A battle of wills

Last year's Pre-Budget Report heralded major changes in inheritance tax planning. Julie Hutchison goes through the changes

On the day of a Pre-Budget Report (PBR) or Budget, it is often the case that detail is lacking and it is difficult to properly analyse the impact of the tax changes. In October last year however, the inheritance tax (IHT) changes for the nil rate band (NRB) were announced with draft legislation and a detailed Guidance Note. This was followed by a Frequently Asked Questions document on the HM Revenue & Customs website (www.hmrc.gov.uk). The level of detail even extended to considering the impact on those whose spouse had died pre-1975 under the old estate duty rules, so the practical application of the new rules seems to have been given some considered thought, which is reassuring.

It is essential that financial advisers master these rules. If life cover is being put in place to pay an IHT liability on second death, it will be important to know what NRB is available in order to calculate that IHT liability correctly. Those dealing with trust advice will also want to know a client's NRB since that will affect whether or not lifetime gifting might be required to reduce the estate.

What are the rules?

To understand what changed, the IHT changes are best illustrated by example. Take Mr and Mrs Smith, a married couple. Under the old rules, assume Mr Smith died and left his entire estate to Mrs Smith. No IHT was due at that point since the spouse exemption applied for IHT purposes. On Mrs Smith's later death, her estate was subject to IHT at 40% on the value exceeding the NRB of £300,000 (tax year 2007/08 figure). The net result was that up to £120,000 of extra IHT could be due overall since the NRB of £300,000 was wasted on Mr Smith's death (since spouse exemption applied to everything he left to Mrs Smith). In the new regime, on Mrs Smith's later death, she would have an NRB of £600,000 on death, not £300,000, assuming Mr Smith's will contained no other legacies and that Mr Smith had not made any lifetime gifts within seven years of his death. These two qualifications are important since such legacies or lifetime gifts would have used up some of Mr Smith's NRB.

The key point to identify here is what percentage of NRB was unused on first death. In the case above, 100% was unused so therefore the estate of the second to die is allocated a 100% increase to the then prevailing NRB. The monetary amount of the first NRB is not carried forward, but rather the percentage unused.

It is important to note that the new rules would apply not just if Mr Smith died after 9 October, but also at any time before 9 October. More complex examples will arise: I spoke to someone recently whose client had been widowed twice, once in the 1940s and then later in the 1970s. Lawyers, accountants and financial advisers will all be working to digest these new rules and the procedure which goes with them to apply for an enhanced NRB on second death. The short answer to the scenario above is that the NRB can never be more than doubled.

What are the practical implications of the new rules?

In summary, the new issues arising are:

1. The need to ask a client if he/she has ever been widowed;

2. The new HMRC form IHT216 used to apply for the enhanced NRB on second death;

3. The paperwork and information required to complete the IHT216;

4. The renewed focus on record-keeping to document lifetime gifts.

Some advisers I have spoken to are checking their client databases to identify widowed clients, to mark out files for review. A client with an enhanced NRB may now require different advice depending on the value of the estate. Advisers should however note that, unfortunately, the enhanced NRB cannot be used to set against lifetime gifts at the time the gift is made. Whether deliberately (or by accident) this aspect of the rules is less favourable. In other words, a client with a double NRB is not able to make a gift to a discretionary trust of £600,000 free of IHT. Their "normal" NRB of £300,000 would still apply for lifetime gifting purposes. A larger PET might however be interesting since PETs only become taxable on death within seven years, at which point any enhanced NRB would be available to set against the failed PET. This could make PETs more attractive for some clients.

What are the advice implications?

A widowed client who now enjoys up to a double NRB of £600,000 may no longer need to make lifetime gifts to reduce their estate for IHT. The new strategy for the adviser here might be to focus on how to keep a client's assets just under the enhanced NRB. For this, a loan trust might be back in focus. A loan trust does not involve making a gift at outset but any growth in the investment is outside the client's estate. This can have the effect of "capping" the position since it will not increase the client's estate. The client retains access to the outstanding loan amount and can take withdrawals, giving good flexibility. The loan can later be cancelled which is effectively a gift for IHT purposes. All these features make this flexible arrangement worth considering for those clients whose estates are near the NRB threshold, be that £300,000 or £600,000.

What about wills?

Many advisers work closely with law firms, to refer clients for wills and powers of attorney. Clients may well be asking advisers about the implications for their wills. This is because it had virtually become received wisdom to incorporate NRB will trusts into the wills for married couples and civil partners to make use of the NRB of the first to die. What should a financial adviser be saying to clients concerned about their wills which contain these trusts? The starting point is that the NRB will trust is certainly not "dead". There are a number of reasons why it still makes good sense to use an NRB will trust. What has changed is that it is no longer so easy to make a generic comment about the merits of having one.

For example, one factor which could indicate use of a NRB trust is to plan ahead for long term care costs and prevent the estate of the survivor being increased. This same point would also apply where the survivor was in business and wanted to keep assets out of their estate with one eye on future possible creditors. These are all sensible asset protection points which arise in the normal course of an estate planning advice process. Where however the main asset is the family home, it might no longer be necessary to use the NRB will trust route and the IUO/charge arrangements which accompanied the will trust to deal with the family home. Each case will require individual advice to decide either way.

Conclusions

Those working in the field of retirement planning will now have more to think about when it comes to IHT. Factfinds are likely to be re-worded; discussions about the suitability of NRB will trusts will take place; loan trusts might be used more often; difficulties will arise in trying to locate all the old paperwork required to support the completion of the IHT216 form to claim an enhanced NRB on the later second death; financial advisers might find they are asked if they still hold records which could be of assistance. The IHT changes in the Pre-Budget Report of 2007 are good news but have created more subtle and complex advice issues which will take time to digest.