Pre-Owned Assets Tax

Pre-Owned Assets Tax

Loans and Gifts

JOHN WOOLLEY reviews the effect of the pre-owned assets tax charge on life policies held in trust.

A GREAT DEAL of uncertainty and considerable discussion has taken place and the dust is finally beginning to settle on how the new pre-owned assets income tax (POT) rules will apply to life assurance policies effected in trust and, in particular, some of the more popular lump sum IHT plans founded on trusts of life assurance or capital redemption policies.

The background to all of this is FA 2004, Sch 15, which introduced the POT rules and which was explained in Barry McCutcheon's two-part article 'The Pre-owned Assets Régime' (see Taxation, 16 September 2004, page 626, and 30 September 2004, page 686).

For the POT rules to apply to intangibles, two conditions in Sch 15 para 8 need to be satisfied:

This issue has caused some considerable concern. If the settlor is merely a potential beneficiary under the trust who might benefit if the trustees appoint benefits to him, why should he be taxed on the basis that the whole trust fund belongs to him? There is no guarantee that he will benefit and whether he will or not is outside of his control.

In these circumstances, the Inland Revenue takes the view that this is 'psychic income'. Its view is that because the settlor could benefit from all of the trust fund, he should be taxed as if he actually enjoyed it (at a rate that reflects the likely loss of IHT). This approach is on a similar basis to that used by the IHT gift with reservation (GWR) rules, which state that if a settlor is a potential beneficiary under a trust the whole of the trust property is treated as forming part of his estate.

The two conditions

I mentioned above the two important conditions that need to be satisfied for a POT charge to apply on a gift of intangibles; let us look at these in more detail.

Settlement

The first condition that needs to be satisfied is that there must be 'a settlement of property'. What does 'settlement' mean for these purposes?

Well, a clue may be given by the second limb of the POT test, which relates to whether the settlor would be taxed under TA 1988, s 660A. This is a clear reference to a settlement in the income tax code. For these purposes, settlement has a very wide meaning as set out in TA 1988, s 660G(1); 'settlement' includes any disposition, trust, covenant, agreement, arrangement or transfer of assets.

However, Sch 15 para 1 states that 'settlement' for the purposes of Sch 15 has the meaning given in IHTA 1984, s 43. This is of fundamental importance because the IHT meaning of settlement in IHTA 1984, s 43 is more limited than that which applies for income tax. For example, a bare trust is not a settlement for IHT (and therefore not a settlement for the purposes of the POT rules), yet a bare trust is a settlement for income tax purposes. It is this mixing of IHT meanings and definitions with income tax meanings and definitions which causes considerable confusion in interpreting these rules.

TA 1988, s 660A

S 660A is the anti-avoidance income tax rule that states that where a settlor (or his spouse) may enjoy any benefit from a settlement, then any income will be taxed on the settlor. For the purposes of the POT rules, however, one excludes any reference to the settlor's spouse (again to provide correlation with the IHT GWR rules). The key question is, therefore, can the settlor benefit under the settlement? In many cases this will be a fairly straightforward question. However, there have been a number of tax cases over the years to test this issue in more difficult cases.

An amendment to Sch 15 para 8(1) of the 2004 Finance Bill at committee stage had the effect of meaning that, for the purposes of interpreting these rules, a trust could consist of a number of separate sub-trusts.

This amendment makes it clear (when different property in a settlement is subject to different trusts) that only the particular property which is 'caught' by para 8 is subject to the charge imposed by Sch 15, and not (where greater) the whole property of the settlement.

Where such sub-trusts exist, it is therefore necessary to test each independently to see if the POT rules apply.

Specific cases

Let us now look at how the POT rules could apply to the more common cases of life policies (single and regular premium) effected in trust.

Flexible trusts

A trust that is commonly used in connection with life assurance policies is the power of appointment (interest in possession) trust. This is frequently referred to as a 'flexible trust'. The basis of this trust is that the settlor will name a person, normally his child, as the immediate beneficiary and that person will have an interest in possession under the trust. This is the person who the settlor currently would wish to benefit from the trust fund, but the trustees have the right to appoint capital and income to other potential beneficiaries.

The settlor is normally excluded as a potential beneficiary because that would give rise to a GWR for IHT purposes. However, the settlor's spouse can be included without a GWR arising and because a life policy is a non-income producing asset there will be no income tax or CGT problems for the settlor.

As stated earlier, in line with the GWR rules, the POT rules do not bite merely because the settlor's spouse is a potential beneficiary. Therefore, there should be no adverse POT implications in connection with this trust.

Reverter to settlor trust

For some time it has been accepted by Revenue Capital Taxes that a trust, where the benefits of a policy revert back to the settlor at a future fixed date or on a future occasion, will not give rise to a GWR as that right is clearly carved out and 'kept back' by the settlor. In effect, the settlor makes a gift of the other benefits under the policy 'shorn' of the retained rights which are held on flexible trusts (similar to that described above) and from which he is excluded from benefit (see the Revenue letter dated 3 November 1986 to the Association of British Insurers (ABI)).

The Revenue has confirmed that, in such circumstances, it takes the view that the different interests in the property can be held in separate sub-trusts. One interest is the settlor's reversionary interest, which is held on bare trust for the settlor. The other is the remainder of the settled property (which represents the value of the trust fund should the settlor fail to survive to the reversionary date) and this is held on power of appointment trusts for the potential beneficiaries.

The effect of this is that the POT rules will not apply because that part of the trust fund under which the settlor can benefit is held on bare trust which is not, for IHT purposes, a settlement. Although the rest of the trust fund is held subject to a settlement, the settlor cannot benefit from this and so s 660A does not bite.

This result comes about because the whole property held on trust can be regarded as held on different sub-trusts for the purposes of the POT provisions. However, this interpretation appears not to represent the view of some lawyers. They take the view that the whole property (i.e. the policy) is comprised in one settlement, but with the settlor having a reversionary interest in that settled property. Despite this, the Inland Revenue has given written confirmation of the favourable interpretation of this legislation in its letter to the ABI and this is very reassuring.

Discounted gift trusts

The idea behind discounted gift trusts is that, under the terms of a trust, the settlor reserves certain benefits to himself by way of a reversion of those benefits when the settlor survives to future specified dates. The reversion of benefits under the trust at regular intervals provides the settlor with regular tax-free capital. The value of the rest of the trust fund will be held on power of appointment trusts, typically, for the benefit of the settlor's family. These power of appointment trusts will apply to the whole trust fund on the settlor's death when the settlor can no longer satisfy the reversion condition.

These plans come in many forms. Some are based on an investment made up of a number of individual policies, which may have a fixed maturity date or be 'open-ended'. Under the terms of the trust, on every specified contingent date or maturity date (provided the settlor is alive) a whole number of policies will revert back into the absolute ownership of the settlor.

Under other plans, the settlor is entitled to a set capital sum on every contingency date. So for example, having gifted £100,000 to trust, the terms of the trust may give the settlor an entitlement to £5,000 every year. Having invested in a single premium bond, the trustees can then raise the cash to satisfy the settlor's contingent entitlements to a cash sum each year by using their 5% tax-deferred withdrawal facility.

Other plans link the settlor's entitlement under the trust to a benefit under the policy that is settled. Here, the settlor will effect a single premium bond which provides for a part-surrender (frequently 5% of the premium) to be made each year. So, for example, when declaring a trust of a single premium bond, the trust may state that the settlor reserves the right to those future 5% part-surrenders made under the policy with all other benefits of the policy being held on power of appointment trusts.

Whilst other variations do exist, a common thread is that under all of the plans the settlor carves out his rights under the trust and gifts the other rights from which he cannot benefit. This means that there is no GWR. It is, however, also important to ensure that the plan is not caught by the specific life policy anti-avoidance rule in

FA 1986, Sch 20 para 7 and this can be achieved by using a capital redemption plan or making sure that the policy is not on the life of the settlor or his spouse.

From a POT standpoint, the Inland Revenue has now confirmed in writing to the ABI (see 'The ABI Letter', Taxation, 18 November 2004, page 176) that the more commonly understood forms of discounted gift trust should not, in general, be caught by the POT rules on the basis that:

As I mentioned under the reverter to settlor section above, some lawyers have had difficulty in agreeing with the Revenue's interpretation of these provisions in relation to plans where the whole of the trust property is in trust with the settlor being entitled to benefit on reversions at future dates. But it must be said that the Inland Revenue statement is reasonably categorical based on an understanding of all the facts and made in full knowledge of the use to which it will be put. It is therefore very reassuring.

Loan trusts

The basis of these plans is that a settlor establishes a power of appointment interest in possession trust under which he is excluded from benefit. This will be done either by making a small gift or merely declaring a trust. He then makes an interest-free loan repayable on demand to the trustees who invest in a single premium bond. From time to time the settlor can demand a part repayment of his loan and the trustees can finance this by making an encashment from the bond. Where no initial gift to the trust is made it is the making of the interest-free loan that fully constitutes the trust.

Here, there is no immediate IHT saving, but other benefits of these plans are:

The IHT GWR rules should not apply to loan trusts on the basis that the settlor cannot benefit under the trust (and so FA 1986, Sch 20 para 5(4) cannot apply to treat property acquired with the loan as being property with a reservation of benefit). Furthermore, the settlor's entitlement to request the loan repayments is a contractual right and not a benefit in the context of GWR of benefit provisions.

As far as the POT rules are concerned, it was thought at the outset that these rules could not apply because, although the arrangement involved a settlement, the settlor enjoyed no 'benefit' under the settlement. This meant that s 660A could not apply and neither could the POT rules. If anything the settlor was a creditor of the trust and so an income tax charge could only arise under TA 1988, s 677 — and that was only if income arose under the trust.

Initially, the Inland Revenue thought otherwise and quoted Jenkins v CIR 26 TC 265 as authority to justify its view that the settlor did enjoy a benefit in these circumstances. This was on the basis that because the trustees could use income of the trust fund directly or indirectly to repay the settlor's loan, this gave the settlor a benefit under the trust.

Fortunately, the Revenue had second thoughts. In its letter dated 17 September 2004, to the ABI as referred to above, the Revenue confirmed its view in considering the application of the POT rules that it is necessary to see if the trust and loan are caught in isolation from each other. Clearly the trust is not caught because the settlor is not a potential beneficiary. And neither is the loan because the loan is not a settlement for IHT purposes. On this basis, the Revenue takes the view that the POT rules do not apply.

Business trusts

The object of a business trust is to place cash in the hands of the co-owner of a business so that on the owner's death (or possibly critical illness) his co-owners can purchase the deceased's interest from his personal representatives. This is achieved by effecting a life assurance policy subject to a business trust. Frequently the parties will also enter into a double option agreement to facilitate the purchase.

This type of arrangement works well while all the owners continue to be involved in the business. But what if one leaves, perhaps following a sale of his shares to the others? This could make the life policies and trusts redundant. To overcome this, business trusts frequently include the settlor as a beneficiary — either as one of the potential beneficiaries to whom benefits can be appointed or as the beneficiary who will automatically become entitled should he or she no longer own an interest in the business.

Inland Revenue Capital Taxes has, in the past, taken the view that this will not result in a GWR for IHT purposes provided the arrangement is commercial and therefore not a settlement. (See Inland Revenue letter of 3 November 1986 to the ABI.) This means that only business owners can be beneficiaries and each owner must pay a reasonable amount for the benefit he is likely to receive. In particular, if the settlor's family are themselves not business owners, they must not be beneficiaries.

The problem is that, as far as the POT rules are concerned, the issues are solely whether there is a settlement (for IHT purposes) and whether (within the parameters of TA 1988, s 660A) the settlor can benefit under the settlement. Clearly, if the settlor is a beneficiary under the business trust he can benefit, but does the arrangement amount to a settlement?

Ironically, the arrangement is not a settlement for income tax purposes if it is a commercial business arrangement, but unfortunately this is not the criterion laid down in paragraph 8. Here the definition of settlement is that applicable for IHT purposes, which would include all trusts other than a bare trust. Consequently, the POT rules could apply. However, there are two possible points that may be raised in mitigation against these rules applying.

The Inland Revenue appears sympathetic to business trusts not being subject to the POT rules and is open to representations to be made to it to enable a case to be made to the Treasury to change the legislation (which can be achieved by way of regulation). But currently such trusts are caught.

Summary

The life assurance industry can feel relieved that, in general, its products and trust packages have been relieved from charge under the POT rules. This means that individuals and investors looking to plan to mitigate or provide for IHT, yet still retain the right to 'income'/capital, can still use these plans, with some degree of confidence that they will not be affected be the POT rules. It is hoped that the position on business trusts will be rectified in the near future. A similar anomaly exists in relation to pre-18 March 1986 flexible trusts of life policies where the settlor can benefit under the trust and it is hoped that this position will also be addressed.

However, the Inland Revenue has not given carte blanche to all life assurance trust schemes whatever their nature. This implies that it has left the door open to take action against any more provocative schemes that are introduced — either on the basis of a discounted gift scheme or otherwise. After all, this was always the ultimate sanction it warned of when announcing the changes in law in the 1999 Budget that stopped future lease carve-out schemes using realty. Designers of future schemes need to bear this in mind!

John Woolley is a director of Technical Connection Limited, and can be contacted on 0207 405 1600.

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