Policyholders can also take payments from offshore bonds worth up to 5 per cent of the original premium each year. The income tax on these payments is deferred until the 100 per cent allocation has been taken. Any excess payments above 5 per cent a year are subject to income tax on gains within the bond.
It is also possible to receive payments of up to 5 per cent a year and defer the tax from insurance plans which are packaged with trusts to mitigate inheritance tax. This enables settlors to give away money and get regular payments.
For example, clients can set up a loan trust. Under this trust, a settlor’s assets are lent to the trustees and are used to buy and be held within an insurance bond. These assets do not leave the settlor’s estate for IHT purposes.
There are two attractions of a loan trust for settlors. They retain access to the money they lend to the trustees. Gerry Brown, tax and trust manager at Prudential International, says loan trusts, therefore, are suitable for cautious individuals who are not sure if they can afford to give away their capital and may need income of up to 5 per cent a year of the original premium in the future.
Another attraction is the fact that any capital growth within the loan trust is outside the settlor’s estate and is free of IHT on the settlor’s death. If the value of the capital growth exceeds the nil rate band (£312,000 in the 2008/09 tax year), however, it will be subject to the 10-year 6 per cent charge.
The attraction of discounted gift trusts is that they enable settlors to gift capital to the trust and get regular withdrawals of up to 5 per cent a year of the original premium.
A value is “discounted” from the capital gifted to the trust and is calculated through the age, health and sex of the settlor and the level of payments chosen. This discount is immediately free from IHT. The difference between the value of the capital transferred to the trust and the value of the discount is free of IHT if the settlor lives for ano-ther seven years. Capital growth within the trust is also free of IHT.
There are potential pitfalls when taking up to 5 per cent payments from offshore bonds and IHT plans, however. If there is no growth or income on the original premium, the capital will only last 20 years if the policyholder or settlor gets 5 per cent payments each year.
The assets within a bond or IHT plan may deliver capital growth or provide income that can be reinvested. This has to at least match or exceed the level of payments taken by the policyholder or settlor to maintain and grow the original capital.
The 5 per cent payments are calculated from the original premium. Thus, if the capital within the offshore bond or IHT plan halves in value, for example, the effective annual payment becomes 10 per cent a year.
It is also important to consider the impact of annual payments on the real growth in the value of the assets. As an example, Tim Brown, director of Jewson Associates, says a policyholder may achieve growth of 7 per cent on the capital in an offshore bond. If there is a rate of inflation of 4 per cent and he or she receives an annual payment of 5 per cent, there is a real rate of return of -2 per cent. If this continues, the value of the capital will decline in real terms.
Concern about the impact of annual payments on the capital within bonds and IHT plans has been heightened by the current stockmarket environment. At the start of the year, many stockmarkets lost more than 10 per cent of their value. If policyholders and settlors took withdrawals of 5 per cent, their capital may have declined by 15 per cent.
Obviously, it may be particularly important for clients to preserve the original capital where they are seeking to provide an inheritance for beneficiaries by setting up an IHT plan. With an offshore insurance bond, policyholders have flexibility over the annual payments.
Steve Whalley, marketing director of Aegon Scottish Equitable International, says if policyholders of an offshore bond are struggling to generate growth or dividend income of at least 5 per cent, they can consider reducing the payment to 3 per cent or 4 per cent, for example.
Jerry Brown says policyholders can also elect not to take a payment in any year. The allocation carries over so the following year they can take up to 10 per cent. There is no time limit on receiving the 100 per cent payments. “Clients should only take the payment if they need an income,” he says.
Income tax on the gain in the bond is only charged if more than the annual allocation is taken and once the 100 per cent allocation has been received. Alternatively, settlors can change the underlying investments to seek to increase their returns or income to at least match the payment from the offshore bond. Settlors also have flexibility with loan trusts. They can reduce the level of their annual payment or choose not to take any payment from the trust.
This flexibility is not available to settlors of DGTs, however. Richard Leeson, head of business development at Prudential International, says the amount of payments, which are received monthly, quarterly or annually, have to be chosen before the DGT is set up. Leeson says: “As the level of payments cannot be altered after the DGT is established, it is advisable to have ano-ther source of income such as from a loan trust, investments outside the trust or cash on deposit.”
He says most settlors opt for 5 per cent payments. “Some settlors are attracted by the fact that the higher the level of payments, then the greater the discount may be. This is because the value of the discount is immediately outside the settlor’s estate for IHT purposes. The rest of the capital in a DGT is outside the settlor’s estate after seven years.
“But if the settlor thinks he or she will die within seven years of setting up a DGT, they might want to consider adopting another strategy. For example, they can use an enterprise investment scheme. This qualifies for business property relief, which means it is free from IHT if held for at least two years.”
Given the lack of flexibility, it is important to think about the investment strategy of a DGT if clients do not want the annual payments to eat into the underlying capital. Leeson says many advisers and investors choose managed and distribution funds.
Traditionally, distribution funds have invested in bonds, equities and property. Robert Burdett, co-head of multi-management at Thames River Capital, says the Thames River distribution fund is currently yielding 5.5 per cent through diversifying across different asset classes, sources of yield and fund managers. This includes increasing exposure to overseas equ-ity income funds. He says: “There are overseas funds delivering a higher yield than UK equity income funds with double the level of dividend growth.”
At the moment, a lot of UK equity income funds are providing a yield of less than 5 per cent.
Burdett holds the Schroder income maximiser and Schroder global dividend maximiser funds, which invest in stocks with the potential to produce high dividend yields and use derivatives to exchange some of the growth for income. He says Barclays Capital’s Celsius European value income fund takes a similar approach and provides capital protection through derivatives.
Thames River distribution has recently increased its bond exposure from 30 per cent to 49 per cent, primarily through corporate bonds. Its holdings include Old Mutual corporate bond, Invesco Sterling bond and M&G optimal income.
Burdett says: “We have also enhanced the yield on the cash holding within the fund by 0.75 per cent through investing in cash funds. The rates on cash paid by trustees are based on the base rate whereas cash funds’ rates are based on Libor. Under the credit crunch, Libor has been significantly higher than base rates because of banks’ reluctance to lend to each other. These cash funds are AAA rated.”