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It shouldn’t happen to a Pet

Changes to the trust rules mean it is vital to make gifts in the right order.

With the number of estates falling into the inheritance tax trap still increasing, the question of avoidance will continue. What is the best way to limit liability to IHT through making gifts? What issues do individuals need to be aware of when trying to mitigate IHT liability?

Despite Chancellor Gordon Brown’s best efforts to create hurdles for those seeking to limit liability to IHT, many are quite rightly undeterred.

Individuals still have at their disposal a number of measures that can help them mitigate against the liability. Rather than adopting just one approach to the problem, a package of measures is more beneficial to avoid the tax but also to provide continuing access to capital and income where this is required.

However, more caution is now needed on the timing of these events than has been the case previously, particularly where an individual is seeking to make both a chargeable lifetime transfer and a potentially-exempt transfer.

The first action many take when reviewing their estate for IHT purposes is to give away money. At this stage in the financial planning cycle, those with assets in excess of their needs are best placed to make gifts, usually to close family.

The ability to do this and avoid IHT is limited, however, and any amounts in excess of an annual exemption of £3,000 will be deemed to be Pets. Unless the donor lives for seven years from the date of the gift, IHT will be payable, albeit on a sliding scale.

For those who depend on ongoing income streams, discounted gift schemes have long been used as an effective way to gain an immediate reduction to IHT. Using a single-premium investment bond, the “discount” is the result of a settlor’s retained right to the portion of the fund deemed to be needed to provide income for the remainder of their life via the 5 per cent rule. However, following changes to trust rules, rather than being a Pet, if written using a discretionary trust, the value of the gift, minus the discount, is now deemed to be a CLT.

Since these are among the most common of IHT tools, it is important to consider what would happen to IHT liability where an individual seeks to make both a CLT and a Pet, as the order in which the transactions occur becomes crucial.

To look at a practical example, in October 2006, Mr Smith makes a gift to his son of £200,000. He has not used his annual exemption for this or the previous year. Therefore, £194,000 is a Pet.

In November, he invests £270,000 in a discounted gift trust, which is a transfer into a discretionary trust. There is no immediate liability to IHT as he has not made any other CLTs in the previous seven years.

Mr Smith dies in June 2012. As seven years have not elapsed, the gift he made, which was a Pet, fails. The position would be as shown in the table (above).

The issue comes at the tenth anniversary of the discretionary trust, when the periodic charge is due. At this stage, tax due is based on the effective rate at the trust’s creation. As the Pet failed, this becomes part of the equation since it is now treated as a CLT. This will increase the effective rate and, thus, the tax payable.

Crucially, had Mr Smith undertaken the transactions the other way round, the PET would not have been taken into consideration as it is only CLTs which come into force before the creation of the trust, and not after, that are counted. Therefore, tax at the 10-year period would be reduced.

If the Pet was made first and Mr Smith survived the seven-year period, then, naturally, the gift would fall out of account and would not have any effect going forward. However, as this example shows, if the Pet is made first and then fails, its value will continue to affect the discretionary trust for as long as it exists, both at the 10-year anniversary and at exit when further charges fall due.

It should be remembered that two CLTs made within seven years of each other will always affect each other, no matter when the settler dies.

The message, therefore, is caution. There are ways to save IHT but it is never going to easy.

Julie Hedge is principal of Christie Scott’s.

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