Inheritance tax is often named as Britons’ most hated tax – not least because it is a levy on assets that have usually already been taxed once during acquisition. It is therefore no surprise that people are prepared to go to some lengths to avoid it.
The recent change in the rules to allow spouses and civil partners to transfer any unused part of the tax-free allowance – the nil-rate band – between them has gone some way towards alleviating the tax burden on couples by effectively doubling the allowance of the surviving partner if no bequests other than to the spouse have been made.
But this concession does not help single people or those with very large estates.
The simplest way to offload assets above the IHT nil-rate band is to give them away, either by means of annual allowances, gifts out of regular income or simply handing over the cash and hoping to survive for seven years to avoid the value of the gift being included in the estate. But that does not help those who rely on the income from the assets.
Gift with reservation rules have made it difficult for those trying to avoid IHT to retain the benefit of assets or derive an income from them without invalidating their move. However, there are a number of ways that are still open and approved by HM Revenue & Customs.
One such is a discounted gift or loan trust, whereby the individual buys a single- premium life insurance bond written in trust for the chosen beneficiaries.
With a gift trust, the premium will be a potentially exempt transfer for inheritance tax purposes and therefore free from IHT if the settlor survives for seven years.
Under the terms of the trust, the settlor will be entitled to regular withdrawals to provide a lifetime income.
This arrangement can be inflexible, however, as once the terms of these withdrawals have been laid down in the trust, they cannot be altered.
With a loan trust, the initial premium is handed over to the trust as a loan to be paid back over time. Unlike with a gift trust, the capital amount will remain inside the settlor’s estate. The growth in the bond, however, falls outside the individual’s estate, so the heirs can receive this cash IHT-free. At the same time, the trustees – usually the settlor, spouse and the beneficiaries of the trust – can make periodic withdrawals from the bond to provide an income.
The proportion of the capital sum required to maintain income payments during the life of the settlor is discounted from the total value of the amount deposited, reducing its value for IHT purposes, which gives this type of trust its name.
The arrangement sounds attractive and is a popular form of inheritance tax planning for wealthier clients but not everyone is keen.
Yellowtail Financial Planning managing director Dennis Hall says: “I am not a huge fan of bond solutions to IHT problems, not least because of the complexity of the charging structure, the amount of charges over the life of the investment and the amount of commission paid to those who sell them.
“Insurance bonds are rarely as tax-efficient as they are some-times presented. They might appear simple to administer but this comes at a price.”
Simon Patterson, an independent financial adviser and manager of the financial planning group at solicitors Dickinson-Dees, is also wary.
He says: “Often, to get the largest initial discount – and thus remove the maximum initially from the settlor’s estate – the maximum tax-deferred income withdrawal of 5 per cent per annum is taken. This can potentially result in erosion of the initial capital, since, to achieve a growth rate in excess of the withdrawals (that is, more than 5 per cent a year) plus the costs of the investment bonds and fund management costs (say, 2 per cent a year), a growth rate of something like 7 per cent a year may be required. To achieve this, investors may decide to take on additional investment risk by investing in higher-risk funds within the trust in order to try to achieve growth at a higher rate.
“We do not recommend this strategy but have seen cases where this has happened.”
Yellowtail’s Hall notes that there has been a big marketing push for Aim portfolio services to meet the pursuit of higher growth but taking on extra risk could defeat the purpose of the bond – securing capital for heirs.
Patterson says: “Income payments must continue at the set rate, whatever the investment conditions, which results in encashments being made when markets are low. If the investments are in higher-risk investments, these may be more volatile or fall further than a corresponding lower- risk fund.”
Hall says the experience of the last two years has highlighted the risks associated with this approach. “The poor stockmarket performance in recent times has meant that a great many of these bond products will likely fail on two counts. With a loan trust arrangement, there may not be sufficient money in the bond to repay the original capital invested and thus there will be no growth in the bond that would pass to the beneficiaries. In addition, they have carried the costs of wrapping it up in the bond.
“Many investors also come to the conclusion that they can afford to give away the growth from the bond but not the actual capital and make assumptions based on receiving 5 per cent a year return of capital.
“I agree that this would also be the scenario if they had invested in a bond without the IHT trust wrapper but if their financial position is heavily reliant on this element of income, should IHT actually be a priority?”
One way round the fear of falling investment values could be to go for a guaranteed product. A unit-linked guaranteed annuity would allow for growth but guarantee a minimum payment to the client in the event of poor performance.
To aid with IHT planning, the guaranteed investment bond can be used in a discounted loan trust.
Peter Carter, head of product marketing at Metlife UK, says the product is “perfect for a loan trust” because the amount available for withdrawal is guaranteed even if the value of the bond goes down.
He says: “The investment is reviewed every year or every two and half years, depending on preference at the outset, and if the value of the fund has increased beyond the base guarantee level, the base level is ratcheted up. The new base level is now used to determine future income. However, if the value of the fund has gone down, the income remains as it was and does not fall.”
As a further advantage of the bond, anyone who does not need income immediately can benefit from deferral step-ups of 3 per cent.
Carter points out that, where the bond is combined with a discounted loan trust, the income payments are used to repay the loan and the guarantees can be attractive to the trustees despite charges that may be steeper than unguaranteed bond solutions.
Carter says: “It is attractive to trustees because it guarantees that the loan will be repaid. Where an investment to a discounted loan trust is more volatile and runs out of money so it cannot pay off the loan, the trustees can be sued by the lender to make up the shortfall. This cannot happen with the Metlife bond because of the guarantees.”
Patterson points out that setting up loan and gift trusts can be complicated and clients need to take not only legal advice on the structure of the trust but also financial advice on who should provide the single-premium investment bond and also on the asset allocation of the underlying funds used in order to meet their risk profile.
Hall also cautions about complicated solutions such as wrapping annuities in bonds.
He says: “I am not sure how using a guaranteed annuity within a bond wrapper achieves anything better than simply using an annuity, in fact, it could be worse. An annuity purchase made directly takes the purchase price outside the estate immediately whereas transferring money into a bond first and then purchasing the annuity doesn’t. The actual transfer into the bond is not an annuity purchase and thus it is a potentially exempt transfer with the seven-year clock ticking.
“Also, the tax treatment is different. A purchased life annuity would be return of capital and some interest element, with the interest element taxed. In a bond, there would be no allowance made for capital element of the annuity.”
Annuity Direct chief executive Bob Bullivant cautions against being “too clever” with income in retirement and says: “The vast majority of retirement planning involves compromise. Establishing income streams is important, whether by annuitising or drawdown, and investors should be careful not to put assets they might need out of their own reach. You can’t generally have your cake and eat it.”