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Loan star

Technical Connection’s John Woolley explains how loan trusts can offer simple and effective inheritance tax planning.

There has understandably been a lot of discussion on the subject of discounted gift trusts especially since last year’s Budget. But aside from the application of the new rules to flexible DGTs, it is recognised that a DGT will not deliver flexible access to the capital invested.

For investors who have cash to invest but also want to mitigate the impact of inheritance tax while retaining access to the amount initially invested, a loan trust may be appropriate.

The essence of a loan trust is that growth on the amount lent accrues outside the investor’s estate so that the investor’s tax-able estate is frozen.

To do this, it is first necessary to establish a trust. This can be done by making a specific cash gift or by promising to lend a sum of money to trustees in the future. The individual (now settlor) then lends a cash sum to the trustees, interest-free and repayable on demand, who invest the loan in a single-premium bond on the lives of the beneficiaries under the trust. As and when the individual needs cash, he requests a loan repayment from the trustees who would normally fund this by making a part-surrender from the bond within their 5 per cent part-surrender entitlements.

The benefits of a loan trust are:

– Estate-freezing investment growth accrues outside the settlor’s taxable estate.

– The ability to enjoy tax free payments (regular or as required) from the trust in the form of loan repayments that can be used as income.

– Estate (and IHT) reduction by the settlor spending the loan repayments and so reducing his taxable estate assuming that the money is spent and not reinvested. It should be borne in mind that the loan remains part of the settlor’s taxable estate until repaid).

– The capability of the settlor (often a trustee) to determine who will ultimately benefit – and when – under the trust.

Two questions that should be addressed when establishing a loan trust:

First, what happens if the lender dies relatively soon after establishing the plan? In the worst-case scenario, the bond might have to be encashed to finance repayment of the loan.

This problem can be avoided by the settlor specifically leaving the rights to loan repayments to somebody under his will so that loan repayments can continue to that person.

Of course, any outstanding loan will still form part of the taxable estate of the deceased but if the settlor’s spouse becomes entitled to the outstanding loan, it will be covered by the spouse exemption.

Second, what happens if the loan is fully repaid with the settlor still living and needing income? This situation is one to avoid if at all possible as the settlor will then have no right to benefit under the arrangement.

It is therefore of some importance that loan repayments are set at a level that is unlikely to mean that the loan is fully repaid during the settlor’s lifetime.

Even if the loan is repaid, then, provided the need is for continuing payments to the lender’s spouse after the lender’s death, this should be possible under a flexible loan trust.

In order that the loan plan is fully IHT-effective, it is clearly important that the arrangement is not caught by the gift with reservation rules as otherwise any IHT benefits would be neutralised.

Provided the settlor is not a potential beneficiary under the trust, it is generally accepted that the anti-avoidance rules in para 5(4) Schedule 20 Finance Act 1986 will not apply to treat the value of the trust property as part of the taxable estate of the settlor.

Her Majesty’s Revenue and Customs also seem to accept that the gift with reservation rules do not apply to properly constructed loan trusts.

These days, the pre-owned assets tax rules can apply an income tax charge on any benefits enjoyed by a donor in cases where the IHT gift with reservation rules do not apply.

However, here, HMRC has given the Association of British Insurers an assurance that these rules will not apply to loan trusts, which has been backed up by statements in its guidance notes on the Poat.

The impact of Schedule 20 Finance Act 1986 is to make any trust (established after March 21, 2006) that incorporates any degree of flexibility subject to the IHT provisions yet many individual settlors will require some degree of flexibility. It is therefore necessary to consider how this tax legislation will apply to the establishment of loan trusts based on a discretionary trust.

Well, the new rules mean that a new loan trust could potentially be subject to an entry charge, a 10-year periodic charge and an exit charge when property leaves the trust. We will look at these in turn.

Because most loan trusts are these days established by a loan to a trust (and not a gift), a chargeable lifetime transfer will not occur and so there will be no immediate IHT charge.

In cases where the trust is established by a small gift, whilst immediate IHT may theoretically be possible, that will not be the case if the gift is covered by the settlor’s annual exemption or does not cause him to exceed the £300,000 nil-rate band on a seven-year cumulative basis.

An IHT charge can arise every 10 years based on the value of the trust property at that time. In general, there will only be a potential IHT charge if the value of the trust property at the 10-year anniversary of the trust, when added to the chargeable lifetime transfers made by the settlor in the seven years before establishing the trust, exceed the then IHT nil-rate band. In this respect, two important points need to be noted:

– In determining the settlor’s seven-year cumulative total before establishing the settlement, Pets do not count. This means that for many people establishing trusts now, they will not have made substantial chargeable lifetime transfers before March 22, 2006.

– In determining the value of the loan trust at the 10-year anniversary, any outstanding loan needs to be determined as this reduces the value of the trust fund.

For these two reasons, it seems unlikely that periodic charges will arise on loan trusts unless either the amount invested is very substantial, or the settlor has already in the previous seven years, before setting up the trust, made substantial chargeable lifetime transfersExit charges can arise when property is distributed out of the trust. However, HMRC has confirmed that an exit charge will not arise on a loan repayment out of the trust to the settlor (or the granting of an interest-free loan to a beneficiary, perhaps in a tax year after the settlor’s death).

Subject to that, an exit charge can apply when a payment is made out of the trust to a beneficiary. This will be based on the rate of tax that applied at the last 10-year anniversary or 30 per cent of the rate of tax that applied when the trust was established.

Therefore, in many cases, an exit charge is unlikely to arise unless the loan trust is of significant value.

There will be cases where an individual wants to establish a loan trust but has already made substantial chargeable lifetime transfers or wants to invest a substantial amount.

In both these instances, a 10-year IHT charge is more likely to arise.

In these cases, two courses of action could be considered. The individual could:

– Establish a loan trust based on a bare trust. Provided it is properly constructed, a bare trust will not be a settlement for IHT purposes and so the 10-year charge and exit charge issues are avoided.

– Clearly, the settlor needs to consider the lack of flexibility inherent in a bare trust; orl Establish several loan trusts on different days with a view to giving each trust its own IHT nil-rate band.

Such action (known as “Rysaffe planning” which is the case which, on the facts, confirmed that such planning is possible) needs to be approached with caution as it is important to ensure each settlement is not treated as a related settlement of the others.

In summary, therefore, for most investors, loan trusts offer a simple and effective (and comparatively uncontroversial) ability to invest a lump sum for medium to long-term IHT planning with flexible access to the original capital invested.

However, as stated above, care needs to be exercised in bigger cases or cases where the individual has already carried out substantial inheritance tax planning.


Bob is 67 and his wife, Sally, is 69. They have two adult children and five grandchildren. Bob and Sally have already included clauses in their wills to establish nilrate band discretionary trusts on the first death.

As well as using the nil rate band of the first to die, this will give the surviving spouse some element of financial security as the widow/er will be a potential beneficiary under the trust. They have not made previous lifetime gifts.

Following the exercise of some share options and the maturity of three endowment policies, Bob has £100,000 to invest. His requirements from an investment are:

– To ensure it is effective for IHT.

– To keep control over who benefits from the investment during his lifetime.

– To retain tax-effective access to initial capital.

After taking advice, Bob invests £100,000 into a discretionary loan trust. No immediate IHT arises because there is no gift. The bond is effected on the lives of children/grand-children. Bob would like loan repayments of £5,000 per annum.

Assuming the growth on the investment bond is at 7 per cent a year, after 10 years its value after loan repayments is £127,633, with £77,633 of this, after deducting the remaining outstanding loan, is free of inheritance tax and outside Bob’s taxable estate.

At the 10-year anniversary of the trust, a periodic charge could arise but because the value of the trust property (the bond after deduction of the loan) is less than the nil-rate band at that time after addition of the settlor’s seven-year cumulative total up to the point of creating the trust, no IHT will arise.

Let us assume that Bob dies after 15 years when the bond is worth £150,258. Assuming Bob has spent all the loan repayments made to him, £25,000 of the outstanding loan would be incorporated into his taxable estate.

However, on the basis that his estate then passed to his spouse, no IHT would then arise and, if Bob had bequeathed the right to loan repayments to his wife, the loan repayments could continue to her, without an income tax or IHT (exit charge) liability.

Let us assume that the loan is fully repaid after 20 years, yet Sally is still alive and needs some financial benefit. At that point, the trustees could then make an absolute and irrevocable appointment of capital to her all at once, or now and again. This would have three tax implications as follows:

– An IHT exit charge may arise. This would be based on the IHT charge at the last periodic anniversary and if none arose then no IHT would arise.

– There would be no income tax charge on the payment to the beneficiary because this is a capital payment.

– If the trustees funded the payment by an encashment from the single-premium bond, this would give rise to a chargeable event on the basis that all the 5 per cent withdrawal allowances had been used. Any chargeableevent gains would be assessed on the trustees, at 20 per cent to the extent that they fall within the trustees’ £1,000 standard rate band and 40 per cent on the excess. A 20 per cent credit is given for tax suffered in the fund for a UK bond.

It may be more tax-efficient for the trustees to assign segments in the bond to the individual beneficiary (no income tax charge) with the beneficiary then encashing those segments. This may be appropriate if the beneficiary is a basicrate taxpayer but much will depend on the circumstances.

In summary, therefore, a loan trust will be suitable for an investor who would normally:

– Be over 50 years of age,

– Have a net estate (either alone or with a spouse) for IHT purposes exceeding the nil-rate band (£300,000 in tax year 2007/08),

– Have capital to invest or realisable investments available for reinvestment without capital gains tax liabilities,

– Require access to their capital, for example, to periodically supplement their income; and

– Need to know that they can call upon the whole (or the remaining part) of the original capital invested at any time should they need to.

For those who require a mixture of flexible access and immediate inheritance tax saving in their inheritance tax planning a mixture of a loan trust and discounted gift trust may be appropriate. If undertaking this planning, always effect the loan trust first – but, of course, that is another story.


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