Plan for a happier estate of affairs

Inheritance tax (IHT) remains “the top priority for reduction”, according to the latest survey of UK taxpayers. But while the chancellor shows no sign of making any further moves to reduce the tax imposed – beyond the transferability of the nil-rate band announced in October’s pre-Budget report – there are some new schemes that can reduce the taxable values of an estate.

According to research by chartered accountants MacIntyre Hudson, 83 per cent of taxpayers now consider IHT to be “an unfair tax on wealth that has often been built up out of post-tax income”.

More than 90 per cent of respondents were in favour of the new measure to allow the unused nil-rate band of a married or civil partner to be transferred on death to a surviving spouse – giving couples a combined IHT allowance of £600,000, rising to £700,000 by 2010. However, a majority of taxpayers still think the tax-free band, per partner, should be higher than £300,000.

With no change in prospect, though, it’s fortunate that two tax-saving schemes have recently been devised to keep large capital sums, and family property, outside of IHT – but, crucially, within HMRC’s rules.

The WAY Duo Inheritor Plan is a clever combination of a discounted gift plan and flexible gift trust.

Discounted gift plans (DGPs) were first set up around 15 years ago by life assurance companies. They allow individuals to transfer capital out of their estates and into an insurance bond held in trust, while retaining the right to make fixed regular withdrawals.

Under the tax rules for insurance bonds, up to 5 per cent a year can be withdrawn without triggering a chargeable event for tax purposes, and any capital growth on the bond remains outside the taxable estate.

If the planholder lives for another seven years, the entire gift becomes exempt from IHT. But if the planholder dies within seven years, the taxable value of the gift is “discounted” by the open-market value of the right to receive those withdrawals.

That is because the right to receive withdrawals, in effect, reduces the residual value of the gift. This discount will vary depending on the level of withdrawals chosen and the actuarial life expectancy of the planholder.

In May 2007, HMRC confirmed that the retained rights would be treated as a “carve-out” from the gift, reducing the taxable value, and that the gift itself would not be treated as a taxable “gift with reservation”, or be subject to the new pre-owned asset tax.

Then, last week, the Special Commissioner found in favour of taxpayers in a test case about DGPs, ruling that HMRC must apply a discount based on the value of future withdrawals, even for someone as old as 90. “It is a welcome vote of confidence,” says Julie Hutchison of Standard Life, “since the decision notes that there was no question of the settlor being treated as having made a gift with reservation of benefit.”

WAY Group, the fund manager, has now combined the tax advantages of DGPs with the flexibility of conventional gift trusts – to deliver less discount on the taxable value of the gift, but give flexible access to up to 60 per cent of the capital, not just 5 per cent a year.

With its Duo Inheritor plan, a discounted gift is created and annual 5 per cent withdrawals are established for just the first eight years – giving a total potential discount of 40 per cent (or less, as life expectancy shortens).

That leaves up to 60 per cent in a conventional gift trust, giving the donor and family flexible access to the majority of the funds.

In this way, Duo Inheritor is a more flexible option for people who are likely to live another seven years and make their whole gift tax free, but who want some way of mitigating IHT if they die sooner.

“Clearly a discount value to any amount gifted is essential for the 10 per cent of 70-year-olds who will on average not make it through the seven-year period before gifts fall out of account,” explains WAY group chairman Paul Wilcox. “But we are more concerned that the other 90 per cent, who don’t need the discount, can take advantage of a flexible arrangement that gives the best of both worlds.”

Close Investments offers an equally ingenious way of keeping a home outside of IHT, but in the family. With its Property Wealth Manager plan, the family home is sold into a fund, through a home reversion. This gives the former owner a lease to live in the property for life and provides the cash to buy a unit-linked whole-of-life bond with life insurance worth 93.5 per cent of the property value.

The bond is then assigned to the chosen beneficiaries, and the cash used to buy the life insurance is a potentially exempt transfer – becoming free of IHT after seven years, or only subject to tax equal to the premium on gifted bonds before that.

As result, the property is effectively removed from the former owner’s estate. On death, the bond pays out to the beneficiaries, who get first refusal on using the proceeds to buy back the home for the family. So, if the bond is taken out seven years before death, 40 per cent tax is avoided for a cost of 6.5 per cent (plus charges).

And, again, it is all approved by HMRC approved. Robert Meyer of Close says: “The Revenue has confirmed that the pre-owned assets tax does not catch it.”