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Pet detective

Now that the dust is settling on the Chancellor’s smash and grab raid on trusts, you need to start thinking about your clients’ inheritance tax planning in a number of new ways.

The Finance Act 2006 has extended the relevant property regime which, in principle, now treats interest in possession and accumulation and maintenance trusts in the same way as discretionary trusts for IHT purposes.

Putting the new legislation (Schedule 20 Finance Act 2006) into practice brings into play an area that you may not have considered before. Crucially, the order in which you solve your clients’ IHT problems may dictate the future taxes applicable to the trusts created.

Consider a client who wants to create a trust of 285,000 for his grandchild. He is concerned about giving them absolute access to these funds so a discretionary trust provides the required flexibility and caters for any new family members.

The trust falls within the available nil-rate band of 285,000 for 2006/2007 and is a chargeable lifetime transfer, with an entry charge of 0.

Additionally, he wants to make an outright gift of 285,000 to his adult children. This is a potentially exempt transfer so entry, 10-year periodic and exit charges are not applicable. The result is that he can give away 570,000 without any immediate liability to tax.

At this point, all the objectives seem to have been addressed but suppose the client dies 18 months later. The key question now is in what order were the gifts made? This will determine how tax is calculated in the trust in future years. Let us consider two examples focusing on the impact of events on the 10-year periodic charge. Let us also assume the residual estate has been passed to his spouse under the spouse exemption and his annual exemptions have been used elsewhere.

Scenario 1: The Pet was created before the CLTIn this scenario, the Pet would be allocated to the available NRB (312,000 for tax year 2008/09) because it was created first. This would leave 27,000 of unused NRB which can be used against the CLT.

The CLT would be taxed as 258,000 (285,000 minus 27,000) x 40 per cent, minus any tax paid on entry (nil). This leaves 103,200 to pay.

There would be no taper relief available as the client did not survive for three years from making the gifts. The 103,200 tax can be paid by the trustees, leaving a trust fund of 181,800. Assuming there are no exits in the first 10 years and that the value of the discretionary trust has by then grown to 400,000, the calculation at the first 10-year periodic charge point will be:

Chargeable transfers within seven years prior to creation of the trust + 285,000 (the failed Pet)+ 400,000 (current discretionary trust value)

Less (assumed) NRB for tax year 2016/17 -375,000 = 310,000x 20% lifetime rate = 62,000Effective tax rate(62,000 / 400,000) x 30% = 4.65%

Tax due (4.65% x 400,000) = 18,608Therefore the tax due is 4.65 per cent of 400,000 which amounts to a total of 18,608.

Scenario 2: The CLT was created before the PetThe CLT would be allocated to the available NRB, which would leave the balance of the NRB to be set against the failed Pet. The tax on the failed Pet would now be 103,200. The 10-year periodic charge on the trust would be as follows:

Chargeable transfers within seven years prior to creation of the trust+ 0 (because the failed Pet was after the CLT)+ 400,000 (current discretionary trust value)

Less (assumed) NRB for tax year 2016/17 -375,000= 25,000x 20% lifetime rate= 5,000Effective tax rate(5,000/400,000)

x 30% = 0.375%

Tax due (0.375% x 400,000) = 1,500The tax due is 0.375 per cent of 400,000 which is 1,500. Therefore, the overall result in this second scenario is that the tax due is significantly smaller. These examples demonstrate that multiple planning strategies can be used to enable your clients to achieve their goals. By using these in the right order, you will demonstrate the true value of advice.

Colin Jelley is head of tax and financial planning at Skandia


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