February 2008

A tricky business

There are many misconceptions and pitfalls a client can fall into without realising the implications of their actions when creating a trust. These unfortunately common events present a real opportunity for the value of expert advice to be demonstrated. Let's consider some areas which clearly need advice.

Order of events

A strategy for reducing an inheritance tax (IHT) liability often involves giving away money as outright gifts. However, many people may not be aware that the order in which gifts are made can have significant implications for tax.

Consider, for example, an individual making a £100,000 cash gift to their adult child as a deposit for his new flat and then placing £300,000 into a discretionary trust for his children or grandchildren. The former would be considered as a potentially exempt transfer (PET) and the latter a chargeable lifetime transfer (CLT).

It would be easy to think that the order in which these gifts were made was irrelevant, but that is not the case. The order in which they are made determines the order in which they are set against the nil rate band (NRB), and can affect the amount of tax that will be due. In this example if the donor dies within seven years, the PET would fail and become chargeable. As the failed PET was created before the CLT, the PET would be counted against the available nil rate band first. This could result in unnecessary IHT on the CLT immediately, on exit and at the ten yearly periodic charge. If the CLT had been created before the PET, then these tax charges may have easily been avoided.

Related settlements

Sometimes one trust is not enough to address planning needs, in which case creating multiple trusts to cater for different needs or just to ensure each trust is separately identifiable may well be good practice. For example multiple trusts can avoid disinvestment problems of real assets when distributions are made to beneficiaries, especially where the age range is significant. The added cost and reporting requirements of using more than one trust is a consideration. However, the key planning point here is to ensure each trust is created on separate days because doing so can reduce a substantial tax bill. Let's consider three discretionary trusts of £100,000 each. If they are treated as related settlements, that is if they are created on the same day by the same settlor, then at the ten year anniversary they will only benefit from one NRB. If the assets perform well and increase in value above the then NRB, unnecessary tax would be due. However, by simply creating the trusts on different days, each trust will be able to benefit from its own nil rate band, thus potentially reducing any future tax liability.

Normal expenditure out of income

This facility is often overlooked. The normal expenditure out of income rules say that an unconditional gift is exempt from IHT, providing that:

- It was made as part of the normal expenditure of the person making the gift;

- It was made out of income (e.g. dividends or interest from investments or bank accounts); and

- After allowing for all gifts which are part of normal expenditure, the person making the gift was left with sufficient income to maintain his or her usual standard of living.

- It is habitual or regular.

Where surplus income exists, clearly giving it away with no seven year rule or entry charge to IHT is very attractive. However, to ensure the personal representatives can claim the exemption detailed records of expenditure and income must be kept as it can only be claimed after death. The gifts do not necessarily need to be of the same amount and this has been demonstrated in case law. However, another point for advisers to be aware of is that although single premium investment bonds offer excellent wrappers for trusts, the 5% tax deferred allowance does not qualify as 'income' for these purposes. Again, an easy mistake to make!

Taper relief

Taper relief reduces the amount of IHT payable on a sliding scale over seven years on gifts. It is often assumed that it applies to the whole gift. However, unfortunately it is only of value where the total of gifts given exceeds the available NRB. Consider a £600,000 estate with an available NRB of £300,000. There have been no previous gifts and the client gifts £200,000 and dies six years later. One could be mistaken for thinking that taper relief would reduce the amount of IHT applicable. However, this is not the case since the total of gifts given is below the nil rate band.

In fact the outcome is as follows. The gift will be added to the estate for the purposes of IHT, and let's assume that with this the estate is still valued at £600,000. The nil rate band at death is £400,000. On death the £200,000 gift is immediately assessed against any available NRB. All growth since the gift was made is outside the estate so suffers no IHT. The remaining £200,000 of NRB will be assessed against the residual estate, leaving a total of £200,000 liable to IHT. Tax at 40% will be due, equating to £80,000. However, if the client had lived for seven years then no tax would have been due on the capital of the gift as the full gift would have been outside the estate and not just the growth.

Domicile

A non-domiciled individual, who is UK resident with UK assets, will generally only suffer UK IHT on their UK situs assets. UK domiciled individuals married to non-domiciles should be aware that the normal NRB trust on death and residue to spouse approach (claiming spouse exemption) will not apply. Assets being transferred from a UK domicile to a non domicile spouse or civil partner will only benefit from a £55,000 spouse exemption, not the normal 100%. This could be an easy point to overlook, so care should be taken to once again avoid unexpected tax.

Phil Carroll
Tax and Estate Planning Manager
Skandia