What is the difference between using onshore and offshore plans to mitigate inheritance tax?Morley: When mitigating IHT, it is important to differentiate between the trust and the investment. The trust is the element of the arrangement which gives rise to the inheritance tax benefit.The main differences lie in the taxation of the onshore and offshore bonds. An onshore bond will pay tax of 20 per cent on realised capital gains and between 10 per cent and 20 per cent on income. This can be contrasted with an offshore bond, where no liability to taxation exists, except for income tax withheld by certain jurisdictions on dividend/distribution income. Perkins: The difference lies mainly in the type of product used, taxation and the costs involved. Onshore products typically use UK investment bonds, where the policy owner gets a 20 per cent tax credit on investment gains. Only higherrate tax potentially applies when a chargeable event occ-urs. Offshore plans are typically life insurance products or capital redemption bonds. Both offer virtual tax-free investment growth. However, investment gains are wholly potentially liable to both lower-rate and higher-rate tax. Tax is only one consideration and all circumstances relating to the donor, trustees and potential beneficiaries need to be considered. Despite the fact that they arguably offer greater potential for growth, because of their tax status, offshore products are typically dearer than onshore products but this could be outweighed by other considerations. Kennedy: We need to be careful about how we use terminology – the terms offshore trust, offshore structure and offshore plan are often presented in a tangled manner.It is important to make a basic distinction – the use of a “true” offshore trust or structure versus the use of an offshore investment to support an onshore trust. The former means that the trust is based (resident) offshore, that the trustees are non-UK-resident. For UK domiciliaries, offshore trusts do not, in general, avoid IHT in any differing way to onshore trusts. Apart from one or two admin differences, the residence of the trust is not material for IHT purposes although it may be highly relevant for the taxation of income or capital gains. Even for non-UK domiciliaries, where the use of an excluded property trust is often paramount, it is not the residence of the trust that counts but the type of property within the trust. The salient difference is generally the underlying offshore or onshore investment (and all that that entails), not the residence of the structure. Accordingly, the main differences will arise around investment return and taxation of that return. What are the advantages of UK investors using offshore IHT plans? For which types of clients is it appropriate to use offshore structures?Morley: Investors with 100,000plus will use an offshore arr-angement. The reasons for this are the sophistication of the client, the tax benefits of gross roll-up of the investment funds, the wide investment choice, the ability to have a fund adviser appointed and a comprehensive policyholder protection regime. Additionally, discounted trust plans are usually arranged via Isle of Man life companies as there is no requirement for insurable interest. This means that the policy can be written on lives other than the settlor’s, thereby avoiding any gift with reservation problems. This is advantageous for all clients, irrespective of the size of the investment. Perkins: UK investors benefit from being able to defer virtually all tax on investment income and gains arising within the fund, which should offer greater potential for medium-term to long-term growth. Offshore plans, specifically capital redemption bonds, are particularly attractive for those investors who want total control over when the investment gains are realised. The fact that there are no lives assured means that gains can arise in the hands of the most appropriate person at the “right time”. It also means that encashment does not automatically occur at an inappropriate time, for example, when investment markets are depressed. Kennedy: With insurance company-based plans, the potential advantages for UK domiciliaries arise from the underlying offshore investment. Offshore bonds operate within a gross roll-up environment and will, therefore, other things being equal, produce a higher comparative rate of annual growth. The first observation is that if the plan is saving IHT on the investment growth, then if the annual growth is higher, so too must be the IHT saving. However, this is too simplistic and it is a complex situation. Ultimately, the investor will be concerned with maximising total return, of which tax saving is a factor. An offshore bond will produce a gross pot of money over time but we must then consider subsequent taxation. When comparing offshore versus onshore bonds, certain factors skew the algorithm in favour of offshore. The first is time. Generally, the longer the term of investment, the more favour-able offshore will become and most IHT planning tends to be long term. Second comes inc-ome tax rates on cashing in. Trusts present additional facets beyond straightforward investment – the taxable person can be the settlor or the trustees or the beneficiaries. With careful tax planning, you can create opportunities with an offshore bond that you cannot with an onshore bond. Look beyond the settlor, who else may benefit from the trust and what is their tax position? Offshore plans will provide more options and should be considered for all clients, their specific circumstances will then dictate the appropriate solution. For non-UK-domiciled clients, assets should be kept out of the IHT net, which means that offshore investments should always be considered. The use of a trust will further assist the planning for those that may remain within the UK. Explain the differences between the various types of offshore IHT plans on the market?Morley: Most inheritance tax arrangements offered by life insurance companies offer more or less the same options, with the only differences being in the detail. The most sophisticated arrangements are discounted trust schemes. These are available in two basic formats, the regular payment discounted trust scheme and the capital plus growth maturing discounted trust scheme. These two discounted trust arrangements are usually used in conjunction with each other when constructing inheritance tax mitigation strategy. Perkins: The introduction of the pre-owned asset tax within schedule 15 of the Fin-ance Act 2004 called into question the effectiveness of a number of “packaged” plans. It has resulted in most providers focusing on the marketing of discounted gift schemes, where the tax status for IHT and income tax has now been more clearly established. Discounted gift schemes typically use a flexible trust which is worded so that the funds settled into the trust constitute a Pet. The trust “carves out” two interests, the right to receive regular withdrawals for the settlor and when that right cea-ses, usually on death, any residual sum passes to the trustees who hold it for the beneficiaries. The settlor’s right can be actuarially valued and discounted from the value of the Pet, hence the term discoun-ted gift”. The value of the Pet for IHT purposes is then the value of the gift less the actuarial value of the settlor’s right to withdrawals. Kennedy: There are some unusual, arguably aggressive and controversial schemes being promoted, for example, excluded property trusts for the UK-domiciled. If you are considering such plans exercise a healthy degree of caveat emptor. Within the mainstream offshore insurance market, despite the use of myriad names, there are in reality less than half a dozen generic types. All are variations around a central tenet of IHT planning which is tax mitigation versus settlor access. There is an excluded property trust for the non-domiciled (very IHT-efficient, with full access) trusts to deal with nil-rate band planning for married couples (tax-efficient with access). For lifetime planning for the UK-domiciled, there are gift-based solutions (tax-efficient but no access), loan-based solutions (not as tax efficient as others but access to the original capital) and income-based solutions (tax-efficient and access to an income only). The latter is the omnipresent discounted gift trust, which aptly demonstrates that while all plans may be founded on the same gen-eric principles, individual features can vary considerably from provider to provider. These individual features can be very important to cli-ents so ensure that you understand where and how DGTs differ. Consider what is relevant to your client and be careful not scope minor issues out of proportion. In which cases is an offshore insurance product appropriate to mitigate IHT and when should a trust alone be used?Morley: An insurance product would be used where the trust alone cannot meet all the client’s needs. For example, using an insurance policy because it is a non-income-producing asset. This means that trusts can be used giving life interests to beneficiaries (who then become the tax point for IHT) without having to give them any income to enjoy. This is very useful for generation-skipping planning. Another example would be where the product is designed to work through the interaction bet-ween the life insurance policy and the trust, as is the case with discounted trust plans. Perkins: As is often the case with a question of this sort, the answer is “it depends on the circumstances”. For the majority of investors, packaged products from recognised providers usually provide a cost-effective means of taking advantage of planning opportunities. Prov-iders have significant experience in the marketing of such plans and advisers are familiar with their use. Bespoke trust arrangements offer a more tailored approach but care has now to be taken that, where appropriate, it is notified to the Inland Revenue under the disclosure of tax avoidance schemes provisions introduced in part seven of the Finance Act 2004. In all cases, investors should seek advice from suitably qualified advisers, which will more often than not require a degree of co-operation between legal advisers and investment advisers, each applying his/her expertise in the advice process. Kennedy: Most offshore insurance schemes are a combination of trust and bond. In theory, trusts can be created to produce the same IHT effect without the offshore bond but that does not mean that you can use a trust alone. The trust will need underlying investment assets so the question is better posed as why is an offshore bond an appropriate underlying investment? For several reasons. At a technical level, we often need to create a Pet and that really requires an interest in possession trust. If you have income-producing assets (which an offshore bond is not), someone has the right to that income which starts to make things complex. Furthermore, there will be the spectre of annual tax ret-urns and accounts. Offshore bonds allow the accumulation of gross return, other investments may not. Switching assets classes and funds creates no issues within offshore bonds. This may not be the case with other investments. Often with these schemes, an annual amount is reverting to the settlor. The 5 per cent facility can be particularly useful here. It would be wholly wrong to think that you could always do this in the same way by, say, investing in cash and reverting the interest to the settlor. Worse still could be using the trust with property. Some of the IHT planning simply would not work. Offshore bonds are often a convenient and efficient investment for use in connection with these types of trust. Other types of investment can create many additional concerns and issues and some just will not work. Which offshore IHT plans are affected by the introduction of the pre-owned assets regime? Which plans are still okay to use?Morley: The primary target for the Revenue appeared to be spouse alienation trusts although business insurance trusts, where the settlor is included as the beneficiary, are also affected. This, however, is the subject of ongoing discussions between the ABI and the Revenue. Therefore, very few of the arrangements being marketed by the offshore insurance companies are affected. Nil-rate band trusts, gift trusts, gift and loan trusts, most regular payment discounted gift trusts and any trust used for post-death planning continue to be both inheritance tax effective and pre-owned assets friendly. Perkins: In introducing the Poat rules, it was clearly the intention to make specific previously marketed plans ineffective. It is probably easier to list those that are generally unaffected life policies subject to flexible power of appointment trusts, where the settlor’s spouse is a potential beneficiary. Revert-to-settlor plans, where a trust carves out two distinct interests for the settlor and the beneficiaries res-pectively, discounted gift trusts, as outlined above, and gift and loan schemes or loan trusts, where the creator of the trust makes a loan to the trustees, which is repayable interest-free on demand. Of these, only the discounted gift plans offer a significant potential for an immediate tax saving. Generally, the other arrangements that are listed provide longer-term advantages. Kennedy: In theory, any settlement incorporating intangibles (bonds, cash, etc), where the settlor retains an interest, will be affected by this new tax. This is a complex piece of legislation that has taken all concerned some time to come to terms with. In summary, gift trusts, loan trusts, DGTs, excluded property trusts and nil-rate band trusts all appear unaffected. Probably the best known of the trusts that will be affected is the so-called Eversden or spousal alienation-type arrangement. These were marketed under a guise of differing names by several offshore insurance companies and cli-ents will soon need to consider their options, of which paying the new tax will be just one. Individual circumstances, size of trust fund and client preference are likely to dictate the best way forward. Fortunately, there should be more options with this type of trust than with some of the onshore property-based schemes that appear similarly affected. David Morley, head of tax and estate planning, Canada LifePaul Kennedy, taxation and trusts manager, PrudentialBob Perkins, technical manager, Origen
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