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Tony Wickenden: IHT and the ‘protection solution’


Last week, I considered the potentially important role life assurance held in trust could play in providing funds for paying inheritance tax. For couples in good health, the “protection solution” could offer a simple and effective outcome.

To the extent giving is not possible, providing for the IHT liability could be appealing – and with no tax risk to speak of. The benefit needs only to be justified by the cost: the premiums. That said, a quick reminder of the IHT fundamentals of life policies held in trust may be timely.

Looking at new policies, premiums will be, in most cases, exempt. This will be mainly as normal expenditure out of income. Life policy premiums, by virtue of their regularity and size and the fact few people will negatively affect their standard of living to pay them, are well suited to access the normal expenditure exemption. 

So the gifted part of the transaction (the premium) is not likely to cause
a problem. Is that it, then? If the trust the policy is subject to is a bare trust, then, essentially, yes.

However, often, the trust will be a discretionary trust or another form of flexible trust. Then you must consider the periodic and exit charges. In most cases, these will
be irrelevant.

The rules on taxation of relevant property trusts are changing but, for most, the “irrelevant” conclusion is unlikely to change. So the charges are substantially based on the value of the trust property. With life policies that have not paid out, this will usually be nil. 

There is also a rule stating that, for the first 10 years of a trust’s life, the rate of tax on any “exits” (that is, payments out of the sum assured by the trustees following the death of the life assured) will be broadly based on the value of the trust property at commencement – always nil or very low value.

As such, regardless of the sum assured, any payments out of the trust to beneficiaries made in the first 10 years of the policy’s life will be free of IHT.

This is because of a combination of the low value attributed to the trust property for the purpose of the calculation and the trust having its own nil-rate band, only diminished by the cumulative total of chargeable transfers made by the settlor in the seven years preceding the establishment of the trust.

What about the periodic (10-yearly) charges? Here, the actual value of the trust assets is important. But how do you value an in-force life protection policy, which would usually be a term assurance?

The basis of valuation is the open-market value, which would usually be the surrender value. However, if the life assured was in ill health, the value of the policy for IHT purposes might be more. 

For non-term protection policies, however, it may be necessary to take into account the premiums paid in the valuation for the purposes of the periodic charge.

For protection policies with low or no surrender value, therefore, unless a) the settlor is in serious ill health at the time of a periodic charge, or b) the sum assured has been paid, exceeds the then nil-rate band available to the trust and is held in trust at the 10-year anniversary, or c) the premiums paid under non-term protection policies (whole-of-life policies, for example) are significant so the value for IHT at the time of the periodic charge (based on an amount not less than the total premiums paid under the policy) is greater than the then nil-rate band available to the trust, there should be no periodic or exit charges under the current discretionary trust (relevant property) regime. 

The reference to “no exit charges” is that those after the first 10 years are based on the previous periodic charge, if any. If there was no periodic charge, there would be no exit charge for the next 10 years.

Where there is the perceived risk of a charge to IHT that would be unacceptable (remember, the amount charged, broadly speaking, is 6 per cent of as much of the value of the trust property being assessed that exceeds the nil-rate band available to the trust), settlors could consider the use of a bare trust where they are happy they will not wish to change beneficiaries or their shares.

Until recently, if a bare trust was not deemed appropriate and there was a perceived risk of an unacceptable periodic (and thus potential exit) charge, settlors would have been encouraged to secure cover through a series of sub-nil-rate band smaller policies, each subject to a separate trust created on different days. Under current law (following the Rysaffe decision), in most cases, each would effectively be entitled to its own nil-rate band and should not give rise to any periodic charges in the future.

However, it is likely new rules will be introduced to prevent such fragmentation strategies being affected and, although not finalised, will apply to trusts established after 6 June.

Tony Wickenden is joint managing director at Technical Connection

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There is one comment at the moment, we would love to hear your opinion too.

  1. I’ve always struggled with understanding valuing policies where the life insured is in poor health. In practical terms, presumably HMRC would investigate if they die shortly after a valuation? But if not? Should the trustees require the life insured to be medically examined every ten years and then get a report from a suitably qualified person as to their life expectancy and the policy’s market value? Surely not! But, if not, should trustees simply say ‘Yeah, I’m sure the policy has no market value’.

    What action should the trustees take in practice? Anyone any experience here? Is there any HMRC guidance?

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