Despite the availability of an inheritance tax (IHT) nil rate band (currently worth £325,000) and the recently introduced residence nil rate band (worth £125,000 for the tax year 2018/19), IHT arising on death at 40% is somewhat penal; in particular, when it is appreciated that much of a person’s death estate has itself been subject to tax in one form or another, be it income tax and/or capital gains tax.
Growth in the value of assets owned during lifetime, which then form part of a person’s death estate, only exacerbates any resultant IHT charge.
Inheritance tax mitigation
Various options exist with a view to mitigating IHT on death, with gifting away in a lifetime being perhaps the easiest and most common, although not always a viable option. The ‘gifts with reservation’ anti-avoidance provisions generally act to preclude the gifting of one’s residence in which one continues to live after effecting a gift of it.
Trusts often appear as vehicles to be used in any tax planning exercise, and in this regard the loan/gift trust may well be an option worth considering.
Elements of the loan trust
A typical such trust involves initially settling (i.e. gifting) a nominal sum on trust (e.g. £100). The settlor of the trust then loans the trust a significant sum of money; the loan is interest-free and is repayable on demand. The trustees are then able to invest the trust monies as appropriate.
Neither the settlor (nor his spouse) is able to benefit from the trust; this is so as to preclude the gifts with reservation provisions from applying and destroying the object of the plan. The loan is structured on the above terms so as to attempt to ensure that the settlor is not making a chargeable transfer when granting the loan (i.e. a transfer which itself is subject to IHT).
‘Freezing’ aspect of the loan trust
The purposes of the plan is to, as it were, ‘freeze’ the value of an asset of the settlor at its value at the date the trust is set up, whilst ensuring any future growth in the asset occurs in the trust and thus outside the settlor’s own estate.
Classic loan trust
A classic example of such a plan is for the trustees to use the proceeds from the loan to invest in a single premium bond. A single premium bond is in essence an investment, but one which contains a small life insurance element on multiple lives insured (excluding the settlor and spouse). Thus, on the death of the settlor or spouse, no tax consequences arise.
Over time, the bond’s value increases but, as mentioned above, none of this growth falls within the settlor’s estate, in which case IHT on the settlor’s estate is avoided to this extent. Of course, the loan itself is repayable and its nominal value will still form part of the settlor’s estate on death.
Why a single premium bond?
There is no necessity for the trustees to utilise the loan proceeds to purchase a single premium bond; any asset may be acquired.
One of the main reasons for the single premium bond option is that, technically, any income of the trust is treated as that of the settlor who is then subject to income tax at his marginal rate of income tax on such income. However, the single premium bond produces no income and hence the imputation of any trust income to the settlor simply does not arise.
The trustees also have the option to make partial repayments of the loan to the settlor tax effectively by utilising the 5% withdrawal facility available under the terms of the bond.
Type of trust
The type of trust used may be adopted to the settlor’s particular circumstances (e.g. a discretionary trust; a life interest trust). However, irrespective of which trust may be adopted, the trust will fall to be treated for IHT purposes as a so-called ‘relevant property’ trust; this means that the trust itself will be subject to ten-year charges which are likely to be minimal (in particular, if the trust benefits from a nil rate band).
If and when appropriate, the trustees may appoint the bond out to the trust beneficiaries to enable them to encash the bond, reducing any income tax charges on the gain made.
There can be no guarantee that the value of a bond will, in fact, increase over time as it is, of course, in essence, a pure investment (despite the life insurance element). Independent financial advice should therefore be obtained.
This article was first printed in Tax Insider in November 2018.