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The generation game

Paul Wright, investment management director for Zurich, considers the changing face of inheritance tax and says advisers should view estate planning as one of their priority areas for clients

It is nearly 2000 years since Caesar Augustus sent out the decree that “All the world should be taxed”.

Given the increasing impact of taxation on just about every aspect of our day-to-day lives, I think it is safe to say that successive British Chancellors have been of the opinion that Augustus set a worthy precedent.

Benjamin Franklin is credited with saying that there are only two certainties in life – “death and taxes” – which seems quite apposite as IHT is a tax that essentially arises on death.

Many people think that death duties are a modern tax, they are not. Estate duty, the precursor of capital transfer tax, itself the precursor of inheritance tax, dates back to 1881 and is increasingly one of the most potent ways of redistributing wealth.

As with all other taxes, there is no need for clients to pay any more IHT than necessary. In fact, former Labour Chancellor Roy Jenkins described IHT as “a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.”

Within limits, everyone is entitled to organise his or her affairs in such a way that their liability is reduced. This is particularly true of IHT as it can be reduced by prudent and sensible planning. Indeed, the Government relies on our failure to make such plans, making it more than possible that a good proportion of your clients’ lifetime estates may end up in the state’s coffers rather than be passed on to their heirs.

Above all other taxes, it is true to say that the taxman is the beneficiary of our inertia when it comes to IHT.

IHT planning has, until fairly recently, been seen as a consideration for only the wealthiest families but with house prices continuing to soar, more and more people are finding themselves unwittingly breaching the threshold.

When he was Chancellor, Gordon Brown raised the IHT threshold to £300,000 for the 2007/ 08 tax year and has committed to raising it to £350,000 by 2010/11. He has also introduced some pretty radical changes to the rules governing certain trusts used in IHT planning. These changes have now been passed into law and are having a major impact on the way that intermediaries approach IHT planning.

Although some intermediaries still perceive IHT planning to be a complicated area, the changes that Mr Brown made have actually simplified the situation by reducing the number of viable options available.

Before the Budget 2006, intermediaries tended to use just three types of popular trust – bare, discretionary and interest in possession trusts.

All three still have a role to play and while there are other factors to consider – including the ability to take income and exit taxes – tax issues and the flexibility of beneficiaries are still the main concerns for intermediaries.

Bare trusts, interest in possession trusts and discretionary trusts all have different characteristics. There is no one size fits all solution and, as a result, intermediaries would be well advised to ensure they are familiar with the differences between the three in order to be able to offer the best advice and solutions to clients.

Before the recent changes, the interest in possession trust was by far the most popular of the three for IHT planning purposes due to its flexibility regarding beneficiaries and its tax treatment as a potentially exempt transfer.

However, following the changes, interest in possession trusts are now subject to the same IHT regime as discretionary trusts, being treated as relevant property and creating a chargeable lifetime transfer at the outset. This has suddenly made discretionary trusts a more preferable option.

If total gifts to a discretionary trust are below the IHT threshold and made only every seven years, they avoid IHT at the time the trust is established. This is an option but it does mean that IHT planning needs to start much earlier than most other financial planning.

However, gifts into discretionary trusts that are above the prevailing nil-rate band – taking account of any other chargeable lifetime transfers made by the settlor in the past seven years – are taxed at half the death rate, currently 20 per cent, when they are established.

The trust also pays a periodic charge every 10 years, on any assets valued above, the then nil-rate band. This tax charge is a maximum of 30 per cent of the lifetime rate, currently 6 per cent.

In addition, there is also a potential exit charge when capital is distributed to a beneficiary of the trust. This is also currently a maximum of 6 per cent.

Discretionary trusts have typically been used for generation-jumping. For example, if a third generation of potential beneficiaries inherits the trust’s assets, IHT is saved on the estate of the previous two.

The difference in taxation lies in the fact that there is no interest in possession at outset and neither is one imposed by a certain age.

In a nutshell, the trust can run for its full perpetuity period, usually 80 years, without its assets being attributable to an individual’s estate for IHT purposes.

If the customer does not want to face the possibility of these tax charges, he or she could consider bare trusts, but while bare trusts retain some of the advantages of IIP trusts, the disadvantage is that they have no flexibility to change beneficiaries – not necessarily a problem but a consideration nonetheless.

As with most areas of financial planning, there is a choice to be made. Does the client want flexibility to change their beneficiaries? Are they prepared to accept the more complex tax rules that come with discretionary trusts? If they do not need flexibility, then a bare trust may be a more viable option.

There have been various figures projected about how much house prices will increase over the next five or 10 years and how many families are likely to be affected by inheritance tax. This is difficult to predict but it is fair to assume that the number of families affected will be significant, making inheritance tax planning one of the most important financial planning areas.

Advisers who are up to speed on the issues and have mastered the intricacies of the various solutions on offer have a fantastic opportunity to add further value to existing clients. They also have a genuine opportunity to reach new ones who do not already have estate planning in place.

We are not expecting any more radical changes to IHT planning in the near future but it is fair to say that the industry was not expecting the changes in the 2006 Budget.

Despite comments from the leader of the Opposition to the contrary, I believe that this tax is here to stay and will affect an increasing number of families.


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