How to lasso a tax efficient plan

Paul Thompson, tax & estate planning consultant at Canada Life, looks at alternative strategies for mitigating IHT liability.

One of the best defences against the potential ravages of inheritance tax (IHT) is an arrangement which, initially at least, has no impact. In addition, it allows the client to access capital at any time during their lifetime, but does not create a gift with reservation, nor does it offend the pre-owned assets income tax legislation.

Let’s start with a simple scenario without a trust. Archie decides to lend £1m to Brenda. He arranges the loan in such a way that it is repayable on demand and, to avoid unnecessary complications, he makes it interest-free. The fact it is repayable on demand is important from an IHT point of view.

Section 3(1) of the IHT Act 1984 states that: “A transfer of value is a disposition made by a person as a result of which the value of his estate immediately after the disposition is less than it would be but for the disposition.”

It could be argued that a loan is not a disposition, a word that is not defined in the legislation itself. However, even if it is a disposition, it seems clear that, provided it is repayable on demand, the value of the lender’s estate is exactly the same before and after. Physically, the cash lent is no longer part of the estate but there is an asset of the estate equal to the amount outstanding, so the two cancel each other out. The loan cannot therefore be a transfer of value.

Future growth

So how is that of benefit as far as Archie’s potential IHT liabilities are concerned? If he died the day after the loan was granted to Brenda, there would be no benefit at all; the value of Archie’s estate would be exactly the same as if he had not made the loan.

However, any future growth on the borrowed money will accrue within Brenda’s estate, not Archie’s, which is the fundamental point. By lending the cash interest-free and making the loan repayable on demand, Archie has effectively put a cap on the potential for IHT, since the value of the loan cannot increase. Not only that, but Archie can rest assured that, should he ever need any funds, he can always ask for part or all of the loan to be repaid.

But there’s a potential difficulty. What if Archie is concerned about Brenda’s willingness or ability to pay? Or what if Brenda is under the age of majority? Perhaps it would be preferable for Archie to create a trust for Brenda’s benefit so that, having appointed trustees, he could lend the cash to them on exactly the same terms.

In turn, the trustees could invest the borrowed cash so that future growth accrued within the trust. Even better, Archie could create a discretionary trust, allowing for greater flexibility in the event of a future change of circumstances.

Regular partial repayments

A potential problem here is that, if the trustees invest in an income-producing investment, income tax complexities arise in the event of any loan repayment in whole or in part. Consequently, it is helpful if the trustees take out an investment bond, since it is a non-income producing vehicle.

Even better, it has the well-known facility to enable up to 5% tax-deferred withdrawals each year for at least 20 years. This means Archie could have regular partial repayments of capital which he could spend as if they were income.

This is the basis of most loan trust arrangements offered by product providers within the financial services industry. As always, there will be some variations around the theme. Some will require a nominal gift to start the trust off, for example, while others will start the trust with the commencement of the loan.

So, as far as the outset is concerned, the creation of a loan trust arrangement is virtually a non-event as far as IHT is concerned. If there is a nominal gift of, say, £10, this will clearly be a transfer of value but, in most cases, it will comfortably fall within an available exemption, such as the £3,000 annual gift exemption. But what about after the outset? Will there be periodic and exit charges?

Careful planning

The fact that, in virtually every case, there will be no IHT payable at outset means there can be no IHT exit charges on any capital paid to the beneficiaries within the first ten years of the trust. Additionally, there will never be any exit charges on any loan repayments to the settlor.