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Term and conditions

What is the valuation basis for the 10-yearly periodic charge on term insurance policies held in trust?

Following the Finance Act 2006, where a life policy, including critical illness-type cover, is assigned into a flexible or discretionary trust after March 22, 2006, the policy will be subject to entry, exit and 10-yearly periodic charges.

Most protection policies will not suffer an entry charge as the premiums will be exempt. This will be by use of the annual inheritance tax exemption (3,000 since 1988) or by claiming normal expenditure out of income exemption. But advisers must ensure they have correctly advised the valuation basis for the 10-yearly periodic charge.

The general rule for valuation purposes contained in s160 Inheritance Tax Act 1984 is that “the value at any time of any property shall for the purposes of this Act be the price which the property might reasonably be expected to fetch if sold in the open market at that time”. However, s167 IHTA 1984 contains specific rules for life policies. Depending on the type of plan, the value of a life policy for the purposes of the 10-yearly periodic charge is based on market value alone or the higher of premiums paid and market value.

For a whole-of-life policy, the basis of valuation is the greater of premiums paid or market value. Market value in this instance will generally be the surrender value, if any. However, where the life assured is in poor health or life expectancy is significantly reduced, market value may be much closer to the sum assured.

For term insurance, the basis of calculation at the time of the 10-yearly periodic charge is solely the market value. As a term policy does not generally have a surrender value, a market value only arises where the life assured is in poor health or their life expectancy is significantly reduced and this coincides with the occasion of a 10-yearly periodic charge.

Some term insurances provide an option to extend the specified term. In this case, the basis of valuation may sometimes be market value alone and sometimes the higher of premiums paid and market value. This is because there are two additional tests under s167(3) which can be summarised as:

– Does the specified term exceed three years or can it be extended so that the total exceeds three years?

– If the life assured were to survive for the specified term, then- Broadly, are the premiums spread throughout that term and- Are premiums in any 12 months less than or equal to twice the premiums payable in any other 12 months?

If both these tests are satisfied, then only market value is relevant for the purposes of the 10-yearly periodic charge. If either is not satisfied, then the policy value for these purposes will be the higher of premiums paid and market value.

Let us consider a 10-year rolling term policy which is assigned into trust at inception. If the trustees choose not to increase the sum assured when options to do so arise and so the premium remains unchanged, both tests will be satisfied. This would mean that the policy would be treated in the same way as a fixed-term policy for the 10-yearly periodic charge and be assessed on its market value.

However, let us consider where the trustees exercise their options to increase premiums. The second test would not be satisfied as the premiums can easily more than double over the first 10 years where the life cover has been increased and, consequently, so does the premium. This would mean that the policy would be treated in the same way as a whole-of-life policy for the 10-yearly periodic charge and be assessed on the higher of premiums paid and market value.

In summary, it is important to understand that special IHT rules apply to life insurance policies. It is clear this gives advisers with the appropriate knowledge a clear opportunity to add value to clients’ financial affairs. It is essential for advisers to be aware of this issue, to inform their clients of the potential implications and to ensure they have a clear record for compliance purposes.

Colin Jelley is head of tax and financial planning at Skandia.

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