Feature

posted 6 Feb 2002 in Volume 7 Issue 2

Having your cake and eating it - investment products and IHT planning

There are a number of insurance products currently in the marketplace that centre around the idea of the investor giving away a cash sum but continuing to benefit from the funds, allegedly without inheritance or other tax problems. Emma Chamberlain, a barrister at 5 Stone Buildings, considers some of the options available. In particular, Emma discusses the inheritance tax schemes involving non-qualifying life assurance policies - typically the single premium investment bond.

I do not discuss here the more standard use of insurance products which is to provide a lump sum on the death of a life assured to pay his inheritance tax liability. However, I should mention that such life policies must be written on trust for the beneficiaries of the estate in order to avoid the proceeds forming part of the deceased’s estate (it is surprising how many such policies are not). In addition, it is important that any such life cover taken out should be appropriate to the needs of the client. There is no point in paying for expensive whole life cover if all one needs is decreasing 7 year term to cover a gift inter vivos. Similarly, if one wants to have a fund to pay the inheritance tax due on the last spouse to die, ensure that the cover is on a joint life survivor basis, that the policy proceeds are written in trust and that the trustees are persons who will be alive on the last death.

I turn now to the insurance bond products.

Reservation of benefit: the inheritance tax position .

The usual problem with the “have your cake and eat it” type of investments is, of course, reservation of benefit. How do the investment bond schemes which allow the investor access to income/capital, get round this?

The current gift with reservation (GWR) rules were enacted in 1986 when capital transfer tax was replaced by inheritance tax. The existing provisions are contained in Finance Act 1986 (Section 102 and Schedule 20). In fact the GWR rules are similar to those which were enacted for estate duty purposes prior to the introduction of capital transfer tax.

The GWR rules are intended to prevent the avoidance of inheritance tax on death when a donor gives away property but continues to enjoy some benefit from it, in other words he has his cake and eats it. The GWR rules apply to a gift if either one of two conditions is not satisfied. Either the donee of the gift does not take up genuine or “bona fide” possession of the gifted asset at or before the relevant period (being the period ending on the donor's death and starting seven years before that date or if it is later on the date of the gift); or at any time in that relevant period the asset is not enjoyed to the entire or virtually to the entire, exclusion of the donor. If the GWR rules apply, the result is that the property remains part of the donor’s estate for inheritance tax purposes (although not for any other tax or property law purposes).

The GWR rules can apply where the donor is entitled to benefit from a gift whether or not any benefit is actually taken or where the donor actually receives some benefit under some informal arrangement with the donee. However, the old estate duty cases established that in applying GWR rules, one first had to decide what was actually being given away and that this could in some circumstances be less than the donor’s entire interest in the property in question. See Munro v Comr of Stamp Duties of New South Wales [1934] AC 61, PC. Re Cochrane 1906 and Commissioner of Stamp Duties v Perpetual trustees Co 1943 AC 425.

These “shearing” or carve out exercises could be applied in a number of circumstances, given the sophisticated nature of English property law by which, as Lord Hoffmann notes in his leading judgement in Ingram and another v IRC [1999] STC 37, “various interests each regarded as separate items of property can subsist simultaneously in respect of the same land”. Thus in the case of Ingram the donor carved out a leasehold interest and then gave away the freehold. What she gave away was the freehold reversion subject to the pre-existing leasehold and therefore it was held that here there was a successful carve out rather than a reservation of benefit. The real nature of the transaction was that the trustees and beneficiaries never at any time acquired the land free of Lady Ingram’s leasehold interest. Thus in a similar way, the idea is that if the donor can give away an investment product such as a bond into trust but carve out certain prior rights allowing him defined levels of income before the gift is made, this is a carve out not a ROB.[1]

In fact, most trusts established for inheritance tax purposes usually exclude the donor from any benefit. It is not, however, necessary to exclude the donor’s spouse from benefit in order to avoid a reservation of benefit problem and as we will see, this let out is exploited in some of the bond schemes.

Income tax and capital gains tax position

It is also important to realise that if either the settlor or his spouse can benefit from the trust in any circumstances (known as settlor interested trusts), then various anti-avoidance legislation will generally result in all the trust income and gains being taxed on the settlor whether or not he actually receives any capital or income. For this reason, it is usual for most trust documents to exclude both the settlor and his spouse from any possibility of benefiting. It is also necessary to exclude the possibility of making loans or repaying loans to the settlor or his spouse because this can cause other income tax problems. It is not necessary to exclude the settlor’s widow from any benefit.

Investment products

How then do the insurance based bonds work where the settlor and spouse can apparently retain interests in a trust without adverse tax consequences?

Most of these bond products involve some type of single premium non-qualifying endowment policy. The initial minimum sums invested are often quite high - £50,000 is not untypical. Thus the client must first have a reasonable amount of cash available to make the investment worthwhile and this in itself may necessitate the client realising other investments in order to produce that level of cash. These sorts of schemes are not generally suitable for clients who will realise large capital gains tax liabilities when encashing other investments in order to get into the bond.

Another point is that the commissions and other charges for going into these investments and indeed in subsequent years are not insignificant. In addition, where a client has a substantial number of his investments in a tax free environment such as PEPs and ISAs, going into the bond environment may well be more adverse income tax wise. He will be limited then to his 5 per cent “tax free” withdrawal. If withdrawals exceed 5 per cent of the premium paid then there is a higher rate income tax charge on the excess subject to top-slicing relief. In addition, the life assurance company, unless based abroad, usually pays tax on the relevant underlying profits currently at the rate of 22 per cent.

However, the 5 per cent tax free withdrawal facility can be very useful when non-qualifying policies are used in conjunction with settlor interested trusts. There is no other trust income produced on which the settlor can be taxed and provided the encashments do not exceed 5 per cent the settlor has no income tax or capital gains tax charge. Thus the fact that the settlor can benefit from the trust does not in practice cause income tax or capital gains tax problems provided the withdrawals are limited to 5 per cent of the initial premium paid. Compliance is also relatively easy.

There are a number of different types of schemes and this article can necessarily only give a brief survey of some options.

Spousal interest trust. Here the donor, say the husband, effects a capital investment bond which is written on interest in possession trusts under which his wife is entitled to the interest in possession. The settlor is among the class of potential beneficiaries. Say six months later the trustees exercise their powers of appointment to terminate her interest in possession in favour of the settlor’s children who take interests in possession. The wife can no longer benefit and is treated as having made a PET when her interest in possession is ended by the trustees. If she survives seven years the initial value of the bond falls outside her estate for inheritance tax purposes. Any growth in the bond should also fall outside the couple’s estate for inheritance tax purposes whether or not she survives seven years.

The husband can continue to benefit and from time to time the Trustees use their five per cent withdrawal facility to make partial encashments from the bond and appoint such capital out to the settlor. Provided the encashments do not exceed five per cent, there is no income tax charge on the settlor.

The idea behind this scheme is that the GWR provisions are avoided due to the initial gift being to the settlor’s spouse. Therefore section 102(5)(a) FA 1986 arguably applies which says that to the extent any gift is covered by the spouse exemption then no GWR will occur.

There have been concerns that the Capital Taxes Office has not accepted this analysis and do in fact argue that there is a reservation of benefit. This is on the basis that there is not just one gift covered by the spouse exemption but a number of gifts inherent in the arrangements. However, the Special Commissioners have just held in the case of Somerset (deceased) v CIR SpC 296 that there was only one gift and it was covered by the spouse exemption so no ROB could apply. At the time of writing it therefore appears that this scheme is effective for inheritance tax purposes although it is important to ensure that the spouse does take a genuine interest in possession and receives some benefit in the initial period when she has an interest in possession. It is not known if the CTO will appeal this decision but even if they do not do so, it may well be that there is a change in the rules in the March Budget.

Of course any income or gains arising in the trust will be taxable throughout on the settlor, but as noted above, the aim is that the trust investment will simply comprise the bond product and therefore any “income” is limited to the tax free withdrawals. Of course if for any reason (such as poor investment performance) the bond is later surrendered, there could be a substantial income tax charge on the settlor.

This scheme (if the rules are not changed by the Budget) may be useful if the settlor is elderly and perhaps the spouse much younger. Then effectively one is using the spouse’s better life expectancy rather than the settlor’s. This is preferable given the seven year run off period for PETS.

Gift and loan scheme. Here the investor as settlor sets up a trust for the benefit of his children. He cannot benefit from the trust. The settlor then grants an interest free loan repayable on demand to the trustees who use this money to invest in a bond normally written on the lives of the named beneficiaries under the trust. The idea is that the loan is not a diminution in the settlor’s estate and therefore effectively no transfer of value has been made under this arrangement at all.

From time to time, the settlor demands repayment of part of the loan and to finance this the trustees will make a part surrender of the bond within their five per cent entitlement. Normally repayment of loans to a settlor can cause income tax problems for the settlor, but as before the idea is that the trust “income” is restricted to the five per cent withdrawal, at least while the settlor is alive.

As the settlor receives loan repayments and spends them, his taxable estate will reduce and the growth in value of the bond will be outside his estate. He can ask for the whole of the loan back at any time although this may trigger income tax charges if the bond has grown in value since the trustees will be forced to encash the bond.

The trust and loan documentation has to be drafted carefully to ensure that it does not breach any anti-avoidance legislation. And this is of course only an estate freezing exercise. There is no immediate inheritance tax benefit because the loan still forms part of the settlor’s estate for inheritance tax purposes. It is the growth in value of the investment product which will be outside his estate for inheritance tax purposes.

The inheritance tax planning is rather inflexible. The settlor may not in fact need repayment of the entire loan but it will still form part of his estate. Alternatively, he may end up needing some of the capital growth in the bond as well but cannot get access to this. Or the client may want to be repaid on the loan at a faster rate than five per cent of the initial premium each year. Calling for repayment at a faster rate than five per cent could, as noted above, generate income tax charges. Many clients might also feel unhappy in this economic climate about basing their inheritance tax planning on the idea that investment products they take out really will grow in value in the future!

If the settlor dies shortly after the product is taken out then some thought needs to be given as to what happens regarding this loan. One would want to avoid a situation where the loan is automatically called in by his executors because this will result in the trustees being forced to encash the bond early. This could be expensive in terms of tax and commission charges. To avoid this, the settlor could leave his right to receive loan repayments to another beneficiary under his will e.g. his spouse. If he leaves the benefit of the loan back to the trust then this will be a chargeable transfer under the terms of his Will and (even if it does not jeopardise the inheritance tax planning) may result in unnecessary tax charges if his nil rate band has already been utilised.

This type of scheme tends to be suitable for the person in their sixties who wants some regular income but is likely to survive for a reasonable period. It does not tend to be suitable for the more elderly client since if they die shortly after taking out the investment bonds there will have been little inheritance tax saving, the funds will have been invested for the benefit of the family in a bond (which the beneficiaries may now want to encash) and there will be all the commission charges etc. The scheme is really for those who see it lasting for a reasonable period to allow sufficient growth in the bond. In addition, since it is only an estate freezing exercise one questions whether one could not achieve exactly the same effect by simply making annual gifts to one’s beneficiaries equal to the capital appreciation over that year on one’s assets.

Trust carve out There are many varieties on the carrveout idea described in the introduction. For example, in some the client takes out a cluster of single premium non-qualifying endowment life assurance policies maturing at regular intervals. The policies are assigned by the settlor to a trust. The terms of the trust provide that the settlor can take if living at the maturity date but otherwise he has no interest in the policy. He cannot benefit in any other circumstances. The trustees but not the settlor have the option of deferring the maturity date and can surrender the policies at any time. In either event the settlor receives nothing. He can only receive anything if the policy actually matures.

The beneficiaries of the trust are usually his children who take immediate vested interests in possession. The idea is that if the settlor requires some income, then the trustees will let a policy mature and he will take the proceeds. If he does not require income, the policy is extended by the trustees and the settlor receives nothing. The argument is that the settlor has 'carved out' or retained a reversionary interest under the trust, but this interest is liable to be defeated in a number of ways by the exercise of powers vested in the trustees. Therefore although the retained reversionary interest is not excluded property (see section 48(1)(b) IHTA 1984), it has little or no value. The beneficiaries take the benefit of an insurance policy which is shorn of a reversionary interest under the trust retained by the settlor.

The CTO appears to accept that the retention by the settlor of a reversionary interest under a trust is not a ROB (see letter to the Law Society dated 18 May 1987). The settlor has retained actual property rather than reserved a benefit in the policy gifted. His rights (to receive the policy proceeds if he is alive at the maturity date and if the trustees do not exercise certain powers) are established from the outset. It is not thought that this scheme breaches the anti-avoidance provisions governing life assurance in para 7 of Schedule 20 FA 1986.

There is some question as to whether the CTO may argue that the effecting of the bond, the assignment into trust and the extension of the maturity date are associated operations giving rise to a chargeable transfer at the date of the last operation i.e. the extension date. Thus there is arguably a further transfer of value then although previous transfers are deductible in valuing this. For example, the premium paid is £30,000. At the date of extension, the bond is worth £40,000. The transfer of value is £10,000.

The policy documentation should be drafted so that the (assignee) Trustees not the assignor have the right to extend the maturity date and there are a number of other points to watch concerning the policy provisions.

In addition, there is a potential double inheritance tax charge if the settlor dies within seven years of settling the property but in that time has received the policy proceeds back on maturity. The Double Charges Regulations would not appear strictly to give relief in this situation.

Discounted gift schemes There are also a number of schemes combining a carve out with a discounted gift idea. Under this route, the settlor broadly retains from the outset certain rights in the trust which add up to more than just a reversionary interest.

The trust is often split into two defined parts with certain rights (for example, the right to withdraw a specified amount each year) belonging to the settlor outright and the other part being called the residuary fund and held on trust for the residuary beneficiaries. These latter persons do not include the settlor. When the settlor makes the investment he is retaining certain rights under the trust (e.g. the right to withdraw a specified amount each year) and therefore the loss to his estate is not the full capital value of the bond. The gift of the residuary fund is treated as less than the face value. The discount depends on the donor’s life expectancy. The longer he is likely to live and draw on the benefits, the greater the discount on the PET.

These schemes depend on the carve out and thus the nature of the settlor’s rights being sufficiently well defined. Again such schemes can be inflexible. It is often not possible to have a surrender of the policy during the settlor’s lifetime without jeopardising the inheritance tax advantages. The settlor’s rights by necessity have to be defined closely at the outset and so there is not the ability to reduce or increase levels of benefit easily at a later stage. There may be issues regarding FA 1986 schedule 20 para 7 and ROB if the documentation is not carefully drafted.

In addition, many of these products are using what are termed capital redemption policies rather than strictly life assurance backed products. A recent income tax case – Sugden v Kent Special Commisioners August 2001, although won by the taxpayer when the Revenue effectively tried to deny the five per cent tax free facility, suggests that the Revenue are looking closely at these products.

Conclusion

There is no easy way for the client to have his cake and eat it. However, in particular circumstances, particularly where the client has some surplus cash and knows fairly clearly the sort of level of benefits or income he will require in the future, insurance backed products may play a part. It is understood that although the Capital Taxes Office does accept that some of these schemes work for inheritance tax purposes, they nevertheless study the documentation very closely in all cases. So clients should be warned!

Emma Chamberlain is a barrister at 5 Stone Buildings Lincoln’s Inn specialising in tax and trust work. She can be contacted on 020 7242 6201 Email: emma@jmchamberlain.freeserve.co.uk

[1] The subsequent anti-avoidance legislation to counteract the Ingram decision which was introduced in FA 1999 was only targeted at gifts of land. Therefore shearing operations in relation to other assets are still possible.