Estate Planning - So Far, So Good!

JOHN WOOLLEY LLB, FCII, FTII   of Technical Connection provides an update on insurance-based tax planning.

THERE HAS BEEN a number of important developments recently with regard to insurance based inheritance tax planning and this article is therefore intended to provide an update on the current position.

Spousal interest trusts

A popular arrangement involves an investor putting funds into an investment bond subject to an interest in possession trust under which his wife (for a male investor) has the initial interest in possession and the trustees have a power to appoint to a wide range of discretionary beneficiaries (including the settlor). After a suitable period of time, the trustees make an appointment so that the settlor's children are given the interest in possession (resulting in a potentially exempt transfer from the wife to the children).

It is claimed that such an arrangement does not amount to a gift with reservation because of the exemption in section 102(5)(a), Finance Act 1986, i.e. where there is a disposal by way of gift which constitutes an exempt transfer to a spouse, a gift with reservation cannot arise. Furthermore, the view was generally held that the question whether the gift constitutes an exempt transfer must be determined once and for all at the date of the gift, the period during which it can be enjoyed by the spouse being irrelevant.

The fact that the spouse is given an interest in possession for six months only and the trustees thereafter hold the gifted trust fund (for example) on discretionary trusts for both spouses is irrelevant because the section 102(5)(a) exemption will save the gift when it is made.

The Revenue's Capital Taxes Office previously stated that it will take the view that there is a gift with reservation in such a case on the basis that the section 102(5)(a) exemption does not fully cover the gift. This is because the initial gift comprises two gifts - a gift partly to the spouse (interest in possession) and another gift partly to the reversionary beneficiaries (including the settlor). The latter gift constitutes a gift with reservation even though the inheritance tax rules treat the transfer of value as being from husband to wife.

However, they introduced a more potent argument recently in the High Court (see below). This was that in construing section 102(5)(a), one should consider the date of death of the settlor rather than the date of the settlement. This is because in determining whether there is a gift with reservation, one always looks back at the seven-year period before the donor's death.

Therefore, in determining whether the exemption in section 102(5)(a) applied, it was necessary to see if the spouse exemption applied to the gift at the date of the settlor's death.

The Capital Taxes Office has made this claim on some of the trusts based on this planning principle and one such scheme, which involves a trust holding a private residence, was taken before the Special Commissioners almost a year ago. The Special Commissioner found that for the purposes of section 102(5), the relevant date to determine whether the spouse exemption applies is the date of the settlement.

The case, known as Commissioners of Inland Revenue v Eversden and another, went on appeal to the High Court and is reported at [2002] STC 1109. Mr Justice Lightman upheld the Special Commissioner's decision and said that the language of section 102(5) looks at the disposal at the date on which it is made and its character (as a transfer between spouses) must be determined as at that date. If the gift answers that character at that date, the gift with reservation provisions have no application.

Mr Justice Lightman's finding that section 102(5)(a), Finance Act 1986 will save this type of arrangement from being a gift with reservation reflects the views of the majority of tax practitioners. It also seems a sensible interpretation as, presumably, on the husband's death 95 per cent of the trust fund (5 per cent of the trust fund was held for the settlor's absolute benefit - see below) had already been included in his taxable estate by virtue of his interest in possession.

Distinguishing factors

Although this is very encouraging news for those schemes founded on this principle, it should be borne in mind that the case is not on 'all fours' with the typical insurance company scheme. To begin with, in the Eversden case the settlor kept back a 5 per cent interest in the settled property. Also, after establishment of the trust, no appointment away from the spouse with the life interest was made. (Indeed such a power may not have existed under the trust at that time.) Instead, following the death of the settlor's spouse, the property passed onto discretionary trusts under which the settlor was a potential beneficiary. The Capital Taxes Office claimed that this amounted to a gift with reservation by the settlor and so the value of the trust fund should be included in the settlor's taxable estate on her death.

In the arrangement before the High Court, the spouse was given a life interest in the trust which comprised a house (and later a different house and an investment bond). The schemes used by life offices are geared towards an investment in an investment bond set up under a flexible trust (with the settlor a potential beneficiary) and the settlor's spouse the default beneficiary with the interest in possession. At a later date the children replace the spouse as default beneficiary.

Even though the facts of the Eversden case are slightly different, the principles are the same. Therefore for the reasons given in the High Court judgment, the gift with reservation rules should not apply to this trust, even though the spouse's interest only lasts for a reasonably short period.

The outlook

Whilst this decision is encouraging, this might not be the end of the matter. The Inland Revenue has applied for leave to appeal and if this is granted (which is likely) then, with considerable tax at stake, it may be some time before a decision is made as to whether such an arrangement involves a gift with reservation which is not wholly saved by section 102(5)(a). The case is unlikely to be heard in the Appeal Court until 2003.

The decision to appeal probably indicates an intention by the Inland Revenue to take the case all the way to the House of Lords if necessary although, given the rejection of the Inland Revenue's argument on the central point by both the Special Commissioner and the High Court, it is hard to see at this stage why the higher courts would reach any other conclusion.

If the Inland Revenue does succeed in the higher courts, it would, of course, mean that any existing settlements relying on the Eversden decision in the High Court would fail to achieve their objective.

Therefore, advisers considering using this type of plan for clients must carefully bear in mind that the whole planning principle underlying spousal interest trusts is currently under review in the courts.

If the taxpayer continues to be successful in the courts, the Revenue is left with the option of introducing amending legislation. It can, of course, do this concurrently with the current court action, but it seems more likely that it will first exhaust the legal process. The general rule is that tax legislation is not applied retrospectively (and there would now be a strong human rights argument if any Government ever attempted to do so) and planning implemented before any change in legislation would therefore be unaffected.

If the Revenue loses the appeal (or is not given leave to appeal), then it may well seek to change the law - possibly, depending on when the appeal process finishes, in the 2003 Budget. On the basis that one takes the view that any such change will not be retrospective (which is normally the case), this would mean that planning using this type of scheme may well be an effective way of overcoming the gift with reservation provisions. However, it would be important that all of the steps in the planning were completed before any change in law. And when considering this, it is clearly also important to avoid the whole arrangement being caught by the Ramsay principle (as modified by later court decisions such as that of the House of Lords in MacNiven v Westmoreland Investments [2001] STC 237).

In order to avoid such an argument, it would make sense to ensure that the spouse's interest had some economic value by ensuring she actually became entitled to income or by paying some benefit to her which arises by virtue of her being the life tenant (i.e. there may be a power to appoint capital to her).

Other important aspects to remember when using this type of planning is to:

• invest only funds belonging exclusively to the settlor, the person creating the settlement;
• appoint a truly independent trustee;
• ensure that the trustees exercise a truly independent view as to whether to appoint benefits. In particular, a reasonable period should elapse before the trustees consider if the spouse's interest should be terminated in favour of other beneficiaries and the trustees should consider all relevant financial and other circumstances before exercising this power.

Worst case scenario

What would be the position as regards existing plans if the Revenue were successful in the Appeal Courts? In those circumstances, it may well be possible for the trustees to appoint the trust fund irrevocably and absolutely to the settlor. All of the trust fund would then be back in his estate but no transfer of value should arise because of the reverter to settlor exemption (in the case of interest in possession trusts). The settlor could then consider some other form of lump sum inheritance tax plan. Alternatively, if the settlor was happy that he required no further benefits from the trust, (which may be unlikely given that this is one of the attractions of the scheme), he could release his beneficial interest. This may well give rise to a potentially exempt transfer based on the value of the trust fund at that time (being a release of a reservation of benefit).

Discounted gift plans

There is a number of different varieties of discounted gift plan.

One scheme takes the form of a lump sum investment into a whole of life policy that is effected as a number of small identical policies. Under the terms of the trust, the settlor will become entitled to trust funds containing one or more policies on consecutive policy anniversaries, known as 'entitlement dates'. Should the settlor not want to become entitled to benefits on these dates, there is a deferral facility whereby the settlor can postpone the date on which he will become entitled.

There has been some concern as to the view of the Capital Taxes Office about this type of plan (and particularly the deferral facility) but, encouragingly, it has now confirmed to one office that it currently takes the view that it would not apply the gift with reservation provisions to that office's plan.

In another development, the Capital Taxes Office raised a question over whether a value should be placed on the reversionary interests in the settlor's estate on his death. This was somewhat surprising given that previously the Inland Revenue had taken the view that no amount should be so included, on the basis that a reversionary interest in these circumstances would have no market value immediately before the investor's death. It seems that the Capital Taxes Office may now have reinstated its previous view on this.

Capital redemption bonds

One simpler yet effective type of plan that seeks to avoid the wide anti-avoidance provisions in paragraph 7 of Schedule 20 to the Finance Act 1986 is that involving a capital redemption policy. This type of policy does not link any payment to a person's death, so that there is no life assured.

The rationale here is that as a capital redemption policy is not a policy of insurance, it cannot be caught by paragraph 7 (which deals with insurance arrangements in which the donee's benefits vary by reference to the benefits accruing to the donor or his spouse). The Capital Taxes Office has confirmed this to at least one life office. To be successful, such plans would also of course need to avoid the gift with reservation of benefit provisions.

However, the Financial Institutions Division of the Inland Revenue contended that the so-called 'capital redemption policy' with an offshore life office more properly amounted to an offshore annuity, which would mean income payments could be subject to income tax as annuity payments.

To test this position, a case (Sugden v Kent [2001] STC (SCD) 158) went before the Special Commissioners who rejected the Revenue's argument and thought that the policy should be subject to the normal chargeable event legislation that applies to capital redemption policies. In other words, payments made out of the bond will be subject to the normal 5 per cent annual withdrawal rule.

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