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Loan star

The introduction from October 9, 2007 of the transferable nil-rate band for married couples and civil partners, coupled with remarks made by the Conservatives about increasing the nil-rate band or abolishing inheritance tax, have caused some clients to think again about the need for IHT planning.

This thinking is basically flawed as the transferable nil-rate band has not given individuals any more than they could have achieved previously by utilising a discretionary will trust on the first death. Also, despite opinion polls, it is by no means certain that the Tories will win the next election or carry out these proposed IHT reforms if they do.

IHT planning using tried and tested methods such as discounted gift schemes should continue to be very important for older, wealthy clients. However, there are a significant number of younger clients, typically entrepreneurs who have sold their businesses and have large amounts of cash in their bank accounts, who recognise that they need to put in place an IHT mitigation strategy but are not comfortable with losing all access to capital. The answer for them could well be that old IHT planning stalwart, the loan trust.

Under these schemes, the investor establishes a trust, appointing himself and other persons as trustees. The investor then makes an interest-free, repayable-on-demand loan to the trustees and they use the loan to purchase a single-premium bond. The trustees then take withdrawals from the bond which they pass back to the investor as part-repayments of the loan. From an IHT viewpoint, the granting of an interest-free loan, which is repayable on demand, does not give rise to any transfer of value for IHT purposes and thus there will be no initial transfer of value. Therefore, if a discretionary trust is used, there will only be the 10-yearly periodic and exit charges to consider.

At the 10-year anniversary, the value of the trust property will be the value of the bond less the outstanding loan. Unless the amount involved is substantial, no 10-yearly charge should arise.

Even for bigger amounts, the problem can be overcome by using a series of trusts created on different days as each trust has the benefit of its own nil-rate band.

On the death of the settlor, any outstanding loan will form part of his estate but one very important feature of this type of planning is that all the growth under the plan will be outside the settlor’s estate for IHT purposes. For example, assume a client effects a bond for £100,000. No withdrawals are taken and a gross 6 per cent growth rate is achieved. After 10 years, the bond would be worth £160,000.

If death were to occur at that time, the IHT liability on the bond would be £64,000. However, if the bond had been written subject to a loan trust, then only the amount of the outstanding loan – £100,000 – would be added back into the estate on which the IHT liability would be £40,000 – a £24,000 saving.

If 5 per cent withdrawals were taken, the value of the bond after 10 years would be £96,900 and the IHT liability, assuming the bond withdrawals were spent, would be £38,760.

If the same strategy were pursued under a loan trust and 5 per cent withdrawals were taken each year as part-repayments of the loan, then on death after 10 years the outstanding loan would be £50,000 on which IHT of £20,000 would be due – a saving of £18,760.

Of course, as the client gets older and circumstances change, he may well feel that he can afford to make gifts.

If this is the case, he can execute a deed to waive part or all of his entitlement to the loan repayments. This course of action would be a chargeable transfer, assuming a discretionary trust is used, and the client would need to survive seven years before the gift falls out of account for IHT purposes.

Loan trusts have been around for a long time but as can be seen, they still have an important role where clients wish to take income from their investments but retain access to capital. They are also useful simply where clients wish to take some action to mitigate IHT but are not certain of their future income and capital requirements.

Brian Murphy is senior financial planning manager at Axa Sun Life

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