The WAY Group Newsletter for Financial Advisers | October 2009

Keeping it out of the family

Recent changes in legislation have improved the tax efficiency of the WAY Inheritor Plans. Mark Benson, Technical Manager for WAY Investment Services looks at these changes and demonstrates the significant additional tax savings that can be achieved using the new rules. If further evidence was needed that a collective based IHT mitigation plan has brought added benefit to tax planning then read on - and discover why beneficiaries will thank you and not question why inheritance tax has been replaced by income tax on their legacy...

One of the major benefits offered by WAY's Inheritor Plans is the availability of a choice of investment wrappers - clients may either invest directly into unit trusts and OEICs, or indirectly via an offshore bond. This allows the IFA to select a plan tailored to the client's (and their family's) circumstances, so as to maximise the tax efficiency by choosing whether the investment gains are subject to Income Tax or Capital Gains Tax (CGT), as well as meeting the principal aim of mitigating Inheritance Tax (IHT). In most circumstances investment within a CGT environment will be preferable and consequently our unique unit trust based WAY Flexible Inheritor Plan is our most popular product making up over 85% of our IHT business. In my view it is the product that is right for most people most of the time.

There have been a number of significant changes to capital taxes over the last few years, from the expansion of the Relevant Property regime for IHT in March 2006, to the introduction of flat-rate CGT with effect from the 2008/09 tax year. These headline changes have fundamentally altered the way that our plans are used and taxed, bringing both advantages and disadvantages for the client depending on their exact circumstances. However there has also been an important secondary effect of these rule changes that has progressively offered a powerful increase in the tax efficiency of our unit trust based plans. In this article I will outline these changes and look at the sort of savings that could result.

An instant held over two years...

A chain of events began in the Budget speech in March 2006 that has culminated in investors in the WAY Inheritor Plans being able to benefit from CGT hold over relief in certain circumstances, which was previously ruled out by a combination of the type of trust used in the plans and the fact that they are settlor-interested. The IHT changes introduced in March 2006 made hold over relief available in limited circumstances, which were very usefully extended by the introduction of the flat-rate CGT regime which became effective on 6th April 2008.

CGT hold over relief is available under s165 or s260 of the Taxation of Capital Gains Act 1992 (TCGA 1992). S165 relief relates to transfers of business assets and is therefore not relevant to the WAY Inheritor Plans. s260 relief allows the gain calculated on the deemed disposal of assets being transferred to be held over where that transfer is a chargeable transfer for IHT to a UK resident. It is therefore available for transfers from individuals into "relevant property" trusts (discretionary trusts and post 21st March 2006 interest in possession trusts) where the transfer is assessed for the entry charge to IHT, and for transfers from such trusts to individuals (beneficiaries) where the transfer is assessed for the exit charge to IHT. The relief is available whether or not IHT is actually paid on the transfer - e.g. transfers within the nil rate band can still enjoy the relief.

Hold over relief and the WAY Inheritor Plans...

The Inheritor plans utilise an interest in possession trust. Until 21st March 2006 transfers related to such trusts were potentially exempt transfers (PETs) and not chargeable transfers and thus hold over relief was not applicable in any circumstances. Plans written before that date will in almost all cases remain under those rules and thus will not be expected to become eligible for the relief.

Plans settled on or after 22nd March 2006 are deemed to be relevant property and the transfers into the trust and out to beneficiaries are chargeable transfers. These trusts do therefore have the potential to claim hold over relief in some circumstances, subject to the anti-avoidance provisions below which have a significant impact on the plans.

The relief is only available where there is a chargeable transfer for IHT that would also be a deemed disposal for CGT. Relief will therefore not be available on some common WAY Inheritor Plan transactions that are deemed disposals, but are not chargeable transfers:

• Annual reversions: A key concept of the plans is that the reversionary interest of the settlor is held under a bare trust and thus any transfers back to the settlor by way of reversion are not chargeable (they are neither assessed for an exit charge nor added back in for calculating the periodic charge). Thus hold over relief is not available on reversions in any circumstances. Any gain or loss realised on the deemed disposal should nowadays be accounted for by the trustees.
• Where loans are advanced to beneficiaries these are investment transactions made by the trustees and not chargeable transfers for IHT. Thus if units are transferred in specie by the trustees to the borrower this will again be a deemed disposal that cannot be held over and must therefore be accounted for by the trustees.

Anti-avoidance provisions for settlor interested trusts ...

There were previously two sets of anti-avoidance provisions within TCGA 1992 that restricted the use of hold over relief. These provisions affect the WAY Inheritor Plans as the plans are settlor-interested due to the existence of the reversionary interest in favour of the settlor. The provisions are as follows:

• ss 77-79: these rules directed that the charge to CGT on settlor-interested trusts would fall upon the settlor and not the trustees. They were repealed in the Finance Act 2008 in conjunction with the introduction of the flat rate for CGT. Thus prior to 6th April 2008 hold over relief was not available on any transfers made out of the trusts during the settlor’s lifetime since the CGT gain would not fall upon the trustees (transferors) who therefore had no assessable gain on which a claim to hold over could be made.
• ss 169 B-G: these rules prevent the claiming of hold over relief on transfers from individuals into settlor-interested trusts. They are still live on the statute. However a close inspection of these provisions makes it clear that they do not apply to transfers made out of the trust by the trustees to beneficiaries. As a result it is not possible in any circumstances to claim hold over relief on the initial transfer into a WAY Inheritor Plan.

The provisions can only apply where the settlor is living at the time of the transfer in question, since if there is no settlor there can obviously not be any settlor-interest. Thus hold over relief became available to new plans settled from 22nd March 2006, for transfers out of the trust made after the settlor’s death. Then from 6th April 2008, following the repeal of ss77-79 hold over relief became available on all transfers out of post 21st March 2006 trusts regardless of whether the settlor is alive or dead.

Summary of availability of hold over relief for WAY Inheritor Plans ...

Table 1: Click here to view full size pdf version of the above table

Whilst it has been possible to claim hold over relief on the WAY Inheritor Plans in certain circumstances since March 2006, it is only very recently that we have seen plans that have been in a mature enough situation for the question to arise. This is not surprising given that the long-term objectives of the plans mean that most post March 2006 trusts will not yet be looking to make appointments to beneficiaries. Furthermore most plans settled after that date will have invested prior to the credit crunch bear market and will at present be sitting on losses rather than profits (the FTSE 100 was over 6000 points on Budget Day 2006!). Hold over relief is only available in relation to gains, although a loss could be passed to the beneficiary under s71 of TCGA 1992 and used to offset their realised gain on that asset in the future.

The potential tax savings ...

As noted above very few real plans will be fortunate enough to be showing a profit for a period beginning no earlier than March 2006, so the actual benefit of the relief for most WAY Inheritor Plans will lie in the future. Let us suppose therefore that in a more favourable market environment, £300,000 settled into a WAY Flexible Inheritor Plan post 22nd March 2006 has grown to £325,000 and no reversions have been made by the trustees. The plan has been written with 10% annual reversions to the settlor, and is the only trust created by that settlor. I have assumed that the CGT annual exemptions and rate are those applying in 2009/10: £10,100 for an individual, £5,050 for a single trust, and a flat rate of 18%.

An individual reversion of 10% would therefore be worth £32,500 and if made would create a deemed disposal gain of £2,500 which would fall comfortably within the trustees’ annual exemption of £5,050. However what if the trustees proposed to distribute the whole of the trust assets to, for example, the son and daughter of the settlor as beneficiaries of the trust, who intended to pay off their mortgages?

The trustees could either liquidate the assets and transfer cash to the beneficiaries or transfer the units in-specie. In either case a (deemed) disposal would be created with a gain of £25,000 and a CGT charge of £3,591 at 18% on the excess over the trustees annual exemption. In this case, if the beneficiaries’ CGT exemptions would otherwise be unused, hold over relief could be utilised to extinguish the CGT charge. One possible strategy would be as follows:

• The trustees sell units to the value of £65,000 realising a gain of £5,000. This falls within their annual exemption so no CGT is due. The proceeds are transferred in cash to the son and daughter in equal shares.
• The trustees then transfer £130,000 worth of units to each of the son and daughter; they jointly submit a claim to hold over the gain of £10,000 on each share. Both son and daughter then immediately sell their newly acquired units realising a zero gain on their acquisition (market) value. In their self assessment return they adjust their gain for the held over amount by adding back the £10,000. The resulting gain falls within each of their individual CGT annual exemptions of £10,100 so once again no tax is due.

Table 2: Click here to view full size pdf version of the above table

Thus by carefully planning the distribution strategy a 100% tax saving has been achieved! Where there are larger gains there is of course the option to realise the gains in multiple tax years to further increase the availability of the exemption. For example in our scenario where mortgages are to be repaid, the trustees and beneficiaries can calculate whether the most efficient strategy is to pay part of the mortgage for another year in order to secure another CGT exemption, or to pay some CGT now rather than incur the additional interest on the remaining loan.

It can be seen that the relief will become increasingly useful as time passes and asset prices recover, and the ability to hold over the gain will become more valuable as multiple CGT annual exemptions may be deployed to reduce or often eliminate the tax charge. Each WAY Inheritor Plan may ultimately benefit many beneficiaries over many years; including children, grandchildren, remoter relations, spouses, partners and even friends. Since many or even most beneficiaries will be income tax payers but will not routinely use their CGT annual exemption, the availability of hold over relief and the flat 18% CGT rate offers a powerful opportunity to shrink or eliminate the potential tax bill - even on very substantial gains. The availability of this relief will therefore further confirm the suitability of the unit trust based WAY Flexible Inheritor Plan as the IHT mitigation strategy of choice "for most people, most of the time".

Please note: Due to limitations of space we have not detailed the complete operation of the relief and there are, for example, circumstances where the relief may be clawed back. We strongly recommend that professional advice is sought before any transfers or disposals are made. This article is based upon WAY Investment Services Ltd's understanding of tax legislation and HMRC practice as at September 2009. E&OE.

If you have a client that you think could benefit from utilising a collective backed IHT strategy and would like to talk through or obtain a recommendation report then why not contact the author or Tony Lyons (IFA Support Manager) on 01202 890895.

Yours sincerely,

Mark Benson
Technical Manager, WAY Investment Services Limited
1st October 2009.

Ends-

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How to contact us

We hope you found this IFA e-newsletter interesting and informative and that some of the issues raised will prove useful for developing business with your clients? If you wish to discuss any matters arising from this newsletter or, indeed, want to talk to us about any of WAY's products, then you are most welcome to call either Tony Lyons, IFA Support Manager, or Mark Benson TEP, Technical Manager , on head office telephone number: 01202 890895. Or, if you prefer, you can use the website: Contact Form to get in touch. We look forward to hearing from you.

Newsletter: October 2009.

Please Note: This newsletter commentary has been prepared for Financial Intermediary Clients and Professional Associates of WAY Investment Services Ltd and is not intended for and must not be distributed to Private Investors. This information is supplied to you in confidence and you may not pass it on to any other party without prior written consent. Past performance is not necessarily a guide to future returns and changes in rates of exchange between currencies may cause the value of investments to rise or fall. No representation or warranty is given (express or implied) as to the accuracy, completeness or correctness of the information nor the opinions, interpretations and conclusions contained in this commentary. The commentary does not constitute investment advice or a recommendation to purchase or sell any security. Neither the author nor WAY Investment Services Ltd accept any liability whatsoever for any loss or damage arising in any way from any use of or reliance placed on the commentary. WAY Investment Services Ltd is an Appointed Representative of WAY Fund Managers Ltd which is authorised and regulated by the Financial Services Authority.