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Settlor’s rights

Loan trusts are an excellent tool for lump sum inheritance tax planning for clients who need ongoing access to their initial investment.

One of the benefits of a loan trust arrangement is that even though the settlor/lender may not need cash payments from the commencement of the arrangement, it gives them the security of knowing that at any time they can recover any of the outstanding loan either as a single sum or in instalments.

However, any growth in the value of the assets underpinning the trust will accrue to the trustees rather than the lender.

Some lenders may, at a later date, decide they no longer need access to the outstanding loan. Faced with the fact that the loan will form part of their taxable estate on death, the lender (who is the settlor and will be referred to as the settlor in the rest of this article) may then be interested in giving up their rights to any outstanding loan.

What is the best method of achieving this objective in cases where the trust assets consist of an invest- ment bond?

Giving up the rights to the loan during the lender’s lifetime

Here, the settlor could consider one of three courses of action. The options are as follows:

i: The settlor could demand repayment of his outstanding loan and subsequently gift cash

The trustees would need to encash the bond in order to repay the loan. This, in turn, will give rise to a chargeable event and if a chargeable-event gain arises, it will probably be taxed on the settlor for income tax purposes.

The settlor can then make a gift of the cash he receives (although he may be advised to keep back sufficient cash to meet his income tax liability). A cash gift to another individual would be a potentially exempt transfer with no immediate IHT and no IHT at all if the settlor survives seven years.

The downsides to this course of action are:

l An income tax liability could arise on encashment of the bond andl If the encashment proceeds of the bond are less than the outstanding loan, then, depending on what the loan agreement says, the trustees may have to make up the deficit out of their own funds.

ii: The settlor could gift his right to the outstanding loan

Any gift by the settlor of the right to the outstanding loan would need to be made by deed to be effective for legal and IHT purposes. The donee of the gift would have the right to receive loan repayments from the trustees up to the amount of the outstanding loan.

If the gift of the outstanding loan is to another individual, this would be a potentially exempt transfer for IHT purposes so no immediate IHT would arise and if the donor survived his gift by seven years, the gift would drop out of account for IHT purposes.

This action also has the benefit of meaning that the bond would not have to be encashed, unless, of course, the donee requested encashment at a later date.

iii: The settlor could give up his outstanding loan

If the settlor waived his rights to the outstanding loan in favour of the trust, he would be treated as making a gift which would be a transfer of value. This would be a chargeable lifetime transfer if the trust was a discretionary trust and a Pet if it was a bare trust.

On the basis that the settlor was excluded from benefit under the trust, this would not give rise to a gift with reservation. The settlor would normally be excluded as a beneficiary but care needs to be taken in respect of loan trusts established before March 17, 1986.

The persons who would benefit from the waiver would be the ultimate beneficiaries under the trust.

To be effective, any waiver must be made by deed, otherwise HMRC will not accept it as being valid.

In summary, this route:

l Avoids encashment of the bond andl Means the beneficiaries under the trust benefit from the loan waiver.

Giving up the rights to loan repayments on the lender’s death

Many clients do need to keep access to the outstanding loan during their lifetime and so a waiver or gift of the outstanding loan would be inappropriate.

However, on the death of the settlor with the loan outstanding, the loan may then need to be repaid by the trustees to the personal representatives.

Further, if the bond has fallen in value, the trustees may, depending on the terms of the loan agreement, have to meet any shortfall out of their own funds.

This would be the case where, for example, the loan agreement did not in any way limit their liability to repay.

Given recent investment conditions, it is more likely that problems could arise in this area than may have been the case in the past.

This potential problem could be dealt with in one of two ways by the settlor taking action during his lifetime.

First, where loan repayments are to continue to a beneficiary under the settlor’s will (that is, because that person has a continuing need for regular cash payments), the settlor could bequeath the right to the outstanding loan (and loan repayments) to that person. The trustees would then continue to make loan repayments to that individual.

There would be a chargeable transfer as the bequest of the loan would be a transfer but if the impact of the bequest were to increase the entitlement of the settlor’s spouse under the will, the spouse exemption would apply.

Second, the settlor in their will could give up their right to the loan repayments to the trust.

This would give rise to a chargeable transfer equal to the outstanding loan but may well fall within the settlor’s nil-rate band. Because this disposition is occurring on death, it would not need to be made by way of a deed – simply a provision in the settlor’s will.


When implementing and managing loan trusts, it is important that thought is given to all of the tax issues in relation to the loan as many of the potential problems that can arise can be easily avoided by taking suitable action during the settlor’s lifetime.


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