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Varying your estate

Where property is inherited, either under a will or under the intestacy laws, it is possible to redirect the legacy (or part thereof) to achieve inheritance tax savings by using a deed of variation, says Brian Murphy.

A typical case of where such a deed may be appropriate is where a married couple have failed to utilise any part of the IHT nil-rate band on the first death (for example by leaving all assets to the surviving spouse). In practice, a deed of variation is drafted to replace the relevant clauses in a will (or a legacy received under the intestacy provisions) with new clauses containing the new provisions.

Provided the deed of variation satisfies the necessary conditions (see below), the provisions of the deed of variation will be treated for IHT purposes as having been made by the deceased. A simple example demonstrates this:Mr Smith died in May 2004, leaving his entire estate to his wife. Mrs Smith effected a deed of variation in September 2004, varying 263,000 of the assets she received to her children. Although Mrs Smith made the gift, as it has been made by a deed of variation, it will be treated as having been made by the late Mr Smith. This has the effect in that it utilises the late Mr Smith’s nil -ate band and avoids increasing the value of Mrs.Smith’s taxable estate.

The requirements for a valid instrument of variation are broadly that:The variation must be executed within two years of the person’s death.It must be in writing (usually a deed).All beneficiaries affected by the variation must agree to and be a party to it.The document must contain a statement that s.142 of the Inheritance Tax Act 1984 is intended to apply.It must not be made for any consideration in money or money’s worth.The beneficiary (or beneficiaries) making the variation must be legally capable (that is, aged 18 or over and of sound mind).

When the property is redirected, the value for IHT purposes remains the value at the date of death.

Varying an inheritance direct to individuals may not be desirable, especially if the original beneficiary requires access to the funds.

Take our earlier example. If Mrs Smith cannot afford to vary the 263,000 legacy direct to her children (for example, as she may require income and/or capital to supplement her income), she could consider varying the legacy subject to a discretionary trust.

Mrs Smith, although not absolutely entitled to any income arising, could be regarded by the trustees of the discretionary trust as the prime beneficiary of such income. In addition, the trust could be drafted to enable advancements of capital to be made if necessary.

Although the varying of the legacy to the discretionary trust would be treated as made by the late Mr Smith for IHT purposes, Mrs Smith (having given up her absolute entitlement) would be treated as the settlor of the trust for income tax and CGT purposes.

Any income arising under the trust would therefore be assessed on Mrs Smith. Similarly any capital gains arising under the trust would be assessed on Mrs Smith. Mrs Smith has statutory rights to recover any tax she has to pay from the trustees.

The solution to this tax trap may be for the trustees to invest into an investment bond, where the 5 per cent a year cumulative tax-deferred withdrawal facility is available to them. A charge to income tax may still arise on the happening of a chargeable event and this would be assessable on the settlor of the trust (that is,the original beneficiary who gave up his/her interest).

However, there may be scope for mitigation of this tax, with the availability to assign the bond (or policies thereof) out of trust to appropriate adult beneficiaries.

The use of a deed of variation for IHT mitigation purposes remains a very important tool in the financial adviser’s armoury. A further factor to bear in mind is that deeds of variation are excluded from the pre-owned assets tax charge being introduced from April 6.

However, a word of caution is necessary. The first step when advising clients should always be to ensure there is an up-to-date will in place which adequately reflects the client’s wishes. Pity the adviser who relies on unscrambling a client’s estate via a deed of variation only to find that planning of this nature falls foul of a change in legislation.

Brian Murphy is senior financial planning manager at Axa Sun Life.

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