Meeting Points

RALPH RAY FTII, TEP, BSc (Econ), solicitor presents highlights from an IBC Conference on insurance and tax planning.

Retained interest trusts

Suppose that Adams wishes to give away some capital as part of inheritance tax planning, but retain some annual entitlement from the gifted funds as well as the possibility of getting some of the capital back as well.

Michael Bryant advised that retained interest trusts are being marketed by insurance companies to meet this scenario. The donor effects a single premium policy on flexible trusts under which the policy and all benefits therefrom are split into two; one part is retained for the absolute benefit of the donor and the second part is held on flexible trusts for the donees and in some cases with power for appointments to be made back to the donor.

The trustees encash 5 per cent of the total bond each year and pay this to the donor as part of his entitlement to his fund within the bond. The 5 per cent withdrawals relate to the whole investment and not just the donor's fund, this being the main benefit of the arrangement.

Some marketed products of this type permit the donor to be included amongst the class of beneficiaries in favour of whom an appointment can be made when there is a beneficiary with an interest in possession. It appears that the Revenue accepts that this does not breach the inheritance tax gifts with reservation of benefit rules unless a future appointment to the donor was pre-planned.

Other products exclude the donor from the discretionary class of beneficiaries under the flexible trusts but leave open the possibility that the donor could become one of the beneficiaries. The argument is that the reservation of benefit provisions apply only in respect of prospective actual benefits and not in circumstances where the donor is not actually in the class of beneficiaries as currently constituted. There is no clear authority on this point, however.

Care also needs to be taken as regards the donor's right to recover higher rate tax on chargeable events from the policy trustees under section 551(1), Taxes Act 1988. Several issues arise here, but the most important one is whether this right amounts to a benefit reserved in the share of the funds given away. If the donor omits to exercise the right, it is considered that the mere omission to act does not constitute a gift and so the reservation of benefit provisions will not come into play.

Loan schemes

For the estate planner who wishes to give away future capital growth on funds currently held but retain the face value of those funds to live on, insurance based loan schemes are available. Michael Bryant said that there are a number of variants each involving an interest-free loan of the capital to trustees, which loan is repaid by regular encashments out of a bond purchased by the trustees with the loan. Simple varieties involve an interest-free loan to a bare trust for a named beneficiary (in which case there is no 'settlement' for tax purposes) and therefore the special provision at paragraph 5 of Schedule 20 to the Finance Act 1986 relating to gifts with reservation and loans to trusts does not apply. Another variety involves an interest-free loan only to a newly constituted trust with no other funds settled (in which case once again paragraph 5 does not apply because there is no gift as such).

Wealth preservation bonds

Assume that the client wishes to continue to enjoy an income similar to that currently received from an investment portfolio but is willing to give away all capital values in the fund. Michael Bryant said that this can be achieved with a wealth preservation bond.

Under this insurance arrangement, the donor effects a whole life policy on his or her own life, under flexible trusts for beneficiaries for a single premium of 1 per cent of the total capital to be invested. At the same time, the donor effects a pure endowment policy with the remaining 99 per cent of the capital and this is issued to the donor as beneficial owner. The capital invested within the bond is divided into two funds, an income fund which receives all the income from the investment fund and a capital fund which is entitled to the capital value of the fund. Units are created in each fund and the income units automatically pay out quarterly distributions of income from the underlying fund, while the capital units reflect the capital of the underlying fund. The units in the income fund are allocated to the pure endowment policy and the distributions provide an income. The units in the capital fund are allocated to the whole life policy.

The pure endowment policy matures on the earlier of the donor's death and the policy anniversary following his or her 105th birthday. The whole life policy matures on the donor's death at any time, the death benefit being the value of units in the capital fund. Provided that the donor dies under the age of 105, the capital fund is paid free of inheritance tax for the benefit of the flexible trust beneficiaries of the whole life policy. Otherwise, the capital fund accrues to the donor on the maturity of the pure endowment policy.

New style PETA plans

The old style PETA plans of the early 1980s were blocked by paragraph 7 of Schedule 20 to the Finance Act 1986. This paragraph deals with cases where the benefits payable to a donee under a policy of insurance vary by reference to benefits accruing to the donor.

Michael Bryant said that paragraph 7 is avoided under new style plans by which a donor effects a single premium bond for, say, £100,000 and requests the bond to be issued under trusts providing a fixed sum of £95,000 or the lesser value of the bond, payable to flexible interest in possession beneficiaries on the donor's death, whilst any excess value of the bond over £95,000 is retained by the donor absolutely. Thus, if there is investment growth, the donor can encash value over £95,000 to provide a form of income. The donor makes a discounted potentially exempt transfer at the outset and only the unencashable surplus value over £95,000 forms an asset of the estate on the donor's death.

Retaining variable capital amounts

Michael Bryant said that marketed insurance schemes exist by which the client can receive variable capital amounts each year but give away the remaining capital and growth on the fund. There are three choices: maturing endowments, maturing endowments with 5 per cent withdrawal rights, or reversionary trusts, all with or without extension options.

Maturing endowment schemes work by means of a series of unit linked endowment policies maturing in successive years. All the policies are issued under one trust to provide that benefits payable on each policy maturing during the donor's lifetime are held for the donor absolutely, whilst those remaining policies maturing on his death, or continuing after his death where policies are in joint lives, are held on flexible trusts for certain donees.

If there is no provision for the maturity date of each policy to be extended, then there is a potentially exempt transfer of 'discounted' capital made at the outset with all policies in existence on the donor's death escaping inheritance tax liability. If there is a facility to extend the maturity date of the policies then there is no discount on the potentially exempt transfer at the outset.

A variant of this arrangement has been developed by offshore companies, using policies on the lives of young beneficiaries, to permit the greater financial benefit of the 'tax free' 5 per cent partial surrender provisions in favour of the donor.

Under reversionary trusts, a succession of whole life policies are issued under interest in possession trusts for selected beneficiaries enduring for a specified period with reversion to the donor, if he is then living, at the end of the specified period. This arrangement relies on the proposition that a settlement on a person for a specified period with remainder to the settlor is not a gift with reservation.

Deathbed schemes

Assume that the client has only a few months to live, is a widower, and has a valuable portfolio of investments with large unrealised gains. Is there any means by which he may carry out some effective inheritance tax planning? Michael Bryant advised that a capital redemption policy scheme may be the only answer. A policy is issued to the client in return for a substantial premium which is expressed as specified assets rather than a monetary sum (namely certain of the shares in the portfolio). The policy provides for a guaranteed return, or the value of a linked underlying investment fund if greater, at the end of the fixed policy term which can be for as long as 80 years. There are no rights to surrender during the policy term.

Immediately after the issue of the policy, the client's estate is reduced as a result of the lower open market value of the policy as compared with the premium. For example, it is claimed that a single in specie premium with a value of £100,000 would give a minimum guaranteed maturity value of £700,000 at the end of an 80-year term; the present value of such a future minimum guaranteed return is calculated to be about £15,000 assuming long term interest rates of 5 per cent. Thus the value of the client's estate for inheritance tax purposes has been immediately reduced by some £85,000.

Although the policy has no surrender rights, the intention is that the life company will grant loans against the policy; these will be subject to the normal part-surrender rules.

Because the shares from the portfolio are disposed of under a bargain at arm's length with an unconnected third party, the consideration received will, under the above example, be only £15,000 for capital gains tax purposes. It is therefore suggested that in many cases an allowable loss for capital gains tax purposes could arise on setting up the scheme.

Michael Bryant said that the great problem with these schemes relates to valuation; it is not known if the Revenue accepts the principles of valuation used by the life companies. Furthermore, the underlying investment fund is tied up in the policy for its full term.

Gifts to children

John Woolley highlighted the use of gifts by a parent into a bare trust for a child to provide funds for education. Assuming the current capital gains tax régime continues broadly in its present form, gains of £12,833 could be realised after 10 years with no capital gains tax liability. Assuming that the annual exemption increases by 4 per cent per annum to about £11,400, capital gains of £19,000 could be realised after 10 years.

If £42,713 is invested in a bare trust for a child of 10, assuming 7 per cent net growth, at the end of years 8, 9 and 10 amounts of £26,320, £25,972 and £26,100 could be withdrawn with no capital gains tax liability. Effectively, capital gains of £35,679 would be tax free.

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