Inheritance tax is becoming an increasing burden for international investors with UK links so it is vital that maximum use is made of the range of planning techniques and vehicles available
Individuals who are otherwise financially aware often fail to look at estate planning. Given that the overall yield from inheritance tax (IHT) in 2002 to 2003 was less than 2% of the total tax yield for the year at only £2,356bn it is not surprising that IHT is perceived as a tax only for the rich. However, it seems likely that more and more estates will fall into the tax net in the future, partly because of rising house prices and the difficulty in planning with this asset. It is also possible that the Inland Revenue increasingly will clamp down on IHT avoidance activities. Planning opportunities should therefore not be overlooked.
IHT is payable if someone"s taxable estate exceeds the nil rate band of £255,000. Where no planning is done during the person"s lifetime and they die with assets exceeding this limit then there is a potential exposure to the tax. However, the tax can be mitigated through lifetime planning, through insurance and through sheltering the estate in certain types of tax-favoured assets. In addition, passing assets to particular beneficiaries during lifetime may result in tax savings.
The possibility of mitigating tax through choosing particular recipients of wealth can be dealt with relatively quickly as this will be of limited interest to most people. Gifts to charities and to political parties would come within this category, but of course most individuals will wish that the bulk of their wealth passes to their loved ones.
There is an exemption for gifts made to UK domiciled husbands and wives. While this exemption is likely to be of far more interest, its use is limited. Any wealth passing to a spouse under this exemption and remaining in their hands will of course be taxed on the death of the second individual. Use of this exemption might delay but does not actually avoid tax. It is therefore significant where one spouse is in poor health and cannot undertake his or her own planning, or where it allows both spouses to take advantage of certain other exemptions, such as the annual gift allowance of £3,000.
Finally, in particularly wealthy families gifts might be made not to other individuals but to discretionary trust structures. This is relatively sophisticated planning necessitating the involvement of professional trustees but can allow tax to be paid at a lower rate than if wealth were cascading through the generations and being taxed on each death.
insuring tax liability
Insuring to pay a tax liability involves calculating the potential tax liability on the person"s estate and purchasing a life policy designed to pay out the amount required to meet this liability on death. The policy is written in trust so that tax is avoided on the proceeds, and the effect of this planning is that the individual"s estate pays the tax as normal, but this does not reduce the amount available for their beneficiaries. If cover can be acquired at a reasonable cost this type of planning might be attractive, since it allows the individual freedom to enjoy their assets as they wish during their lifetimes - no restrictive planning is required.
Sheltering assets in tax-favoured investments is another possible approach. This involves taking advantage of the generous reliefs available for business property and agricultural property. Property qualifying for Business Property Relief (BPR) may be the more appropriate choice for a passive investor, since this is potentially available at 100% on business property that has been owned for a two-year qualifying period.
Business property includes shares in AIM listed trading companies, and portfolio structuring in this area is understandably popular. The amount of property that can qualify for relief under these reliefs is currently unlimited. This means that a wealthy individual with an appropriate risk profile could invest all of their wealth in excess of the IHT nil rate band in such property, undertake no lifetime planning, have unrestricted access, yet still die with no IHT liability.
There are two problems in relying on this approach. The first is that not everyone can hold all of their assets in this form. The second is that this is a relief that could be the target for future reform. While it may be true to say that the tax system favours involvement in business, the changes in CGT that happened when retirement relief was abolished and replaced by the very generous business taper relief system might be seen as a foretaste of how the IHT regime could change.
Whereas under retirement relief it was possible for gains to be totally excluded from tax within certain limits, under the business taper regime the gain remains in tax, albeit at a very reduced rate. A similar approach could be taken with IHT, or it could be that reform might put an overall financial cap on the amount that could be claimed by one person. It has been standard professional advice for some years now that reliance should not be placed on the continuation of the existing uncapped relief for planning purposes.
Where none of these opportunities are to be utilised the individual"s remaining option will be to consider taking planning steps during their lifetime. This could involve drafting a tax efficient will and this will involve considering the making of lifetime gifts.
Drafting a tax efficient will is essential where the person is married. This is because, as mentioned above, passing assets to the surviving spouse is generally tax exempt but leads to the aggregation of both estates on second death. This means that the advantage of one nil rate band of £255,000 is lost. The solution to this problem is that assets up to the nil rate band can be left to other, non-exempt beneficiaries with only the balance passing to the surviving spouse. This is often done via a will trust, and access as necessary for the surviving spouse can be built into the arrangement by making this person a potential beneficiary (though not the main beneficiary) of the trust.
Difficulties can arise in this type of will planning where insufficient liquid assets are held to allow full use of the nil rate band. At one time it was relatively common to consider putting a half share of a house into discretionary will trusts for nil rate band planning. This has fallen out of favour for two reasons. Firstly because this step causes a capital gains tax issue - the interest in the house that is held in trust no longer gets the benefit of main residence exemption. Secondly, because there are issues about whether the Revenue will accept the effectiveness of this planning. It has become more common to use IOU arrangements based on the house value as the trust asset in this situation, and specialist legal advice should be considered if this type of drafting is required.
Once the will has been sorted out, the next step would be to consider making lifetime gifts of assets. The individual might calculate how much capital can be gifted with no need for future access and gift this, maximising the exemptions of £3,000 per year and for gifts in consideration of marriage. Any balance might be gifted outright or into a trust for the expected beneficiaries, and this would be exempt if the person lives for seven years from the date of the gift or taxable on a death within that period.
While using exemptions the individual might also consider using the helpful exemption for gifts that are regular expenditure out of income. This can avoid the unhelpful build up of additional capital to be taxed at a later date. Finally, the individual will have to look at planning involving making gifts of capital to which access might be required in future. This is a difficult area, because any gifting will only be effective if the gift avoids the rule that a gift will not be IHT effective if the person retains any benefit from the assets gifted.
There are packaged solutions available involving making gifts into trusts from which capital will be returned at fixed future dates. Care should be taken in using such schemes because the Revenue attitude to them may well be to challenge their effectiveness. One planning scheme to bypass the gift with reservation rules, which was widely used, has been under challenge in the Eversden case, and was halted by the 2003 Finance Act. In the current climate other schemes can expect to be looked at in detail, and sensible advice would be to ensure that any arrangements that appear to be aggressive are based on solid analysis of the tax legislation.
To conclude, IHT is likely to be a growing burden, and it is important to make maximum use of the planning possibilities that are currently available. Planning will generally involve a variety of techniques, and it is important to bear in mind when choosing which to use that this is a climate that is becoming more aggressive.
Increasing house prices and a potential clampdown in avoidance activities means more people are likely to face IHT liability.
There are a number of planning techniques that will mitigate IHT. These range from drafting an efficient will, to gifting, to insuring the potential IHT liability.
Use packaged solutions with caution as these are coming under increasing scrutiny by the UK Inland Revenue.
Speaking at PA360 North
Speaking at PA360 North
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