Shaken but not stirred

Karen Barretto discusses the pros and cons of using discounted gift trusts.

The economic climate today is uncertain, we have seen a cocktail of falling asset values mixed with lower investment returns. Understandably this has caused more people to concentrate on preserving financial security for themselves and their family. Secondary to that will be the mitigation of inheritance tax. Is it possible to achieve both objectives?

Estate planning often involves a person giving away assets during their lifetime, however once the gift is made, it cannot be called back. Outright gifts are straightforward but inflexible; if circumstances were to change, the gift cannot be reclaimed. As such arrangements which provide the ability for the donor to benefit in some way have gained in popularity.

We as an industry are pretty well versed with the benefits of discounted gift schemes and gift and loan arrangements, but these do not come without their limitations. The discounted gift scheme gives the client the ability to make a gift for inheritance tax purposes while retaining the rights to regular withdrawals from the policies, thus giving rise to a discount for inheritance tax purposes.

However, it is vital that discounted gift trust is not sold on the back of the discount alone or where the client already has a more than adequate income and has no need for more income on top. If the client does not need the income, this can lead to problems, as most arrangements will not have a facility to turn this income off.

As such, the income will need to be taken and hence find its way back into the estate, further exacerbating the problem rather than mitigating it, as was the intention. Furthermore a discounted gift trust does not suit a client whose family may have need of capital advancements while the settler is still alive, most arrangements will provide that no distributions can be made to the beneficiaries during the client's lifetime.

A gift & loan arrangement, on the other hand, works on the basis that it allows the client to make settlements into trust. The initial gift is typically £10, but can be an amount equal to the client's annual IHT exemption.

After making the initial gift, the client will make an interest-free loan to the trustees of the settlement and the trustees invest that amount into a bond. This loan is repayable on demand and any loan repayments are funded by withdrawals from the bond.

On the death of the client any outstanding loan amount will form part of their estate for inheritance tax purposes. However, any investment growth on the bond owned by the trustees will be outside the client's estate. The trust will also have the advantage of avoiding delays on the death of the client, because there is no need to obtain a Grant of Representation in this respect, provided that there is a surviving trustee.

It is important to note that the client can only receive ‘income' in the form of loan repayments. Once the original loan amount has been repaid, the client is no longer able to benefit from any further payments from the trust. Also should the client die in the early years of the arrangement, very little in the way of inheritance tax mitigation will normally have been achieved.

Is it possible to achieve a middle road between the two? An arrangement which offers the ability to mitigate inheritance tax, while still allowing the client flexible access to "income" at times when it is most needed? Providing for unforeseen circumstances is part and parcel of good estate planning, and arrangements which offer such flexibility are key to such planning.

A solution which has been gaining in popularity is one that allows individuals to make a gift of capital while having access to, in a flexible and IHT efficient fashion, periodic payments of cash, if needed. The appointed trustees can distribute payments to beneficiaries at any time, if required, offering families a high degree of flexibility as their circumstances change.

The arrangement has been designed to be exempt from income tax on pre-owned assets and outside any charge to capital gains tax, while minimising income tax and IHT which may be payable in the future.

This arrangement is often referred to as a flexible reversionary trust. It is a discretionary trust which allows a wide class of beneficiaries and allows for future beneficiaries to be brought in. One point to bear in mind is that this structure uses a life insurance policy which is a non income producing asset. This is especially relevant following the recent budget which introduced a 50% income tax rate for discretionary trusts from 6/4/10.

It is typically designed as a series of annual maturing life policies which are initially settled on a bare trust and subsequently a discretionary trust arrangement. The gift to the discretionary trust is a chargeable lifetime transfer for IHT purposes. As such it is usually suggested that the client only gift up to his or her available IHT nil rate band, assuming he or she does not wish to pay any chargeable lifetime tax entry charge.

The proceeds of the maturing policies are available for the client by way of a reversionary interest under the settlement. The trustees are able to extend the policy maturity date should the maturity payments not be required. This provides the flexibility to keep the assets within the trust or have access to the maturing policies should the client's circumstances change.

Furthermore, the trustees can also surrender any of the policies and pass the proceeds to the beneficiaries, but beware of the income tax charge. Alternatively, policies can be assigned to beneficiaries by the trustees at any time before surrender to move the tax point from the client to their chosen beneficiaries. This would be beneficial where the beneficiaries in receipt of the assigned policies have a lower tax status.

Scenario
The benefits of this type of arrangement are can be illustrated by looking at a fairly typical client scenario which shows how this arrangement would work in practice. Let's take Mrs Knight as an example.

Mrs Knight is aged 66, she is widowed with two children and three grandchildren. Her grandchildren James, Angela and Sue are aged 11, 9 and 5 respectively, Mrs Knight is currently in receipt of her state pension, a pension from her ex employer and income from both savings and investments. As such she has no immediate need for further income, however given the recent volatility in the markets she is concerned that her income will not remain constant and may at some time in the future require access.

Mrs Knight has approached her financial adviser with a number of objectives:

• A review of her current financial status,
• Limiting her potential exposure to inheritance tax and
• Making provision for her children and grandchildren.

Her financial adviser, upon conducting the review has established that as things stand, given the total value of her estate, she has more than sufficient income in the short term but has a liability to inheritance tax. She will not benefit from a transferable nil rate band, as her husband has made gifts using up his nil rate band on death. Therefore the only available nil rate band is her own.

Her adviser has established that she has sufficient capital to gift £300,000 and therefore suggested that in order to meet Mrs Knight's objectives she should make a gift into a discretionary flexible reversionary trust for the following reasons.

• The establishment of the FRT will give rise to a chargeable lifetime transfer but will not create an inheritance tax charge as it utilises her nil rate band.
• After seven years the gift will fall outside her estate for inheritance tax purposes.
• It provides, by way of maturities, access to "income".
• Trustees are able to make distributions to a class of discretionary beneficiaries which will include her children and grandchildren.
• Due to the structure of the arrangement there will be no liability to pre-owned asset tax.
• There is no underwriting required.
• The structure has been signed off by leading counsel.

Having considered the advice, Mrs Knight is happy with the recommendation and proceeds accordingly.

Weigh the options
Moving forward it is important to note that any arrangement will have its plus and negative points and there is a lot to be said for any arrangement which is not only effective for inheritance tax but gives the client access in some way, without breaching the Gift with Reservation of Benefit rules. In fact, looking to combine some of these structures, rather than using them in isolation can often provide better results. Clients planning on using a combination of trusts should be mindful of the possible inheritance tax consequences depending on the order of gifts.

The taxation of discretionary trusts can be complex and is outside the scope of this article but briefly there is an advantage to the later taxation of discretionary trusts if discretionary trusts are established before potentially exempt transfers (PETs). If the PET comes first and later becomes chargeable, they will be taken into account when calculating IHT payable by the trust during the life of the discretionary trust. Any exempt transfers should be undertaken before the establishment of a chargeable lifetime transfer or a PET.

The current inheritance tax legislation encourages lifetime gifting, whether by parent, grandparent or others, and wherever possible clients should take full advantage of their ability to recycle their nil rate band every seven years. Estate planning is a continuing process, it requires a strategy based on short and long term forward planning and when undertaken early, the best results will often be achieved.

Karen Barretto is senior tax manager at Canada Life