Inheritance Tax

Order of gifting

Gifting in the right order is essential for effective estate planning and may well require the use of a number of different trusts. Getting the wrong order could be costly but getting it right could save inheritance tax (IHT). More frequently gifting is starting from a much younger age.

Making gifts

Making a gift every seven years, into trust for example, of up to the nil rate band (£325,000) could be considered for clients as young as 40, particularly bearing in mind that trusts can be created that allow clients to retain access to some or all of the capital. When looking at IHT planning, advisers will have to consider the client’s overall assets, their history of previous gifts and the order in which they establish any new IHT planning structures.

Bare trusts

Gifts into bare trusts are potentially exempt transfers (PETs) and the trust itself is not taxed as a discretionary trust would be. Bare trusts, however, do not have the ability to pass the trust assets down through the generations.

Therefore, the continued use of discretionary trusts, such as discounted gift trusts and flexible reversionary trusts, up to the value of the standard nil rate band, should still be considered in conjunction with bare trust arrangements or gift and loan arrangements.

Discretionary trusts

Unlike bare trusts there is no individual who isthe tax point for IHT and, therefore, trustees of discretionary trusts may have to account for IHT based on the value of the trust assets. But they will usually not pay any tax if the value of the assets is less than the available nil rate band.

And if not, the tax charge only arises when trust property is distributed to beneficiaries or when beneficiaries become absolutely entitled to some or all of the trust property, commonly referred to as the ‘exit charge’. In addition, every ten years, the ‘periodic charge’ applies.

The exit charge in the first ten years of the trust is based on the effective rate of tax the settlor paid (or could have paid) at the creation of the trust. The exit charge after ten years is based on the effective rate of tax for the previous periodic charge.

The periodic charge is calculated as though the original settlor had gifted the trust property again and is referred to as a ‘hypothetical transfer’. The trustees are allowed to offset the standard nil rate band at that date but this is reduced by any chargeable lifetime transfers (CLTs) made by the settlor in the seven years before the date the trust was created.

For this reason PETs made in the seven years before the discretionary trust was created have to also be considered, if the settlor dies within seven years of the making of those PETs. These become chargeable transfers and will reduce the available nil rate band for the purposes of calculating any periodic charge and exit charges. So it is best to avoid making a PET before establishing a discretionary trust, just in case this happens.

Related settlements

Trusts could be established on separate days to avoid them being related settlements as the values of related settlements are aggregated when computing charges to IHT. Where a number of arrangements are being considered then the order in which arrangements are entered into is also important.

Structures that do not create large CLTs or PETs at outset should be considered first as other arrangements that create large CLTs or PETs (which could subsequently become CLTs) could impact on these arrangements. Similarly a gift into a discretionary trust should be made before a gift into a bare trust because the gift into the bare trust would be a PET which could subsequently fail and become a CLT and, therefore, impact on the discretionary trust arrangement when the periodic charge is calculated.

Planning the arrangements

The following recommendations assume no CLTs or PETs are made in the seven years before setting up any of these arrangements. The suggested order (with at least one day between each structure), where a number of solutions are being considered to solve a specific IHT situation, is as follows:

  1. Gift and loan discretionary trust.
    This is IHT neutral at outset as the asset of the trust (apart from an initial gift of £10) is the loan.  No transfer of value occurs (and so does not impact on subsequent arrangements) but IHT is payable to the extent that the growth exceeds the nil rate band available to the trust. This should be done first as previous CLTs (including failed PETs) created by other arrangements would impact on the gift and loan periodic charge.
  2. Whole of life plans such as the Flexible Life Plan, in a discretionary trust.
    This arrangement should be set up before other structures that create PETs or CLTs. The first premium that establishes the trust will have little, or more likely, no impact on subsequent arrangements as it can be offset against the annual exemption or be covered by normal expenditure relief.
  3. Discretionary gift trust (such as Canada Life’s Wealth Preservation Trust and discounted trusts). 
    These need to be established before bare trust arrangements that create PETs because if the PET failed it would become a CLT, which would impact on the discretionary trust arrangement periodic charge.
  4. Bare trust arrangements such as bare gift trusts and bare discounted trusts.
    These are last for the reason given above. 

Bare gift and loan trust arrangements can be entered into at any time as they are IHT neutral. There is no gift on creation (with the exception of the £10) and no periodic or exit charges.

Key facts about gifting and IHT planning

  • Consider all the client’s assets as a whole, do not plan in isolation
  • Don’t forget that PETs made in the last seven years could possibly impact on new discretionary trust arrangements if the donor dies within that seven year period
  • When considering more than one arrangement do them on separate days and in the correct order
  • The above assumes that all arrangements are made around the same time since gifts into discretionary trusts can affect PETs made up to seven years later (referred to as the 14 year rule)

This briefing note has been prepared for professional adviser use only.

This document is based on Canada Life Limited’s and Canada Life International Limited’s understanding of applicable legislation, law and current HM Revenue & Customs practice as at December 2018. It is provided solely for general consideration. The information regarding taxation is based on our understanding of current legislation, which may be altered and depends upon the individual financial circumstances of the investor. We recommend that investors take their own professional tax advice.

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