August 2007

Inheritance tax

Restoring relations

The recent ruling by the Special Commissioners on the Phizackerley case continues to be a source of debate. This case, and its implications for inheritance tax (IHT) planning, raises important issues for financial advisers to be aware of. This was not a test of new legislation - section 103 FA 1986 is over 20 years old - but a new application of existing legislation. A crucial point to consider is that although this particular case involved the use of a share in the family home within a will trust, in reality the ruling could have far-reaching implications extending beyond planning involving the family home. In fact it needs to be considered for all trusts making loans to beneficiaries. It is essential that ordinary trusts making loans to beneficiaries to create debts on their estate understand the legislation which HMRC has used in the courts.

The details of the case have been extensively reported elsewhere, but to recap, the principle relates to a main residence scheme where an 'IOU' or debt was intended to arise on the first death of Dr and Mrs Phizackerley. In this case, Mrs Phizackerley died first and a debt, to the value of her half share in the property was created - a common approach. The key point is that HMRC did not challenge the use of a debt or 'IOU', but actually the original source of the funds.

Indeed in this case, the half share of the house, left on Mrs Phizackerley's death to her trustees, in HMRC's view actually came from Dr Phizackerley. Mrs Phizackerley never worked and the property purchase was only funded by Dr Phizackerley. This means that the half share of the house exchanged for the debt was actually 'property derived from the deceased' and hence there is no relief for the debt against Dr Phizackerley's estate. This principle of the origin of the funds is the focus of the case.

Application of the law

It is not the legislation that is new, but the application of this law to these property structures. The outcome of the case is confirmation that the source of the funds is extremely important when recommending any type of trust, not only at the point of establishing the trust, but the original source. Less widely publicised than the focus on property in the Phizackerley case is the fact that the same principles can be applied to any trust arrangement where a beneficiary receives a loan from the trust, rather than receiving a sum of money outright.

For example, lifetime discretionary trusts are also a core part of initial IHT planning for many people. One of the key benefits is that access for the spouse of the settlor can be achieved without the trust forming part of their estate. Trustees may decide to make payments in the form of loans, rather than advancing capital. Providing that these loans are spent, they will effectively reduce the taxable estate of the surviving spouse as they will create a debt against their estate on death, provided the spouse of the settlor had not made substantial gifts to the spouse who created the trust.

The principle is perhaps best illustrated with an example. Consider a wife who sets up a discretionary trust of £100,000 for her husband and children. On her death, the trustees lend her husband £60,000 from the trust which he subsequently spends. On his death, the £60,000 would be repaid to the trust. This would reduce his inheritance taxable estate by this amount and so the IHT bill would be lower. However, if the husband had made substantial gifts to his wife since Budget Day 1986, his estate would not be reduced by the full amount of the loan. Instead, it would only be reduced by the proportion that the difference between the loan and the total amount of those gifts bore to the loan. As a result, his inheritance taxable estate might not be as low as might have been expected and neither would the IHT bill, leaving an unpleasant surprise for the surviving beneficiaries if they had not been made aware of this.

The issue of IHT, and hence the need for IHT planning, continues to grow in importance and is a source of concern for many clients. In this area, opportunities for both new and existing trusts continue to arise. 'IOU' and debt type schemes are particularly popular with solicitors drafting wills and may already be in place, but following the Phizackerley case the need to review these is more important than ever. Failing to make full use of the nil rate band could potentially cost a client £120,000 (up to 40% of £300,000), so avoiding this is a clear opportunity to demonstrate the value of good financial advice. Advisers taking the time and care to establish where monies have come from could save significant amounts of tax in the future.

The key point that advisers must remember is that when creating or advising on trust arrangements, advisers must ask whether the settlor's spouse (or any other beneficiary of the trust) has made substantial prior gifts to the settlor at any time since Budget Day 1986. This must be factored into their recommendations to minimise the risk of any similar 'Phizackerley challenge'. To achieve the best outcomes for clients, the Phizackerley case has demonstrated the need for closer working relationships between advisers and their clients' other professional connections. The need for high quality financial advice has once again been clearly demonstrated.

Colin Jelley
Head of Tax and Financial Planning
Skandia