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Strike up the nil-rate band

To what extent are last year’s Budget changes likely to impact on the use of trusts in estate planning?

Over the course of my career I have built up pension entitlements in several different funds. I am now approaching retirement and have been warned I may be affected by the lifetime limit. Is this something I should be aware of?

How strange life can be. The new pension regime means that best advice for a client could be to cease being a member of a respectable final-salary scheme and in some cases means that a pension fund is not worth what you think it is worth.

I was dealing with applying for primary and enhanced protection on behalf of a client and I thought the case study was a perfect one for some knotty financial exam. This is because of the various types of pension which this client has and the different multiples and ways of working out their contribution to the lifetime allowance.

Frank is a deferred member of an unfunded final-salary scheme. He still works for the firm but, because of the other pensions he has, he has ceased being a member of the occupational pension scheme as otherwise we could not apply for enhanced protection.

I have to say it is bizarre and very alien to advise someone to come out of an occupational scheme but such is the regime we have.

In addition to Frank’s membership of the final-salary scheme, he has two plans that are in unsecured income. One had income paid before A-Day and the second, because it contained protected rights, was due to have income paid after A-Day.

I needed to wind back the clock and look at the situation on April 5, 2006.

The first pension – the final-salary part – was due to pay Frank a tax-free cash sum of 6,000 with an income of 2,000 a year. Working out the contribution towards the lifetime limit meant that we took 20 times the 2,000 annual income, as it was not yet in payment, and added on the tax-free cash sum of 6,000. This made the total contribution of this part of Frank’s pension provision to be 46,000 towards the lifetime limit. So far, so good, as clearly this was a smaller amount.

Frank’s second pension was the protected-rights portion of a contracted-out money-purchase plan that had not been triggered as at April 5. This value was taken as the value as of April 5, 2006 and was 800,000. Since then, Frank has taken his tax-free cash sum, which he has banked, and the remaining funds are in unsecured income.

The third portion of his pension scenario was the non-protected-rights part of the Comp, which for Frank was unsecured income in payment prior to April 5, 2006.

This third part of the pension had an investment value of 700,000 as of April 5, 2006. Although Frank was not drawing the maximum income possible, the maximum income was what we needed to use in order to work out the contribution towards the lifetime limit of this particular pension.

The maximum Government Actuary’s Department rate for him was 5.7 per cent, which made the maximum income he could draw of broadly 40,000 a year. This needed to be multiplied by 25, as it was already in payment, making a contribution towards the lifetime allowance of 1m. Ouch.

I must say Frank was mightily amused that suddenly his real value fund of 700,000 turned into 1m in terms of the lifetime limit but I had to explain that these were the vagaries of the calculations.

Therefore, Frank’s total contribution to the lifetime limit was 46,000 from the final-salary scheme, 800,000 of the value of a pension not yet in payment, and 1m from his unsecured income in payment. This made a total of 1.846m and gave us the relevant figure for the lifetime limit.

In this particular case, the tax-free cash was not more than a quarter of the lifetime limit, as tax-free cash had already been taken from the unsecured income, and the other tax-free sums did not amount to more than 375,000.

In another case, a client of mine has a final-salary scheme paying 76,000 income a year. He also has a residual AVC worth no more than 20,000. Because of this residual AVC, which is not yet in payment, we have applied for protection for him as otherwise there could be a sticky situation with tax on this pension.

It should be noted that one has to be very careful that minor amounts in tiny little pensions can mean that protection is needed, which might not always be evident.

Amanda Davidson is a director of Baigrie DaviesSo, the Daily Express has done its job. Now it’s up to you. I have been around long enough to know that the combination of acute public awareness, a wide community of those affected by an issue and a high degree of anxiety over an issue makes for a potentially worthwhile area to concentrate some effort on. Provided effort is directed at the right segment of one’s client base, the return should be worthwhile.

An asset class-based approach to segmentation may be worth considering in relation to estate planning. In my experience, it helps you to keep estate planning real and not just theoretical.

Residential property, private businesses and investments are three such broad categories.

Targeting all clients with properties worth more than 285,000 should produce a pretty big segment. For couples, however, 285,000 may be too low given that everyone has a nil-rate band that can be used to pass assets to the next generation free of inheritance tax.

In determining how much of the nil-rate band is available on death, it is necessary to take into account chargeable transfers made within seven years of death. Given the wider reach of the definition of chargeable transfers since the 2006 Budget and Finance Act, one might wonder if this factor has become more important. However, given that potentially-exempt transfers made within seven years of death become chargeable anyway, perhaps this factor will not have too much of an effect when considering the availability of the nil-rate band for transfers on death.

I believe the greatest impact of the 2006 provisions widening the definition of chargeable transfers is likely to be on transfers above the nil-rate band or transfers of property where the value is likely to exceed whatever the nil-rate band will be in the future, particularly at 10-year trust anniversaries.

Obviously, at the point of transfer, if the loss to the transferor’s estate exceeds the available nil-rate band. then a liability to IHT will arise at 20 per cent on the excess if the trust to which the transfer is made is other than a bare trust. In addition, if the value of the property subject to the non-bare trust exceeds the nil-rate band at 10-year anniversaries, a periodic charge will arise, very broadly, at 6 per cent of the excess of the value of the settled property over the available nil-rate band at the time. There is also the possibility of an exit charge.

Especially where the available nil-rate band will be exceeded by the initial transfer, the transferor will need to consider carefully the value that he or she attributes to the retention of control (usually as a trustee) and flexibility over beneficiary choice that the non-bare trust gives. A clear cost/benefit analysis needs to be made to determine whether to transfer in excess of the nil-rate band to a non-bare trust.

In the Treasury’s quest to maintain the tax base and, thus, the increasing revenues from IHT, it may well have taken a view, in widening the classification of chargeable lifetime transfers, that the imposition of the discretionary trust regime on all but bare trusts would act as a kind of cap on lifetime giving. It could be that it was thought that donors of more substantial gifts would be uncomfortable with making outright gifts and, if the control and flexibility that a settlement gives came at a price, then this would cause some to desist from making the transfer. It may even be that, if transferors are properly advised, this constraint on giving may also be at play in connection with transfers of less than the nil-rate band, for example, in connection with assets on which there is expected to be high growth.

Even if the nil-rate band was not exceeded when the transfer was made, if there were a risk of the future nil-rate band being exceeded at the 10-year anniversary, then this might cause the transferor to build in some headroom and keep the initial transfer below the nil-rate band.

Many will have read about the growth on certain asset classes – property especially – significantly exceeding the growth in the nil-rate band. Where transferors feel confident that they would make up their mind regarding who benefits within 10 years of the gift, it may be that they would be comfortable making a gift below the nil-rate band into a settlement (avoiding an initial charge) on the basis that, in most cases, an exit within the first 10 years could be made without tax charge, regardless of the value of the settled property exiting the trust.

Whatever the impact of the new provisions on the overall landscape of IHT planning, I do not believe that they will encourage a greater level of nil-rate band gifts. Indeed, they may well cause some, with a view to minimising the risk of a periodic charge, to make gifts below the nil-rate band and some may be put off making gifts altogether.

The fact is, the new rules do not make lifetime giving any easier. Do not forget the still existing gift-with-reservation and pre-owned assets tax legislation which is still very much on the statute books.

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