May 2008

The evolution of IHT

Gone are the days of inheritance tax (IHT) being the exclusive bane of the most affluent. As house prices remain high, IHT planning has become a very real issue for many, not least the intermediaries who are trying to keep up to speed with this continuously evolving issue.

We've witnessed yet more change with the Chancellor announcing a potential doubling of the nil rate band for some married couples and civil partners in his Pre-Budget Report in October. The Finance Bill 2008 will introduce legislation to allow a claim to be made to transfer any unused nil rate band on a person's death to the estate of their surviving spouse or civil partner who dies on or after 9 October 2007. The Chancellor is effectively helping couples with their nil rate band planning.

This most recent change will help to remove some from the IHT trap but many will still be caught. Married couples and civil partners with estates in excess of £600,000 (currently) still have a need for IHT planning, and advice on the different types of lifetime trusts available.

Which trust?

Before the 2006 Budget, intermediaries tended to focus on three types of trust for IHT planning: bare, discretionary and interest in possession trusts. While the changes announced in the 2006 Budget have had an impact, all three still have a role to play but as before, it is the IHT treatment and the flexibility of beneficiaries that are the main concerns for intermediaries.

As can be seen from the table, the three types of trust all have different characteristics. There is no 'one size fits all' solution and, as a result, intermediaries would be well advised to ensure they are familiar with the differences between the three so as to be able to offer the best advice and solutions to customers.

Prior to the 2006 Budget, the interest in possession trust was by far the most popular of the three for IHT planning purposes due to its flexibility regarding beneficiaries and its tax treatment as a potentially exempt transfer.

However, following the changes, interest in possession trusts are now subject to the same IHT regime as discretionary trusts, being treated as relevant property and creating a chargeable lifetime transfer at the outset. This has made discretionary trusts the more preferable option.

An important point for intermediaries to remember though, is that pre-Budget interest in possession trusts that continue to receive regular premiums, for life plans, are not caught by the new rules. In addition, increases to these plans may also avoid the trust being brought into the post-Budget rules if they form part of the policy contract conditions.

How are discretionary trusts taxed?

If total gifts to a discretionary trust are below the IHT nil rate band and made only every seven years, they avoid IHT at the time the trust is established. While this is an option it does mean that IHT planning needs to start much earlier than it does for most.

However, gifts into discretionary trusts that are above the prevailing nil rate band - taking account of any other chargeable lifetime transfers made by the settlor in the past seven years - are taxed on the excess at half the death rate, currently 20%, when they are established.

The trust also pays a periodic charge every 10 years, on any assets valued above, the then nil rate band. This tax charge is a maximum of 30% of the lifetime rate, currently 6%.

In addition, there is also a potential exit charge when capital is distributed to a beneficiary of the trust. This is also a maximum of 6%.

Why are gifts into discretionary trusts taxed as chargeable lifetime transfers?

Discretionary trusts have typically been used for generation jumping. For example, if a third generation of potential beneficiaries inherit the trust's assets, IHT is saved on the estate of the previous two. The difference in taxation lies in the fact that there is no interest in possession at outset and neither is one imposed by a certain age. In a nutshell, the trust can run for its full perpetuity period, usually 80 years, without its assets being attributable to an individual's estate for IHT purposes.

If the customer does not want to face the possibility of these tax charges, he or she could consider bare trusts.

Are bare trusts a viable option?

Yes, very much so. The IHT treatment of bare trusts has not changed and gifts into them are classed as potentially exempt transfers. As a result, where it is necessary to create a potentially exempt transfer a bare trust is the best solution, however, advisers must take full consideration of the fact that beneficiaries, and their share of the trust, must be specified at the outset and this cannot then be changed. It is also normally possible for the beneficiary to demand their share of the trust fund any time after the age of 18.

However, some of the new discounted gift bare trusts, are written to protect the assets while the donor is still alive. In other words, the beneficiaries cannot force the trustees to make payments to them while the donor is still alive.

The result of all this is that if a settlor/donor requires flexibility in the choice of their beneficiaries, either now or in the future, it is likely that a discretionary trust will be the best solution. Conversely, if the settlor/donor is certain as to who they wish to appoint as beneficiaries, a bare trust may be a more appropriate and simpler solution - at least from a tax perspective.

So, as with most areas of financial planning, there is a choice to be made. Does the client want flexibility and, if so, are they prepared to accept the more complex tax rules that come with it?

What about whole of life plans in trust?

This form of planning offers the customer a way of covering an IHT liability.

If a whole of life plan is written into a discretionary trust, the premiums are treated as chargeable lifetime transfers. However, the vast majority of gifts into these plans will fall within the annual exemption of £3,000 and/or the normal expenditure out of income exemption. If the premiums are exempt, there is no entry tax. Depending on the individual circumstances, for larger cases especially, there may be a periodic and/or exit charge.

Of course, it is possible to put a whole of life plan into a bare trust where flexibility to change beneficiaries is not needed.

Are discounted gift trusts still a viable option for IHT planning?

Yes. Things have changed, but the trust continues to be a valuable tool for intermediaries to use in IHT mitigation.

HMRC has confirmed that the chargeable lifetime transfer is the discounted gift - the value of the fund minus the settlor's right to income. If the discounted gift is below the available nil rate band, there will be no entry tax charge.

At the ten-year point, it is possible to revalue the trust without the need for underwriting, providing the settlor was underwritten at the outset. HMRC has provided a simple way to calculate the settlor's rights at this time. Providing the trust value minus those settlor rights does not exceed the available nil rate band, there will be no periodic charge.

If the entry and periodic tax charges can be avoided, which in turn should avoid the exit charge, discretionary trusts offer great flexibility with no lifetime cost.

In addition, discounted gift trusts can now be written as bare trusts and we have seen a number of products enter the market designed to help intermediaries make the most of this. With these trusts, trustees are obliged to make payments back to the donor but while it is possible the fund will exceed the level required to maintain the donor's payments, the beneficiaries cannot force the trustees to make any payments to them while the donor is alive.

IHT planning is a growing and complex issue. Advisers who are up to speed on the issues and have mastered the intricacies of the various solutions on offer have a fantastic opportunity to add further value to the work they do for existing clients. They also have a genuine opportunity to reach new clients who do not already have estate planning in place.

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Paul Wright
Investment Management Director – Proposition Management & Development
Zurich