Chapter 12 - Planning using Investments

In Chapter 11 we looked at ways to delay or avoid tax using trusts. We now look at the use of investment-based plans (usually involving life insurance based plans) to help you cut the Inheritance Tax bill.

Loan-based plans

Loan-based plans are intended to stop your estate from growing by putting the income from your capital into trust, while leaving the capital available for you to spend. 

If you lend a sum of money to a trust and the trust puts the cash on deposit, you will always be owed the original sum and run no risk of loss. The interest will belong to the trust. Although the loan value stays in your estate for IHT proposes, the growth (i.e. the interest) is outside your estate from day one. The beneficiaries cannot get at the interest during your lifetime, so you cannot lose out. So for those who can’t afford to give away their capital but who could afford to lose the income, this is a good way to stop the IHT bill getting bigger.

A sensible investment for the trust is an investment bond as the bond avoids the need for a trust income tax return. An investment bond has the benefit of allowing payments of 5% a year for 20 years to be paid to the owner, without the payment of any tax. This 5% is treated as if it were the return of the original capital, so no tax falls due.

By taking advantage of these rules you could structure the arrangement to provide:

• An “income” of 5% a year for 20 years (after which you have had all your capital back).
• Full access at any time to your original investment less the “income” taken to date.
• All growth is outside your estate for IHT purposes.

A suitable trust would be normally supplied by the investment bond provider at little or no additional cost. 

Warning! If the investment falls the trustees are personally liable for the shortfall. Make sure appropriate steps are in place to cover this possibility.

Discounted gift schemes

For many people, an income is needed in later life while the capital is not needed. If the income and capital could be separated, and the capital given away but the income kept, this would be ideal for IHT. Unfortunately, as  we saw earlier, a gift which is not made fully is a “gift with reservation of benefit” and fails.

A discounted gift scheme gets round these rules by effectively splitting the gift into two quite separate parts. The settlor (the person setting up the trust) “carves out” rights to an “income”. Typically this might be achieved by keeping 5% a year for life.

The settlor has a life expectancy (which will be calculated by an actuary and confirmed by medical evidence from a doctor) and so a value can be placed on this stream of “income”. This stream is known as the settlor’s “reversionary interest”.

The remainder of the fund is the beneficiaries’ interest. Provided the settlor lives for 7 years after making the gift, no IHT is due on the death of the settlor.

Now here’s the clever bit! IHT is measured on the estate at death plus any gifts made in the seven years before death. A gift is measured not by what the recipient gets, but by how much the estate was reduced by the gift.

The value of the gift here is the amount put into the trust minus the reversionary interest.
(Suppose you had a life expectancy of 8 years and had carved out 5%  a year for life. You might argue that the value of this carve-out is 40%  i.e. 8 x 5%. So your gift is only worth 60% of its face value for IHT purposes. If you die early only 60% of your gift is taxed). 

This benefit for early deaths is valuable, but for every earlier-than-average-death there must be a later one so overall this sort of scheme  is presumably neutral. This is probably why HM Revenue and Customs do not seem to object to them at present. Their manuals refer to them so they are an accepted part of the tax planning environment.

It is unwise to set up these plans looking for a benefit on premature death as HM Revenue and Customs are likely to investigate every such case. Nevertheless the benefit on an unexpected premature death is considerable.

As HMRC will investigate early deaths, it is important to have medical evidence available as to the state of health when the plan is entered into.

In other words it is essential to have the ‘discount’ underwritten at the outset. Be wary of advisers trying to sell this scheme because of the discount (which is just a by product of, and not a reason for, setting up the plan). Also note that these schemes may not be used by the over 85s.

Finally the scheme should be approached with great caution. It is irreversible and gifts cannot be made to the beneficiaries before the settlor dies. The income of 5% is fixed for life and could rapidly lose purchasing power to inflation. The settlor can never regain control of their capital so if circumstances change (e.g. going into care) the scheme could cause a great deal of suffering.

Note that gifts over the nil-rate band may trigger lifetime tax changes. 

Flexible Reversionary Interest Trusts
(also known as “conveyor belt” trusts)

A small number of sophisticated plans are available which are more flexible than the discounted gift schemes and more effective than the loan trusts. These work by splitting up the trust investments into parcels, say 10 in total. Each year on a specific date, you (the settlor) have the right to one (and one only) of the parcels. The others are out of reach. Each year you decide whether or not to take none, part or all of your parcel. Anything you do not take is left on the “conveyor belt” and falls out of reach for another ten years. Next year the conveyor belt moves and another parcel becomes available. This provides great flexibility over the amount of “income” you can take each year.

At first sight this seems too good to be true and you would think these schemes would fall foul either of “Gift with Reservation of Benefit” rules or “Pre Owned Assets Tax” rules. However the schemes’ promoters say that they have Counsel’s opinion about the validity of their schemes and there are many thousands in existence.

A further major benefit is that you may make gifts out of the trust at any time and you only have to survive by the balance of the original seven years. For example, if you have it in mind to make a gift to your 16 year old grandson on his 21st birthday, you would have to survive until he was 28 (i.e. 7 years beyond his 21st birthday) for the gift to be IHT free. Using this scheme, you would only have to survive to his 23rd birthday for the gift to be IHT free.
A word of warning here, too. Only a minority of advisers are aware of these schemes so always ask about your adviser’s experience in this area.

At the time of writing there were three providers of these schemes and none distribute directly so you need to find an independent firm to help you. 

AIM and EIS schemes/portfolios

Certain shares quoted on the Alternative Investment Market (“AIM”) qualify for 100% Business Property Relief after being held for two years.

Similarly, some shares which qualify for Enterprise Investment Relief will also qualify for Business Property Relief.

It is possible to buy shares on the AIM which also qualify for EIS relief and these have the following additional benefits.

• Income tax relief of 20% of the sum invested up to £500,000 a year (but limited to how much income tax you actually pay).
• You can defer capital gains tax which arose in the past three years or which arises in the next year – saving 18%. 
• Advantageous capital gains tax treatment of any fresh gains.

Only certain shares qualify but a competent stockbroker should be able to help. Some stockbrokers specialise in these portfolios. Be careful, though, because charges vary enormously.

There are also packaged EIS schemes on the market. These are expensive and usually completely illiquid so that you cannot get out of them.

All these investments are very risky and some are very illiquid i.e. there is a very limited market. However, where a very elderly person is unlikely to survive for seven years, but is expected to last for two years, this could be the last chance to save IHT.