Tax Planning As You Like It

JON GOLDING ATT, TEP takes a quirky look at tax planning from birth to death.

THERE HAVE BEEN many varied analogous interpretations of Shakespeare's plays but, not surprisingly, few, if any, have extended to tax planning. However, the play As You Like It contains in Act II scene 7 the seven ages of man which with some imagination might be so interpreted.

The infant

At first the infant, mewling and puking in the nurse's arms.

From the day it is born a child is entitled to allowances and reliefs such as the personal allowance, currently £4,535, and the capital gains tax allowance of £7,500. In most cases there is little or no income or capital in the child's ownership or under guardianship at this stage against which to use these valuable reliefs. It is important not to lose the tax allowances available if possible, and to this end the transfer of funds that give rise to income and capital appreciation is tax advantageous.

It is not tax effective for the parent to transfer capital to the child as the income will be treated as that of the parent under section 660B, Taxes Act 1988. However, bare trusts created on death of the parent or by an unconnected third party or relative during lifetime are effective, provided that there is no reciprocal arrangement in operation. Bare trusts created by parents, however, can be effective for capital gains tax purposes where the trust is used to purchase investments designed to produce capital growth. The annual capital gains tax allowance of £7,500 can be used whereas the use of, say, a discretionary trust will only attract half this allowance.

Accumulation and maintenance settlements can be set up when parents, relatives and third parties gift assets to minor children (see Part XV, Taxes Act 1988). The income is not taxable on the parent, thereby avoiding a potential rate of 40 per cent, because capital and income must be held on trust until the child reaches the age of 25 or the appropriate age. Income on the accumulated funds which suffers a charge of 34 per cent may be expended on, say, education or maintenance while the child is a minor, although to the extent that the trust funds are derived from parental gifts, such distributions will be treated as income of the parent and not the child. That rule does not apply to capital distributions out of capital gains realised; these are never assessable on the settlor so long as he or she derives no benefit from the trust; it is generally assumed that the payment of school fees is not a benefit to the settlor. A gift into an accumulation and maintenance settlement is a potentially exempt transfer with no periodic charges (unlike a discretionary trust) and no exit charges on a beneficiary obtaining an interest in possession on or before the age of 25 (section 71, Inheritance Tax Act 1984).

A parent can avoid the section 660B charge by gifting capital up to £1,000 into a national savings children's bonus bond where all interest is exempt from tax. Similarly, premiums of up to £270 a year may be paid by each parent into a friendly society qualifying policy which can also include an insurance element. Finally, the Government has proposed the introduction of a child's trust fund at birth and ages 5, 11 and 16 ensuring that an endowment is paid to all children with those from the poorest families receiving the most help.

The schoolboy

Then the whining schoolboy with his satchel and shining morning face, creeping like snail unwillingly to school.

The restrictions of section 660B apply until the child is 18; then the parents may pass capital or income to the child. At this stage, for inheritance tax purposes the normally exempt gifts for family maintenance will fall out of exemption after the 5 April following the child's 18th birthday or, if later, after ceasing full-time education or training. Despite this, the use of the annual exemption, normal expenditure out of income and potentially exempt transfers can make the incidence of an inheritance tax charge remote.

Parents, grandparents and other relatives can make contributions under the stakeholder pension scheme for the child up to the earnings threshold of £3,600 a year (£2,808 net) even if the minor has no net relevant earnings (section 632A(6)), Taxes Act 1988). It must be shown that there is an eligibility to pay a personal pension, but the anti settlor legislation, such as section 660B, does not apply provided that the contribution is being made by the relative on the minor's behalf and the minor (or legal guardian) is appraised of the situation. The pension payments will usually be treated as gifts out of regular income, and be exempt under section 21, Inheritance Tax Act 1984. The child will be unable to benefit from the pension until the appropriate age (50 years for personal pensions), but at least he will have begun his pension planning at an early age and be able to withdraw a tax-free cash element at retirement.

The lover

And then the lover, sighing like furnace, with a woeful ballad made to his mistress' eyebrow.

Thoughts at this time might turn to marriage. Gifts in consideration of marriage by one partner to the other are exempt under section 22, Inheritance Tax Act 1984 provided that they do not exceed £2,500.

After the marriage, gifts between husband and wife for capital gains tax purposes are not chargeable provided that they are living together. So, for instance, the husband with capital wishing to benefit his wife may transfer assets on a nil gain/nil loss basis (section 58, Taxation of Chargeable Gains Act 1992). The wife may then dispose of those assets using her capital gains tax exemption to the extent of gains arising of £7,500. Where one spouse cannot use potential capital gains tax losses, assets with gains can be transferred to that spouse to be set off against the potentially unused losses.

If one spouse passes property to the other, which is then owned jointly, for tax purposes there is a presumption that it is owned equally, even if it is owned in different proportions. So one half of the income will go on the spouse's tax return even if the property is 95 per cent owned by the other spouse. A declaration on form 17 may be made to the Revenue where ownership is unequal, from which time the income will be taxed according to the shares detailed in the declaration (section 282B, Taxes Act 1988). It should be borne in mind that withstanding the form 17 declaration and the income tax treatment, the actual majority beneficial ownership of the assets of the spouse with the lower marginal rate may be preferable (see the Revenue press release dated 21 November 1990).

The equalising of the estates between spouses is tax beneficial from the point of view of capital gains tax, but can also use the other spouse's personal allowance and tax bands at the lower marginal rates. The transfer of assets is also beneficial for inheritance tax, because transfers between husband and wife are exempt and this releases the unrealised benefits of a potential additional nil rate band for the spouse of £242,000 as well as annual exemptions, etc. The more cautious spouse may wish to tie up the gift of capital to the other spouse in the form of a discretionary settlement.

There is no formal protection for co-habiting couples, as protection under common law marriages was abolished in 1753. Therefore, when an unmarried couple shares the family home, it is important for the owner partner to consider making a declaration of trust that the property belongs to them both as joint tenants in equal shares. For inheritance tax purposes, the gift would be a potentially exempt transfer where one party had not contributed to the cost or had only marginally contributed.

The soldier

Then, a soldier, full of strange oaths, and bearded like the pard, jealous in honour, sudden, and quick in quarrel, seeking the bubble reputation even in the cannon's mouth.

Changes in circumstances during adulthood may result in bankruptcy, divorce, redundancy, etc. which also require planning.

Divorce requires certain financial obligations based on each partner's entitlement to the assets mainly by reference to their 'reasonable' requirements but now tested by reference to a yardstick of equal division, and reference should also be made to section 25, Matrimonial Causes Act 1973. From 1 December 2000, pension entitlement also has to be considered; for instance, see White v White [2000] 3WLR 1571 where pension accrued to the husband was made attributable to the wife.

The inter spouse capital gains tax exemption on the transfer of assets applies only to assets transferred while a married couple lives together, so where possible it is important to ensure that assets transferred by reason of a court order or matrimonial settlement are made during the tax year the couple is living together. Otherwise capital gains tax will have to be considered, other than exempt items such as those where business gifts relief applies in the period between separation and divorce (see sections 165 and 222, Taxation of Chargeable Gains Act 1992). The inheritance tax spousal exemption applies until decree absolute, after which the exemption for family maintenance may continue to apply.

Insolvency

Problems may arise in the individual's business dealings, and he may find himself insolvent under section 381, Part XI of the Insolvency Act 1986. The options which arise are to declare bankruptcy or enter into an individual voluntary arrangement. Where no assets are available then it may be best to declare bankruptcy but, if bankruptcy debars the individual from practising his profession, then an individual voluntary arrangement may be more suitable.

A trustee in bankruptcy will have no rights against a discretionary trust to which the individual or his wife are potential beneficiaries. However, the trust must not have been deliberately set up to defraud the potential beneficiary's creditors. The use of offshore trusts in the form of a trust that can protect assets from many varied creditors may also be considered. The settlor's assets may be protected in this way with perpetuity periods of 100 years or more. The offshore jurisdiction will need to be assured of the settlor's solvency for at least two years prior to the setting up of the settlement. Once the trust is in place, depending on the jurisdiction, the assets will invariably be excluded from inheritance tax, capital gains tax and income tax in that jurisdiction, as well as unchallengable in the jurisdiction's court by subsequent creditors. The choice of offshore jurisdiction is important in this respect, but is beyond the scope of this article.

Employment issues

Where an individual leaves employment, he may be paid wages in lieu of notice or compensation for loss of office, these are liable to pay-as-you-earn in the normal way. Even where the employer has broken the contract conditions and makes the payment, there can be a liability under section 19, Taxes Act 1988; see Richardson v Delaney [2001] STC 1328 where the sum paid was broadly equivalent to the amount otherwise payable under the contract. Genuine redundancy payments in excess of the statutory amount are not normally taxable (within the section 148 £30,000 limit), as they are not paid by reason of employment but because the job has ceased to exist – see Statement of Practice 1/94).

If the employee undertakes not to pursue a court action against the employer in the form of a restrictive undertaking, the amount will be free of tax, under section 313 and National Insurance (see Statement of Practice 3/96). However, following Appellant SpC 268, it is important that payment in these circumstances is not attributable to other restrictive undertakings which the individual may give in relation to his employment. If that is the case then the Statement of Practice does not apply and section 313 applies to incur a Schedule E charge on the payment thereby losing the opportunity of the section 148(1) exemption.

Justice

And then the justice, in fair round belly with good capon lin'd, with eyes severe... full of wise saws and modern instances...

The new restricted provisions for carry forward of unused relief for personal pensions from 6 April 2001 under Schedule 19 to the Finance Act 2000, mean that thought should be given to paying extra contributions. 31 January 2002 was the cut-off date for elections to carry back to the year 2000-01 a contribution paid by that date, so that unused reliefs for the years 1994-95 to 2000-01 may be used up. The one proviso is that the net relevant earnings for 2000-01 must not be exceeded. Old style retirement annuity contract holders can still carry forward unused relief and, in rare cases, premiums may be paid following an investigation settlement (section 625(3), Taxes Act 1988).

Individual savings accounts up to the maximum limit of £7,000 should be considered along with the use of single premium investment bonds that allow five per cent tax free withdrawals a year. Alternatively, the single premium investment bond five per cent withdrawals may be left to accrue in order to accumulate for withdrawal at a later age when the cashing in of the bond for someone over 65 who would be entitled to age allowance results in the loss of the age allowance. Where the level of income on retirement precludes the age allowance, then the bond encashment in excess of the five per cent should be judged so as not to exceed the basic rate. This is because the bond is deemed to have had notional basic rate deducted already and amounts up to the basic rate band result in no further tax charge (section 547(5), Taxes Act 1988).

The use of a discretionary trust at the end of this age may be tax effective. This is especially so where gains on assets held by the settlor may be treated as reducing the trustee's acquisition cost (sections 165 and 260, Taxation of Chargeable Gains Act 1992). Upon distribution out of the trust whilst it is still discretionary, the trustees and the beneficiary may elect jointly for any tax liability to be deferred, so that the beneficiary's acquisition cost is reduced thereby ensuring a capital gains tax charge does not arise until subsequent disposal. On the other hand if the trustees dispose of a business asset which they have held for four years (or two years where the disposal is after 5 April next) the capital gains tax liability may be minimal following taper relief under section 2A, the effective rate being 8.5 per cent, i.e., 25 per cent x 34 per cent.

The transfer of assets into a discretionary trust is treated as a chargeable transfer, and may be taxable at the lifetime rate of 20 per cent on the settlor, but the liability may be mitigated by using the nil rate band and annual exemptions, if available, i.e., £248,000 in total. A periodic inheritance tax charge each ten years of a maximum of six per cent applies to the discretionary trust, and therefore the winding up and distribution of the assets before ten years have elapsed after the commencement of the settlement may be beneficial, incurring a much reduced rate depending on the date of appointment. An income tax charge on distributions from the trustees has a 34 per cent notional tax deduction, but due to the discretionary element of the trust such distributions may be directed to beneficiaries who pay little or no tax thereby ensuring that all or part of the tax is reclaimed.

Sixth age

The sixth age shifts into the lean and slippered pantaloon, with spectacles on nose and pouch on side...

This age shifts to retirement and risk adverse strategies. The main asset will in many cases be the family home, which often attracts a large proportion of the estate duty charge on death. The difficulty of mitigation in this respect and the need to retain sufficient liquid assets at this stage is of prime importance.

The Financial Services Act 1986 and greater regulatory body participation (Financial Services Authority) to curb mis-selling and financial abuses has promoted greater confidence and general awareness in investments. However, reported abuses and suspensions still occur on a too frequent basis. Some, but not all, investments are covered by compensation schemes (encompassed by the Financial Services Compensation Scheme from 1 December 2001), but even where coverage is in place, compensation may only be paid after litigation and a great deal of time has elapsed.

The maximum amount each individual is guaranteed to receive in a winding-up of his bank or building society is 100 per cent up to a deposit limit of £2,000 and 90 per cent of the next £33,000, so a restriction of funds in excess of £35,000 in each of these investment mediums might be prudent. Similarly, the investments are guaranteed no more than £48,000 (100 per cent of the first £30,000 plus 90 per cent of the next £20,000), and a life company's investments are protected by up to 100 per cent of the first £2,000 and 90 per cent of the remainder without limit in cases of default (Financial Services Authority policy statement 'Financial Services Compensation Scheme' September 2001). Gilt-edged securities and National Savings are guaranteed by the Government and therefore presumably free from risk of default. The cautious investor should in any case seek to spread investments to ensure that the maximum desired exposure risk is not exceeded.

The gift of a property or interest therein will, after 17 March 1986, not leave the donor's estate for inheritance tax purposes if he reserves some benefit in it. The donee must be seen to have assumed possession of the property and the property is used to the entire exclusion or virtually the entire exclusion of the donor (section 102(1), Finance Act 1986).

The Revenue's Tax Bulletin, November 1993 states a number of exclusions from section 102(1)(b), but these are not significant for more permanent tax planning opportunities. However, paragraph 6(1)(b) of Schedule 20 to the Finance Act 1986 provides circumstances where the need to pay full consideration to avoid the gifts with reservation rule is not a requirement, and this includes occupation by the donor where he has become unable to maintain himself since the gift through old age, infirmity or otherwise, and the interest in land represents reasonable care and maintenance provided by the donee who is a relative. This relief is not mutually exclusive from the position where the donor gifts his property and continues to live in it, thereby ensuring that an inheritance tax charge may arise because there is a reservation of benefit unless a 'market rent' is paid. See the Revenue's inheritance tax form D3 (Notes), page 7.

However, where the donor gifts, say, a half share of the property by deed of declaration to the son or daughter who resides at the property, and bears his fair share of the home's running expenses, this arrangement will not give rise to a gift with reservation (section 102B(4), Finance Act 1986). The seven-year period from the date of the gift must expire before the discharge of the value of the property drops from the cumulative total of the donor. The occupation of the property by the donee is a difficult area, and evidence of council tax, water rates, electricity bills showing the co-ownership of the property, will go some way towards providing this proof. If the son or daughter owns his or her own property then it may be appropriate to set up a discretionary settlement whereby their children become the beneficiaries complying with section 102(1), Finance Act 1986. Where the property would be the beneficiary's only or main residence, the benefits of the capital gains tax exemption on sale would also apply (section 225, Taxation of Chargeable Gains Act 1992).

Sans everything

Last scene of all, that ends this strange, eventful history, is second childishness and mere oblivion, sans teeth, sans eyes, sans taste, sans everything.

The last age brings a time of confusion, when tax planning may be ignored resulting in a higher estate duty charge than is necessary.

In this respect where the individual is no longer mentally capable within the meaning of section 94(2), Mental Health Act 1983, the opportunity to set up a disabled trust may arise. Normally where someone is incapable of handling his own affairs, he comes within the control of the Court of Protection and a receiver may be appointed to administer the affairs. However, where a settlement is set up and authorises the trustees to apply the income for the benefit of the beneficiary and retain any income not so applied, it should not be necessary to appoint a receiver. The capital gains tax benefit is that the disabled trust is entitled to the full annual exemption (paragraph 1 of Schedule 1 to the Taxation of Chargeable Gains Act 1992).

Special rules apply in respect of inheritance tax when setting up a disabled trust; the gift into the trust is a potentially exempt transfer and the disabled beneficiary is treated as having an interest in possession (sections 3A and 89, Inheritance Tax Act 1984).

The use of power of attorney and, in the case of an individual who is not mentally capable, an enduring power of attorney can assist in the organisation of the individual's affairs so that the best tax opportunities may be effected (Enduring Powers of Attorney Act 1985).

Finally, even where the individual has died, there is still the opportunity to use the deed of variation or disclaimer under section 142(1) and (3), Inheritance Tax Act 1984 and section 62(7), Taxation of Chargeable Gains Act 1992. A deed of variation must be made in writing to the Board within six months of the date of the instrument varying the disposition. The instrument of variation must be made within two years of the date of death. It must clearly indicate the subject matter and the destination. In the case of the disclaimer, the deed should be unilateral and the disclaimed benefit is treated as if it had never been conferred. This affords the opportunity to effectively rewrite the deceased's will, disposition by reason of intestacy or otherwise so that tax effective planning may be assumed in retrospect.

Jon Golding is a senior tax editor with Butterworths Tolley.

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