IHT planning: Why one wrong move could prove costly

Paul Thompson, tax & estate planning consultant at Canada Life, on why the order of steps taken to mitigate your clients' inheritance tax (IHT) liability are so important...

Where a client is considering a series of steps to mitigate a potential inheritance tax (IHT) liability, the order in which those steps are taken can have a marked impact on their effectiveness.

Get it wrong and a great deal of IHT can become payable unnecessarily. Get it right and clients will be very grateful, although HM Revenue & Customs (HMRC) may not be so impressed.

The first type of arrangement to consider should be one that involves no gift. For example, consider the client who makes an interest-free loan which is repayable on demand. This would not reduce the value of the client’s estate, since the loaned amount would still be an asset. The effect, however, would be to cap the client’s IHT liability, as any future growth would accrue outside the client’s estate.

There may be some reluctance to make such a loan, particularly where the intended borrower is a spendthrift or a child, but these concerns can be alleviated by creating a relatively simple trust and lending to the trustees.

Exemptions

Clearly, exemptions from IHT need to be exploited as much as possible, so these need to be next on the list. Some exemptions, such as the £3,000 annual exemption, apply each tax year, so they will be wasted if they are not used.

After non-gifts and exempt transfers, it is tempting to consider potentially exempt transfers (PETs) next. After all, if an outright gift is made from one individual to another, the whole amount will be completely exempt from IHT, without limit, provided the donor survives the date of the gift by more than seven years.

While this is perfectly true, it might be better to consider making chargeable lifetime transfers (CLTs) first before making any PETs. To a degree, this seems counterintuitive – surely, it would be preferable to make transfers that are potentially exempt sooner than transfers that are chargeable? However, as we shall see from the following case study, that may not be so.

Case study

Bill and Ben are both wealthy widowers who have just retired. When their wives died, they utilised the whole of their nil rate bands (NRBs), meaning that Bill and Ben have only one NRB each. They have been considering some IHT planning, and have decided to take the following steps:

• Give £255,990 outright to their three adult children as a PET, £85,330 each.
• Make an interest-free loan of £300,000, repayable on demand. The growth is intended to be for the benefit of their young grandchildren, so a £10 discretionary trust is to be created for their benefit and then £300,000 borrowed by the trustees.
• Make a CLT of £325,000 into a discretionary trust for their children and grandchildren.

Bill is keen to start straightaway, so he immediately writes three cheques for £85,330 and hands them to his grateful children. The following week, he takes out a £325,000 investment bond and makes it subject to a discretionary trust and, the week after that, he creates a £10 discretionary trust for his grandchildren and lends £300,000 to the trustees, which they use to take out an investment bond.

Ben, on the other hand, consults his financial adviser, who suggests that Ben firstly creates a £10 discretionary trust and then lends £300,000 to the trustees. The following week, he advises Ben to make an outright gift of £5,990 to his three children. One week later, he helps Ben take out a £325,000 investment bond subject to a discretionary trust and, finally, one week after that, Ben makes another outright gift to his children of £250,000.

Summary:

When Bill made his outright gift of £255,990, he had his annual exemptions available from both this year and the previous one, so £6,000 would have been wholly exempt, leaving £249,990 to be a PET. The £325,000 bond under trust would have been a CLT. Since the PET is assumed to be exempt at the time it is made, the subsequent CLT would be within the current NRB, so no IHT is payable. The £10 used to create the subsequent trust would also have been a CLT.

Unfortunately, this means that Bill’s total of CLTs has exceeded the NRB, resulting in the need to submit an IHT100 to HMRC, as well as triggering a 20% IHT liability on the £10 in excess of the NRB. However, the £300,000 loan is repayable on demand, so this is not a transfer of value and, hence, no IHT will be triggered by this.

Just like Bill, Ben had his annual exemptions available from both this year and the previous one, so the £10 that Ben used to create his first trust would be wholly exempt. As with Bill, the loan of £300,000 is repayable on demand, so no IHT will be triggered by this. The subsequent gift of £5,990 effectively mops up the remainder of Ben’s annual exemptions. Next, the £325,000 bond under trust is within his NRB. As it is a transfer of cash, there is no need to report it to HMRC and there is no IHT. The subsequent gift of £250,000 is a PET.

IHT summary:

Let’s assume Bill and Ben are both killed in an accident three and a half years later. They each have an estate of £800,000 (including the outstanding loan) which they leave to their respective children. We’ll also assume that the £300,000 bonds have each grown to £350,000 and the £325,000 bonds have each grown to £380,000. What’s the position as far as IHT is concerned?