your income.
The bond provides an immediate IHT saving simply because you do not really give away the whole of the sum transferred. You keep back the right to receive income for the rest of your life. That right has a value and you have only given away the difference. But the notional value of the income stream will die with you and does not feature in the estate and calculation of IHT on death.
The value of the right to receive income for the rest of your life is actuarially calculated by reference to your age at outset, your state of health and amount of income required. It is for this purpose that basic medical information is obtained from your doctor.
The remaining balance of the bond is a gift and is classed as a Pet. However, taper relief may apply after three years which can reduce the amount of tax payable. After your death, your beneficiaries are entitled to the whole of the value of the bond. All growth on your entire investment is outside your estate on day one. Therefore, after seven years, the whole investment is outside your estate.
To date, under an earlier version of this plan, where there have been a significant number of deaths, the Capital Taxes Office has agreed the actuarial value of the income stream (the discount) calculated in every case. A certificate is issued following investment confirming the value of the discounted gift, the balance being the amount which falls out of your estate immediately.