The announcement in the pre-Budget report last December of the Government's plans to introduce the so-called “pre-owned assets tax” has now borne fruit in the form of Schedule 15 Finance Act 2004. Having led the industry representations on this subject, it gives me great satisfaction that the Revenue has confirmed that the discounted gift schemes currently available are not affected by this generally inequitable and retrospective tax.
In spite of this, it is very important for you to realise that not all discounted gift trusts are engineered in the same way and that this has tax effects for your clients.
Currently, there seem to be two basic structures available in the inheritance tax discounted gift trust market. First, is what you might describe as the carve-out arrangement. Second, is the reversionary interest arrangement. What is the difference? If a provider has built a reversionary interest arrangement then using it would be tantamount to you advising your clients to play Russian roulette to improve their health.
Under a carve-out arrangement, two separate interests exist during the life of the settlor. The settlor has an interest in possession in his share of the trust fund and the default beneficiary has an interest in possession in their share of trust fund.
Under a reversionary interest arrangement, only one interest exists during the life of the settlor but the beneficiary of that interest changes with time. The default beneficiary has an interest in possession in the whole trust fund and the settlor has no interest in possession in the trust fund until a capital sum becomes payable. When the capital sum becomes payable, part of the trust fund reverts to the settlor. The settlor's then interest in possession is extinguished by the advancement of the capital sum.
What practical impact does this different engineering have on the taxation of the arrangement?
Under a carve-out arrangement, by s49 Inheritance Tax Act 1984, the value of the beneficiary's interest is the difference between the total value of trust fund and the value of settlor's interest. What is the IHT position on the death of a beneficiary having an interest in possession? Only the then value of the beneficiary's interest, which would be a sum less than the whole value of the trust fund, would be included in his estate.
Are any of the capital payments to the settlor included in the beneficiary's estate? No, the beneficiary has made no transfers of value, as the capital payments are merely paid in satisfaction of the settlor's interest in the trust.
Under a reversionary interest arrangement, however, by s49 IHTA 1984, the value of the beneficiary's interest is the total value of trust fund. By contrast, what is the IHT position on the death of a beneficiary having an interest in possession here? Once again, the then value of the beneficiary's interest would be included in his estate.
However, this time this would amount to the whole value of the trust fund. Oh dear! That was the chamber containing the bullet!
Again, are any of the capital payments to the settlor included in the beneficiary's estate? As each payment is a transfer of value by the beneficiary to the settlor, they are only excluded from the beneficiary's estate where they are exempt. Usually, the payments will qualify for the “revert to settlor” exemption contained in s53 IHTA 1984. However, this may not be so where there were joint settlors (married to each other) and they are later either divorced or only one has survived.
Here, as much as half of the last seven years of capital payments may fall into the estate of the now-deceased beneficiary. Oh no! Russian roulette with two full chambers!
Therefore, you might ask why product providers offer the reversionary interest structure which creates this game of Russian roulette. This is especially relevant when the innovative solution of carve-out trusts creates a gun with six empty chambers.
In summary, understanding the distinction between the product and the structure of the engineering used is as important as the price your client eventually pays. Make sure you recommend a provider that delivers a flexible solution, which meets all the needs that you and your clients demand.