Planning For The Future -- II

JOHN WOOLLEY LLB, FCII, FTII of Technical Connection completes his round-up of the insurance-based products available to the tax planner.

The first instalment of this article, published in last week's issue of Taxation examined lump sum plans, spousal interest trusts (based on a trust arrangement which has been adapted by the life insurance industry for its products) and discounted gift schemes. This week's instalment concludes the subject with a summary of two more life assurance based strategies for the tax planner.

Gift and loan (and loan only) schemes

Gift and loan schemes are probably the most well-known form of lump sum inheritance tax planning. They have been used successfully for a number of years by a number of offices. Readers will be familiar with the way in which gift and loan schemes operate but, in very brief terms, the investor (as settlor) will normally establish a trust for the benefit of his children. While a flexible trust can be used, it will clearly not be appropriate for the settlor to be a potential beneficiary under this trust. In some cases, the trust is established by the transfer of a sum of money, and in others by a mere declaration with the trust becoming fully constituted when property is transferred to the trustees by way of loan (see below).

The settlor then grants an interest-free loan repayable on demand to the trustees who use this money to invest in a capital investment bond normally on the lives of the named beneficiaries of the trust. From time to time the settlor will demand repayment of part of the loan and, to finance this, the trustees will make a part surrender of the bond – normally within their five per cent withdrawal entitlement. As the settlor receives loan repayments and spends them, so his taxable estate will gradually reduce.

There are anti-avoidance rules that apply to combat the use of loans to overcome the gift with reservation provisions. One, paragraph 5(4) of Schedule 20 to the Finance Act 1986, applies to attack arrangements whereby an individual makes a loan to a settlement that itself had given rise to a gift with reservation. In these circumstances, the property derived from the loan will also be regarded as being part of the gift with reservation. In the gift and loan schemes available in the market place it is not thought that this provision will apply either because the trust used is a bare trust (and is therefore not a settlement for inheritance tax) or the settlor is excluded from benefit under the trust and the initial gift (if there is one) is ringfenced, so that the trustees cannot access it to make loan repayments to the settlor. In either case, there would then be no gift with reservation to begin with. A further means of avoiding this provision would, however, be for the arrangement to be established without an initial gift, i.e. the settlor promising to make a loan to the trustees, the receipt of which (or property representing it) will fully constitute the trust.

But what are the tax implications of an interest-free loan repayable on demand in itself? Could this be a gift with reservation? For a long time the majority of tax advisers considered that although an interest-free loan repayable on demand could be a gift, it could not be a gift with reservation because it was impossible to identify the property gifted and indeed determine what the benefit of the gift was; to be a 'gift with reservation' there needs to be a 'disposal of property by way of gift' to start with.

The story so far

A few years ago, the Revenue took this further and argued that an interest-free loan repayable on demand was a gift of the future income given up on the monetary loan (on the basis that there was no prospect of the lender demanding immediate repayment) and that the right to receive loan repayments was a benefit to the lender. Putting these two points together, it argued that there was a gift with reservation of benefit.

This view was refuted by legal arguments on the basis that, first, there was no gift element for inheritance tax on an interest-free loan because the prospect of interest or income given up on a monetary loan was not 'property' for the purposes of section 272, Inheritance Tax Act 1984. Nobody in advance could determine precisely what this would or might be. Second, it was inherent in the nature of a loan that the loan should be repayable and therefore this gave no benefit to the lender.

The Capital Taxes Office accepted these arguments and since then, as the terrace chant goes, 'it's all gone quiet over there'. Having taken advice from its solicitor on this matter, it would be strange if the Revenue were to resurrect these arguments again especially against a scheme which involves no immediate inheritance tax saving and is thought by many to be one of the least contentious type of scheme available.

The pros and cons

Coming back therefore to the main advantages of the gift and loan (and loan only) schemes, these would be as follows:

• growth in value of the investment made is free of inheritance tax, basically estate freezing has been achieved;
• as loan repayments are received by the settlor and spent by him, the value of his taxable estate reduces;
• loan repayments to the settlor will be treated as a return of capital and not be subject to income tax thus giving him tax free cash, possibly on a regular basis;
• the settlor can access any of the outstanding loan at any time by demanding a loan repayment;
• the policy can be effected on a joint lives last survivor basis on the lives of the beneficiaries and therefore more control can exist over the timing of any chargeable event arising on encashment.

There are some drawbacks to the gift and loan scheme, as follows:

• Once all the loan has been repaid to the settlor he effectively runs out of 'income'. This is a very important point to consider at outset in determining the amount of loan made to the trust and the size and period over which loan repayments should be made. It should be noted that after the settlor's death, if a flexible trust is used, the trustees could make appointments to a surviving spouse without this having adverse inheritance tax implications.
• The scheme achieves no immediate inheritance tax saving. It relies on the settlor living for a reasonable period, so that inheritance tax free investment growth can accrue. If a bigger gift is made to establish the scheme, this will normally be a potentially exempt transfer and fall outside the taxable estate on the settlor's survival for seven years. The trustees should not have access to this gift to make loan repayments.
• In the event of the settlor's death shortly after effecting the scheme, little inheritance tax saving would be achieved. In addition, the settlor's personal representatives would usually have to call for repayment of the loan which would then mean that the trustees would have to encash the capital investment bond with possible income tax implications. To avoid the possible adverse consequences of this, the settlor could, under his will, consider leaving his rights to loan repayments to another beneficiary, typically his surviving spouse. The trustees could then continue to make loan repayments to this person who inherits the loan without the need to fully encash the bond. Effectively the whole scheme would then continue to operate throughout the joint lives of a couple, continuing throughout the lifetime of the surviving spouse. Although the outstanding loan would form part of the settlor's estate on his death, if this did pass to his surviving spouse it would be covered by the spouse exemption.

In general, the gift and loan (or loan only) scheme is a good solution for persons in their sixties and early seventies who want a long-term flexible solution to inheritance tax planning.

Retained interest trust

The retained interest trust is a special trust which applies to a capital investment bond investment. The trust is divided into two parts: the donor's fund and the gifted fund. At outset the settlor specifies, in percentage terms, how much of the trust fund will be held for his benefit in the donor's fund and how much will be held for the gifted fund. Under the terms of the donor's fund the settlor is absolutely entitled to benefit. The gifted fund resembles a flexible power of appointment interest in possession trust under which the settlor is not a potential beneficiary but whose spouse can be. The settlor's children would be the named default beneficiaries. As the settlor's entitlement (the donor's fund) is carved out for his absolute benefit, the general gift with reservation rules should not apply. Furthermore, paragraph 7 of Schedule 20 to the Finance Act 1986 should not apply because any variation of rights between donor and donee occurs under the terms of the trust and not the terms of the policy. Further protection on this point can be included if required.

So, for example, if an investor was investing £100,000 into such an arrangement he may choose from the outset to hold 50 per cent of this for the benefit of the donor's fund and 50 per cent for the gifted fund. On day 1, ignoring charges, the value of the donor's fund would be £50,000 and the value of the gifted fund £50,000. However, it is important to note that future investment growth would apply proportionately across these two funds according to their respective values at that time, in particular taking account of any withdrawals made for the donor's benefit.

As and when the settlor requires benefits from his plan, the trustees can make a part surrender and pay this to him as an advancement of his capital entitlement under the donor's fund. It is in this area that the particular attraction of this plan applies because when making the part surrender the trustees can base their five per cent withdrawal on the initial premium paid to the plan i.e., in the above example £100,000. So, for example, if the trustees took a £5,000 withdrawal, they would then pay this out in part satisfaction of the donor's entitlement to the donor's fund and so, ignoring any growth on the plan and the initial entitlement assumed above, his outstanding capital entitlement would then reduce to £45,000. While the donor has some capital entitlement under the trust, the trustees can take withdrawals and make payments of up to his entitlement to him.

The advantages of the plan are as follows:

• When the settlor establishes the plan, he makes a potentially exempt transfer (equal to the amount passing to the gifted fund) and after his survival for seven years this potentially exempt transfer will drop out of account totally.
• Any growth in value of the gifted fund is outside of his taxable estate for inheritance tax purposes.
• The settlor can enjoy regular tax-free payments as advancements of his capital entitlement to the donor's fund and in financing these payments the trustees can base the 5 per cent withdrawal on the initial premium into the policy.
• The policy can be effected on a joint lives last survivor basis on the lives of children thus giving the trustees the ability to defer the actual date of final encashment to produce the best income tax results.
• The settlor's spouse can be a potential beneficiary under the gifted part of the trust so she can receive benefits from the trust after the settlor's death without inheritance tax problems. It is not recommended that payments are made to the settlor's spouse during the settlor's lifetime as an indirect gift with reservation could then occur.

The disadvantages of this particular plan are that:

• in terms of his entitlement to 'income', the settlor is very reliant on investment returns. Should investment returns be poor, the payment of his capital entitlement under the trust could significantly use up his entitlement and could mean that he runs out of 'income' quite early on, especially when the percentage return he is taking from his fund is quite high;
• any growth in the value of capital investment bonds which is attributable to the donor's fund will fall within his taxable estate for inheritance tax purposes.

Subject to these points, this plan can be quite effective. Certainly it is very simple, although actuarial calculations and systems procedures are required to monitor the precise value of the bond attributable to the donor's fund, taking account of investment growth and withdrawals made, and the gifted fund. It is probably most appropriate for people in their sixties or early seventies who want some flexibility over access to capital should circumstances change.

The right objectives

We have the likelihood of a settled inheritance tax régime over at least the next 12 months and so this is an appropriate time to consider some of the attractive lump sum inheritance tax plans available. The key to ensuring that the right plan or combination of plans is effected by any particular investor is the adviser understanding fully how each plan works, understanding the requirements of the client and then selecting the right plan to achieve the client's objectives. Well informed advice is essential.

John Woolley is a partner in Technical Connection which produces an analysis of inheritance tax plans. It can be contacted at 7 Staple Inn, London WC1V 7QH, and can be contacted on 020 7405 1600; e-mail: host@techlink.co.uk.

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