September 2007

Inheritance tax

Mitigating circumstances

The classic view is that there are three ways to mitigate inheritance tax (IHT); to give away all your assets; fund payment of the tax, usually by an insurance policy written in trust and so outside the estate, and thirdly to SKI. This last is not the traditional use of the word SKI rather it is "Spending the Kids' Inheritance".

All three views have their supporters. We all make gifts to a greater or lesser degree for instance. Some of us also choose to fund IHT liability on the basis that every payment of the annual insurance premium is contributed to by the Treasury and, we all like to enjoy ourselves from time to time even (perhaps especially!) at the expense of our children.

IHT planners received a rude shock in Budget Note 25 which led to the Finance Act 2006 (FA 2006). For many years, indeed for centuries, the classic English way of giving assets for the benefit of the next generation was to place them in trust. While there was a limit on what you could put into a discretionary trust without paying IHT immediately upon making the settlement, there was no limit to the amount that you could settle on a life interest trust or an accumulation and maintenance trust. "Alignment" meant that all trusts were treated as if they were discretionary trusts. So what is left for IHT mitigation?

First, there has been no alteration to the rules about outright giving. £250 can be given to a series of individuals each year; £3,000 can be given each year though not to the persons who receive the £250. Each of these gifts is exempt, so does not have to wait the seven year period before falling out of the estate for IHT purposes.

Likewise, you can marry off your children (and, no doubt, pay for the privilege of doing so!) and give them an IHT exempt gift of £5k per parent. Charities remain exempt from IHT in respect of gifts made to them. For those of a particular frame of mind, gifts to political parties are also exempt!

Surplus income

One other form of exempt giving comes sharply into focus following the Finance Act - that is regular giving out of surplus income. Note that there are three qualifications for the gift to be exempt. The giving has to be regular and it has to be out of income; and, having been made, the net income with which the donor is left has to be sufficient to enable him to maintain the standard of living that he had before he commenced the regular pattern of giving. So a large gift out of surplus income in one year will not be exempt if it is not followed in subsequent years. It needs to be part of a pattern.

That does not mean that you have to give the same amount each year; you can make it clear by a note written at the time you make the first gift that it is your intention henceforth to pay each year a regular amount that approximates to the whole or a particular part of your surplus income. You will need to keep meticulous records showing your income. This includes the tax that you pay on it, your living expenses and to demonstrate the amount of the surplus and show the amount of the surplus given away each year. With that caveat gifts out of surplus income are an excellent way of taking monies out of your estate on an immediate basis. As the gifts of surplus income are exempt you can even put them into a trust without falling foul of the provisions of FA 2006.

IHT can be mitigated by a strategic use of investments with those assets defined as relevant business assets having 100% exemption from IHT. The business can be that of a sole trader or a partnership or an unquoted company. However, it must not be as an investment business. Hence the whole myriad court cases concerning caravan parks and whether their (deceased) owners were trading (the provision of services to happy campers) or holding the park as an investment (landlords collecting the rent for the various pitches).

Likewise a property used for the purposes of agriculture is also 100% relieved from IHT.

Complex rules

With such a generous concession, no IHT to pay, it is hardly surprising that HMRC examines carefully, and does not hesitate to challenge, all claims for these reliefs. The rules are hedged with conditions and need to be considered very carefully as what you might think is obvious is not always the reality. There are also traps for the unwary by way of anti-avoidance provisions, particularly if the donor dies within seven years of making the gift and the nature of the asset has changed in that period.

We all know that gifts have a seven year claw back period but business property or agricultural property needs to be held for two years only before it will be exempt from IHT. When two plays seven it is hardly surprising that many brokers are marketing their AIM portfolios. AIM is not traded on a recognised stock exchange and accordingly the shares listed on AIM are within the business property regime for IHT purposes.

Irrespective of the draconian provisions enacted by FA 2006 in relation to trusts, a gift from one individual to another remains a potentially exempt transfer (PET), though subject to the seven year survival rule. It is hardly a level playing field but we have to play the game according to the current rules and not what we would like those rules to be.

Finally, a gift to a bare trust remains a PET. There was a scare about this recently but HMRC has now confirmed what everybody else knew namely that a gift to an infant, albeit, of legal necessity, held by trustees for that infant, remains an outright gift and not a gift into trust. The only snag from the perspective of the giver is that as soon as the child attains 18 he or she can demand the asset be transferred to him or her from the trustees which leaves many people wary of making such gifts.

Geoffrey Shindler
Partner
Lane-Smith and Shindler