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Of all the world’s major economies, the UK is second only to Ireland in the percentage of a taxpayer’s estate that is surrendered to inheritance or estate tax. Meanwhile, the nil rate band, frozen at £325,000 until at least 2018, is around £180,000 below the average price of a property in London and only £50,000 ahead of the UK average[1]. Reliefs are available, though not to all. The demand for practitioners to find effective but uncontroversial methods to pass on assets and either reduce or satisfy the inheritance tax bill is therefore more acute than ever. But when it comes to keeping control, given the potential tax cost of overreliance on discretionary trusts and the risk that an enhanced DOTAS represents for more innovative structures, what is left in the inheritance tax planning toolbox?

Gifting with Control

For individuals already domiciled or deemed domiciled in the UK, outright gifts continue to be one of the most efficient techniques available. The potential to pass on unlimited wealth to the next generation free of inheritance tax after seven years, while reducing the value of one’s estate at death is not to be taken for granted. However, a gift commonly entails loss of control and, particularly where children or grandchildren are not sufficiently mature to handle the assets received, family wealth can be placed at risk. Gifts into bare trust certainly offer a degree of protection.  Assets are nevertheless available to the beneficiary from age 18. Flexibility and trustee discretion on the other hand can give rise to undesirable relevant property regime charges on settlement, 10-yearly and on exit. In an ideal world, one would still be able to gift to the next generation via potentially exempt transfers while also granting the donor peace of mind via an element of lasting influence. An insurance-based solution might still offer this possibility.

A life policy, being at its simplest a contract between two parties, offers ample scope for planning via the amendment of policy terms, and without engaging the relevant property regime. For example, a policy whose terms supress the total surrender right for a period of years and prohibit, or cap, access via part surrenders for the same period can grant much sought-after control over the extent and timing of access by any beneficiary to whom the policy is then gifted. The policy restrictions are lifted automatically after a predetermined number of years, allowing full access by the recipient child or grandchild (or other relative or third party).

Example

£1,000,000 is invested by Mr A in a life policy subject to suppression of the total surrender right for fifteen years (the Suppression Period) and limitation of part surrenders to 3% of premium per policy year for the same period. Expiry of the Suppression Period coincides with his son’s 35th birthday beyond which he expects that the £1,000,000 and accrued growth are less likely to be misused. The policy can be gifted to the son without giving rise to a chargeable event gain [2] and the assignment, rather than being a transfer of value, is a potentially exempt transfer to the extent of the greater of premiums paid or market value [3] (the former being the more likely figure). No tax is due if Mr A survives seven years. During the chosen Suppression Period, the son can withdraw funds only to the extent allowed by Mr A at outset. However part surrenders, even up to the maximum £30,000 (3%) limit imposed are not taxable as they do not exceed the 5% allowance [4]. After fifteen years the restrictions are lifted and there is full access again.

If the intended recipient is a minor, the assignment can instead be made to a bare trust. The tax result is the same and suitable wording drafted by a private client advisor can provide for advances to be made for maintenance and education during minority.

Planning for the Unknown

Yet circumstances change, and unforeseen events may mean either that full access to the value of the gift at the chosen date becomes undesirable or that funds are required at a time when they are contractually unavailable. One of the great attractions of discretionary trust planning is the ability to cater for such change. However, planning in this way after Finance Act 2006 can attract substantial inheritance tax expense. Might it be possible, therefore, to achieve some or all of the flexibility offered by a discretionary arrangement at no or negligible inheritance tax cost?

A life policy comprises a collection of rights and obligations. Among the rights are the right to surrender and the right to part surrender, as described above (we can call these collectively the Surrender Rights). Provided they are adequately defined, further rights can be created that sit alongside these and that are capable of assignment individually. From here it is relatively easy to see how the solution set out above might be enhanced.

As before, a life policy could be acquired which, from the outset, includes restrictions on the Surrender Rights. These restrictions again last for a predetermined Suppression Period. Now though, an additional set of rights exists, which permit the creation of an entitlement to part and total surrenders, and which also permit the cancellation or amendment of that entitlement after it has been created (we will call these the Modification Rights). Put another way, a person (or discretionary trustees) holding the Modification Rights could modify the restrictions placed on the Surrender Rights. The policy would then be assigned to the intended adult donee or to bare trustees for a minor.

Example

Mr B acquires a life policy for £2,000,000 subject to total suppression of the part and total surrender rights for seven years. The Modification Rights are assigned to a discretionary settlement drafted by his solicitor while the policy itself is gifted to Mr B’s daughter, who is also a discretionary beneficiary under the terms of the settlement. Four years later, the policy is worth £2,500,000 and the daughter requests access to £400,000 to be put toward the purchase of a property. The trustees, after considering the request, exercise the Modification Rights to grant temporary access via part surrender within the accumulated 5% allowance. They then reinstate the earlier restrictions. Fresh requests for access can be considered from time to time by the trustees and exercised in favour of the daughter in much the same way as a conventional discretionary arrangement. However, the inheritance tax position is improved. In fact £2,000,000 may pass inheritance tax-free.

While a policy assignment of this sort would again not be chargeable to income tax and would be potentially exempt from inheritance tax, the settlement of the Modification Rights would be immediately chargeable [5]. However, the value of this transfer is limited to the difference between premiums paid and the value of the policy shorn of the Modification Rights [6]. Based on an indicative professional valuation, the lifetime transfer in the above example would amount to around £84,000 and sit comfortably within an unused nil rate band, as compared to £400,000 at the usual lifetime rate of 20%. Importantly, in view of a strengthened DOTAS, there is no attempt to avoid an immediate charge to IHT, rather any tax is paid and the bulk of the value moves via a transfer that is only potentially exempt.

Afterlife

For clients less willing to part with an income, alternative arrangements must usually be put in place. Discounted gift trusts are still a mainstay in this respect. Growth in the value of the policy takes place outside the investor’s estate and any payment on death of the last surviving life assured will also accrue outside the estate for inheritance tax purposes. Provided an entitlement to capital is precisely carved out, there is no gift with reservation [7] and the structure can be drafted to prevent the application of Schedule 20 Paragraph 7 Finance Act 1986. Part surrenders to fund the retained entitlement can also be kept within the 5% allowance for income tax purposes. Both bare and flexible trust arrangements can be used but again the greater discretion offered by the latter comes at potentially higher tax cost. Or does it?

We have seen that a life policy’s terms can accommodate a control mechanism to limit or prevent access before a certain time. Provided it is agreed at outset, such a mechanism need not come into play immediately. Rather, the Suppression Period might start on the death of the original policyholder, and by writing the contract on multiple lives, this control could be made to endure. The potential advantages are clear: the transfer is potentially exempt as it is to bare trustees and the donor retains a tax efficient income stream. Death of the donor has two important results: that the beneficiary, if of sufficient age, can demand the policy but also that the Suppression Period begins so as to control access by that beneficiary in the manner chosen by the now deceased donor.

Trusts Abroad

It is tempting to view this article as relevant exclusively to those remaining within the UK inheritance tax net. Nevertheless, individuals departing with domicile of either category will still be looking to their advisers for a means to alleviate any UK inheritance tax burden during the three-year inheritance tax ‘tail’ that follows physical departure [8]. Even for non-domiciled individuals, for whom inheritance tax may be less of a concern, control will very often be important.

Central to any decision on which arrangements should be put in place is the treatment of trusts in the new host country given that in certain jurisdictions they can be treated somewhat unfavourably. The reporting requirements imposed by France since 2011, for example, are now well-known and certain non-Hague Convention signatories, such as Spain, go as far as to disregard trusts in both law and tax, which can give rise to dramatic and unintended consequences. As such, the availability of a contract-based investment arrangement that can incorporate lasting control, be freely transferred and be modified with relative ease for tax efficiency in the new country of residence may be an option for practitioners with mobile clients.

Final Remarks

Offshore life policies, as an additional and established vehicle in private client planning, have a great deal to offer clients concerned with the ever increasing burden of UK inheritance tax or those simply apprehensive about giving up control. Far from displacing traditional trust structures, they can frequently be drafted so as to enhance existing planning while alleviating trust taxation and ensuring continued tax efficiency on a change of residence. As such, they are set to remain a tool of choice for practitioners advising in both fields for some time.


Please do not hesitate to contact Simon Gorbutt or your usual Lombard International Assurance representative if you have any queries or require further information.


By Simon Gorbutt

 
References:

[1] Office For National Statistics House Price Index, January 2015 Release

[2] s 484(1)(a)(ii) Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005)

[3] By virtue of the special valuation rule in s 167(1) Inheritance Tax Act 1984 (IHTA 1984)

[4] s 507(2) ITTOIA 2005

[5] s 3(3) IHTA 1984

[6] S 167(1) IHTA 1984

[7] For the purposes of s 102 Finance Act 1986

[8] s 267(1) IHTA 1984

 

This article was published in the STEP Journal (Volume 23, Issue 5).