Using Life Assurance to mitigate Inheritance Tax
Most of us use insurance policies in a variety of ways, to protect ourselves against the financial implications of loss of different kinds. Typical examples are insurance against damage to our homes (eg by fire or storm), against personal possessions (theft or destruction) or policies of a more personal nature (for example, the curiously named ‘permanent health insurance’ to guard against having to retire from work before the anticipated retirement age because of ill health; medical insurance to pay for the cost of private health care; critical illness insurance and long-term care insurance).
In one sense life assurance (the traditional name for life insurance) stands in a class of its own: after all, life is priceless and, once it has gone, it is gone. However, it may well make financial sense to make provision against the cost of unexpected death to the family.
So, how can life assurance be put in place in a tax-efficient way?
Setting the scene
Assuming that an individual’s estate exceeds the current nil-rate band of £325,000 (or £650,000 as between a married couple/civil partnership) there will be an Inheritance Tax (IHT) liability, typically on the second death. Given the exemption on the first death for property passing to a surviving spouse/civil partner, Wills should be drawn so that no more than the available nil-rate band of value goes to other members of the family at that point. And indeed, under the transferable nil-rate band, any percentage of the nil-rate band unused on the first death can be carried forward for use on the second. In the rare case where the first to die is UK domiciled for IHT purposes, but the survivor is not, there is a historic limitation of the exemption to just £55,000, though a consultation this Summer might see an increase from 2013 to (perhaps) the nil-rate band – albeit no more.
It makes sense to keep an ongoing watching brief on how cash to meet the IHT bill might be generated, in particular to avoid the forced sale of assets such as land or buildings or even personal chattels. Of course it may well be that when the time arrives there are available cash or stock exchange securities to fund the IHT liability, which is generally due at the end of the month following the six months after death, though very rarely will all the tax be paid at that point - and interest accrues at (currently) 3% on unpaid IHT.
The suggestion in this Bulletin therefore is that you might like to consider the use of life assurance to meet at least a part of the prospective IHT liability on death. What one might call the investment rationale for such a proposal is that, through the payment of regular premiums, sums are being extracted from the chargeable estate in order to provide an IHT-free pot outside that estate which can be used to help meet the IHT bill. The policy proceeds arise outside the estate because they are (or, at least, should be) written in trust, whether on a discretionary trust or specifically for the benefit of those on whom the IHT liability will fall.
One practical advantage of doing this is that the life company will pay out the proceeds on production of a death certificate, which makes it easy to meet the six months timetable for paying the IHT. By contrast, although banks and building societies are now prepared to release funds from the deceased’s accounts specifically to pay IHT before probate has been granted, the traditional problem with accessing assets owned by the deceased for this purpose is that a grant of probate must first be obtained. Probate is the authority of the Court to the executors to deal with the estate – and it can take nearly up to the deadline of twelve months after the end of the month of death to submit a return of the chargeable estate to Her Majesty’s Revenue & Customs (HMRC) Trusts and Estates on form IHT 400, only after which will the grant be issued.
Qualifying and Non-Qualifying Policies
This is the fundamental distinction for tax purposes. Proceeds arising from qualifying policies are generally free of all tax. While Capital Gains Tax (CGT) is not payable on death, there could be a lifetime disposal on for example of surrender of rights under a policy. Such a disposal will not produce a chargeable gain for CGT purposes, except where the policy is ‘second hand’. Accordingly, if A buys the rights under a policy on B’s life, a chargeable gain may arise to A when B dies. Further, the maturity of a qualifying policy does not generally trigger any Income Tax liability (although exceptionally the early surrender of a UK Whole of Life Policy can trigger a liability to up to 30% Income Tax – or 50% if a non-UK policy), whereas a non-qualifying policy can well give rise to Income Tax.
Broadly speaking, qualifying policies will include:
(a) Whole of Life Policies, whether on single or on joint lives;
(b) Term Assurance Policies, perhaps taken out to protect against the IHT implications of death within seven years after a potentially exempt transfer to an individual for IHT purposes, when survival for that period will make the gift exempt; or
(c) the traditional Endowment Policy for a term of at least 10 years, where the policy will mature on the earlier of survival to a specified date (perhaps 20 years hence) and prior death.
Non-qualifying policies have more of an investment than a life assurance content and mainly comprise:
(i) Single Premium Bonds; and
(ii) certain Unit-Linked Whole of Life Policies.
A wide array of choice
Perhaps the simplest form of policy is one where an individual takes out a policy on her life, paying annual premiums until she dies, and writes the policy in trust for her son who following his mother’s death receives a lump sum on payment on the production of the death certificate. The longer the policy remains in force, the larger the amount which builds up, whether under a With Profits Policy or a Unit-Linked Policy. With Profits Policies were the traditional, though now less common, form, with annual ‘reversionary’ bonuses declared each year, followed by a terminal bonus on maturity. Unit-Linked Policies carry a greater risk, though also a greater potential for growth, where the policyholder selects investment funds in which the annual premiums are invested (less charges).
Within that broad description various options can be built in, for example depending upon financial circumstances to continue paying annual premiums of a regular amount of up to say age 65 and then make the policy ‘paid up’.
Term Assurance provides comfort that, if death follows within a certain number of years, a cash sum will be paid to meet particular needs – not just for payment of IHT, but perhaps also the cost of educating the children or maintaining the family where the main source of income has gone.
The thinking behind Endowment Assurance combines features of both Whole of Life and Term Assurance, with premiums invested as with Whole of Life Policies. While the traditional use of such policies was to pay off a mortgage on a private residence, performance of the Endowment has for many years now failed to match up to expectations on maturity, producing a shortfall on the sum required to pay off the mortgage – which has to be found from other sources.
Non-Qualifying Life Policies
Because it has the characteristic of investment, a non-qualifying policy is taxed on a ‘chargeable event’. Gains made can attract a charge to the higher or additional rates of Income Tax (an extra 20% or 30% respectively), on the assumption that with a UK policy the equivalent of 20% basic rate has been charged to the life company already. This Briefing assumes that the policy has been issued by a UK company: with a non-UK policy, basic rate Income Tax also is charged. While a chargeable event will arise on a variety of occasions, typically this will be the partial or complete surrender of a right under the policy or the contract, the sale of those rights, a death which produces benefits or the simple maturity of a Life Policy or a Capital Redemption Policy.
One particular feature of non-qualifying policies is the ability for the policyholder to take withdrawals of up to 5% per annum of the original lump sum premium. We should emphasise that these withdrawals are not tax-free, but rather tax deferred, because they will be taken into account on final maturity of the policy, possibly (though not necessarily) after the expiry of 20 years (20 x 5% = 100%). If in any policy year the total withdrawn exceeds the cumulative 5% annual allowances, there will then be a chargeable event – and, if over 20 years, annual 5% withdrawals have been taken, there will be a chargeable event at that point. So-called ‘top-slicing relief’ is available on any chargeable event. This works by dividing the gain by the number of years over which the policy has been in force and adding the resulting amount to taxable income for the year. Suppose the policy has been in force for ten years and the gain is £100,000; the rate of tax on the £100,000 is found by seeing what the rate of tax is on £10,000 by adding it to the taxable income, whether that produces (in 2012/13) a rate of 20%, 40% or 50% - or somewhere in-between, where the rate bands are straddled.
One advantage offered by a non-qualifying rather than a qualifying policy is the case where some benefit is or might be needed from the policy value during the lifetime. It is obviously simplest if not. If so, however, the immediate problem might seem to be the reservation of benefit (GWR) rules with IHT. That is, in broad terms, a gift will not be effective if either an actual benefit or the possibility of benefit is retained by the donor. Furthermore, in cases where GWR does not apply but there is still a benefit, there could be a liability under the Pre-Owned Asset (POA) Income Tax regime introduced in 2005/06, which applies an annual Income Tax charge on the benefit retained in certain circumstances. Happily, however, with the following types of IHT mitigation arrangement involving non-qualifying policies, HMRC have confirmed that neither GWR nor POA applies and we proceed to outline how these work.
Gift and Loan Plans
An individual makes a trust with say £100 for the benefit of his family (excluding his spouse/civil partner and himself). He then lends a sum of money, say £250,000, to the trustees which he can demand back at any time. The trustees use the cash to take out a bond, typically on the lives of the children. The anticipation is that the individual will want the benefit of the annual withdrawals of up to 5%, so the trustees might ensure that the bond is divided into 20 (or more) ‘segments’, one (or more) of which will be surrendered each year to repay the loan.
Given that the annual withdrawals do not exceed the 5% allowances, any higher or additional rate Income Tax liability will be deferred until the earlier of the withdrawal of 100% of the bond and some other chargeable event. Any tax liability at that point may be relieved by top-slicing relief. Any loan outstanding when the individual dies will form part of his chargeable estate. However, increases in value in the bond meanwhile will arise for the benefit of his family outside the estate. So, the longer that the taxpayer survives, the better – although the only gift that has been made is the £100 or so (typically exempt) with which the trust was created in the first place. Usually the 5% withdrawals will simply be ‘spent’ as income. There are no immediate IHT implications, because there is a loan rather than a gift at outset.
Discounted Gift Schemes (DGS)
These do involve a gift for IHT purposes at outset. The individual will put cash into a trust of such a ‘value’ (see below) that he does not exceed his nil-rate band of £325,000 (for 2012/13), so avoiding an IHT liability of 20% on the excess. The trustees will invest the cash in one or more bonds, again typically on the lives of the children. Within each bond there are two sets of rights, under a ‘retained fund’ and a ‘settled fund’, respectively. The retained fund is held for the settlor absolutely and it is these rights which will fund the annual withdrawals of up to 5%, again typically found through encashing one or more discrete segments. Under the settled fund (from which the settlor and spouse/civil partner are excluded from benefit) the value increases outside the estate.
The IHT ‘magic’ of the arrangement is that, given the existence of the retained fund, the actual value which can be put into the DGS without exceeding the nil-rate band is rather more than £325,000. How much more will depend upon the life and health of the settlor. The uplift, however, can be quite significant. Let us suppose that in a particular case the amount invested is £800,000, so that the retained fund is £475,000 and the settled fund £325,000. The retained fund will be used to make the annual payments to the settlor: to the extent that he does not spend the payments, they (plus any interim growth) will form part of his chargeable estate on death, but otherwise the settled fund is extinguished at that point.
The planned withdrawals under the DGS will tend to be tailor-made to the life expectancy of the settlor, so that by the time of his death he would not have withdrawn 100% of the initial amount invested and, by writing the life assurance on the lives of say the children, the chargeable event is postponed until after the settlor’s death. At that point the settled fund can be assigned to the beneficiaries absolutely, so that the Income Tax liability on the taxable gains arising on subsequent encashment of the policies can be spread across a number of individuals and indeed mitigated through top-slicing relief.
There is one further point: being a formal trust, there is the potential for the ten-yearly and exit IHT charges on the settled fund to the extent that they exceed the nil-rate band at successive ten-year anniversaries and IHT might have to be paid at that point.
Generally speaking, the Courts have confirmed in two recent cases (Bower and Watkins) that a DGS is not effective where the settlor is aged 90 or over at the time.
The flexible reversionary trust (FRT)
An individual takes out a series of ten single premium endowment policies, each one having a term ranging from one to ten years. He gives all the rights under the policies to a trust from which settlor and spouse/civil partner are excluded from benefit. Again, the settlor will not want the total value settled to exceed the available nil-rate band, which will not be more than £325,000 for 2012/13. The proceeds of each policy on maturity belong to the settlor. However, the trustees have power to prevent that happening, for example by appointing the capital of the policy to the children – or indeed the trustees have power to extend the maturity date of any particular policy. Because the trustees effectively have the power to prevent the settlor from recovering any capital under the policies, even should he survive to the maturity date, there is no discount up-front as there is with the DGS. On the other hand there are not further transfers of value for IHT purposes when a policy matures, whether the proceeds are payable to the settlor or for example to the children or indeed on the postponement of a maturity date.
The FRT is therefore more flexible than the DGS, in terms of the ability to vary what the settlor may get, which unlike the DGS will include any investment growth. While the DGS can produce IHT savings even where the settlor survives for less than seven years, the FRT should be considered only where the settlor is likely to live for at least seven years.
The potential problem with the FRT is a trust rather than a tax one. In an ideal world everyone will be ‘speaking’ to each other, in the form of the older generation, the younger generation (as beneficiaries of the trust) and the trustees. However, the trustees need to consider whether a failure to exercise their powers, either to appoint to the children or to extend the maturity dates, is failing to maximise the benefit of a trust fund for the beneficiaries who do not of course include the settlor and spouse/civil partner. That is, there could be a conflict between the settlor’s IHT mitigation objectives in creating the FRT in the first place (in being able to ‘have his cake and eat it’) and the responsibilities of the trustees towards the beneficiaries.
Life assurance for partnerships
This is a very substantial subject which can receive only brief mention here. It needs to be addressed where one or both of the older generation is a partner in a business or perhaps owns shares in a family company either of which might have significant value. In general terms the partner/shareholder will want the value of the capital account/shares to pass to the family, while the continuing partners/shareholders will want to share between themselves the interest in the partnership/shares. A separate question is whether the partnership interest or shares secure business property relief from IHT at 100%, which will be the case if it is a trading partnership but not in broad terms if the business is of an investment character.
Typically the interest in the business or shares would under the Will go to the family. Each of the partners/shareholders would take out a policy on their own life, writing the benefits in trust for the surviving partners/shareholders (or, generally less satisfactorily, each partner would take out a policy on the lives of the other partners). The idea would be to produce funds on death whereby the family of the deceased could be bought out at market value. A variety of tax issues arise under such arrangements, including GWR and POA issues, which HMRC accept are avoided if the beneficiaries under the trust are restricted to surviving partners/shareholders, with the power to bring in new partners/shareholders within the class of beneficiaries.
The setting up and maintenance of such arrangements (with careful regular review) should be seen as an essential part of the governance arrangements of small family businesses.
We should emphasise that the above is a very bare summary of the subject. Anyone who is concerned about the potential impact of IHT on their estate should seriously consider whether some form of life assurance can play its part in helping to produce the funds necessary to pay the tax. The rationale for this is as suggested above.
Meanwhile, you may like to consider:
- what is the chargeable value of your estate and, if married or in a civil partnership, the joint estates;
- what roughly is the IHT which is going to be payable on, we assume, the second death, depending on the terms of the Will of the first to die;
- where the funds are going to come from, if not obviously from ready cash or investments;
- whether some form of life assurance cover might be appropriate;
- whether the benefit of any existing policies have been written in trust;
- whether a conventional Whole of Life Policy might, subject to its terms, be an appropriate measure; or
- if there is a cash sum available for IHT mitigation, but some ongoing benefit is required, whether any of a Gift and Loan Arrangement, a Discounted Gift Scheme or even a Flexible Reversionary Trust might ‘fit the bill’.
For further information please contact Danny Clifford
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