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Flexible reversionary trusts: an anniversary waltz

The concept of reversionary interests in English law has been around for many years and you will come across the concept in discounted gift trusts for instance, where the donor or settlor retains a right to the regular reversionary payments from the trust.

Discounted gift trusts are very efficient by allowing part of the gift to be outside of the settlor’s estate immediately, with the balance of the original gift being outside after seven years. Any growth on the investment as a whole is outside of the estate immediately. They also provide regular withdrawals (which cannot be varied) and as the trustees have a commitment to provide these payments for life, they are unable to distribute benefits to beneficiaries until after the settlor’s death.

For many individuals the rigidity of these arrangements is a trade-off against the immediate reduction in the inheritance tax (IHT) payable by their estate when they die. This structure does not suit everyone and there is a desire for greater flexibility with some individuals prepared to remove the potential for a discount in return for this flexibility.

This desire led us to look at other ways in which reversionary interests could be used for mainstream IHT mitigation products and in 1991 a flexible reversionary trust utilising life policies was launched to the UK market. This was called the Estate Preservation Bond and was initially available using UK-based life policies, but was closely followed by an international version written through the Isle of Man.

This year sees the 25th anniversary of launching the flexible reversionary trust and since that event, numerous clients have successfully protected their investments from IHT. Because it used a long-standing legal principal that has never been a concern for HMRC.

The Inheritance Tax Office of HMRC accepts that the retention of a reversionary interest does not jeopardise the IHT effectiveness of the arrangement.

The original structure used a flexible interest in possession trust holding a series of life policies that were assigned into the trust by the investor. At outset, each policy was given a maturity date and on maturity the value of the policy would revert back to the settlor. Any death benefit or surrender benefit payable under the policies would go to the beneficiaries of the trust.

The policies that were issued had deferrable maturity dates which meant the trustees could, if they wanted to, defer the maturity dates before they occurred. This would keep the money invested inside the trust with a new maturity date and when this date approached the trustees could defer it again if they chose.

The ability to defer these payments meant that the reversion was not necessarily invoked and, therefore, the arrangement did not qualify for a discount. In addition to this, the trustees were able to distribute benefits to the beneficiaries before the settlor’s death. One way to look at this was that a flexible reversionary trust traded the availability of a discount for flexible access.

Under the legislation at that time, any investment into a flexible trust was a potentially exempt transfer which made the arrangement very efficient from an inheritance tax perspective. There was no danger of a lifetime IHT charge at outset and individuals could invest as much as they like – providing they lived for seven years, the value of the gift was outside of their estate.

2004 - Pre-Owned Asset Tax (POAT)

In 2004 the then Chancellor of the Exchequer, Gordon Brown, introduced a regime targeting the avoidance of inheritance tax. This legislation was aimed at people who used artificial structures designed to avoid inheritance tax by removing assets from the taxable estate but which allowed them to continue to enjoy the benefits of ownership. This is known as Pre-Owned Asset Tax.

From 6 April 2005 those people that enjoyed the benefits of schemes caught by the legislation would be subject to an annual income tax charge in respect of the benefits they enjoy, or were capable of enjoying.

Unfortunately the legislation was unclear when it came to interpreting its effect on a number of inheritance tax mitigation arrangements. This included reversionary trusts such as discounted gift trusts and flexible reversionary trusts as the settlor could be seen as giving money away but continuing to benefit.

In most cases the availability of such arrangements, including the Estate Preservation Bond, was reduced whilst the full impact of this [new] legislation was assessed and clarified.

Although HMRC confirmed in writing that POAT would not apply, they declined to make any legislative change to this effect which, to Canada Life, was unacceptable for marketing a tax saving product.

2006 - Déjà vu? : Not quite

Despite obtaining clarification around the effectiveness of reversionary trusts, Canada Life thought an IHT solution should be compliant with the wording of the POAT legislation. HMRC’s provision of a letter of understanding does not mean an arrangement is compliant with legislation; after all understanding can change as we have seen in recent years.

The desire for a robust and compliant solution led to the development of the Wealth Preservation Account, which was launched in 2006. This has similarities to the Estate Preservation Bond, in it consists of a series of life policies with maturity dates, where the trustees are able to defer some or all of the maturities before they actually occur.

When policies are deferred there is no further gift as the settlor does not control the maturities, the trustees do, but where any policies do mature the value reverts back to the settlor. The death and surrender benefits are available to the beneficiaries and the settlor cannot benefit from these.

In order to be watertight as regards POAT, there was a change to the trust structure being used; the Wealth Preservation Account uses a unique double trust structure.

The policies are assigned into a bare trust where the settlor is the beneficiary. The equitable rights of the policies are then gifted to a discretionary settlement and the legal title remains with the trustees of the initial bare trust. The use of policy maturities and the separation of equitable and legal ownership clearly identifies the trust property that can revert back to the settlor – and as the settlor cannot be a beneficiary of the settlement there is no gift with reservation. This arrangement is sometimes referred to as a ‘carve-out’.

As the taxation of trusts changed on 22 March 2006, the new arrangement used a discretionary trust rather than a flexible trust.

Clearly if the settlor was to benefit, directly or indirectly, from the trust in any other way except for the maturity proceeds, it could be argued that the original investment was a gift with reservation. Like other trust arrangements, the settlor’s spouse should therefore only be added as a potential beneficiary in the capacity of widow or widower.

As the equitable rights are gifted to a discretionary settlement this arrangement is a chargeable lifetime transfer for IHT purposes. If the available nil rate band is exceeded the trustees will be liable to 20% lifetime IHT on the excess amount. This would have implications for any distributions made to the beneficiaries in the next ten years, before a periodic charge calculation.

2016 – Not letting go: Flexible Reversionary Trusts and estate planning

The suitability of different estate planning solutions will depend on the individual’s own circumstances, needs and objectives. When considering the different solutions available there is a trade-off between IHT-efficiency and access.

This is summarised in the table below:

Trust

IHT efficiency

Access

Capital

Income

No trust

There is no IHT benefit and the individual has full access to the investment.

In estate

In estate

Capital and growth

Bare Probate trust

Again, there is no IHT benefit as the individual has full access to the investment through the trustees.

In estate

In estate

Capital and growth

Gift and loan trust

A gift and loan trust only has a minimal gift with the main investment being made up by a loan. The outstanding loan remains in the settlor’s estate and they only have access to loan repayments.

In estate

Outside estate immediately

Capital

Flexible reversionary trust

This offers a balance between access and IHT efficiency. It is possible for the settlor to receive all trust property through policy maturities.

Out of estate after 7 years

Outside estate immediately

Capital and growth

Discounted gift trust

The advantage is having a discount, however the regular payments cannot be changed and if unspent will accumulate in an IHT environment.

Part outside immediately

Part outside after 7 years

Outside estate immediately

Regular payments

Gift trust

The settlor has no access to the trust property.

Out of estate after 7 years

Outside estate immediately

None

 

Overall a flexible reversionary trust provides a greater level of flexibility than a discounted gift trust and can offer individuals a greater level of control – this can be attractive as can the ability to distribute benefits prior to the settlor’s death. However, for some individuals a discounted gift trust can still offer advantages. The ability to invest more than the nil rate band should not be overlooked and some people will need, and like, fixed payments – budgeting becomes much easier.

In some instances a combination of solutions can be a suitable alternative; a discounted gift trust to cover known expenses and a flexible reversionary trust for the discretionary expenses. If other funds are earmarked for estate planning then a gift and loan may be a suitable destination allowing loan repayments after seven years to fund further gifting to discretionary trusts.

We say...

Many advisers and clients will be more familiar with discounted gift trusts than they are with flexible reversionary trusts, but both solutions have longevity and are suitable in the right circumstances.

This year sees Canada Life notch up 25 years’ experience in administering flexible reversionary trusts and still offers this solution in the robust double-trust structure of the Wealth Preservation Account, which reaches its tenth anniversary. The flexible reversionary trust is an established, uncontroversial estate planning solution.

Remember that the suitability of a flexible reversionary trust, like any other estate planning solution, will depend on the client's individual circumstances. As with any investment there is risk; the value can fall as well as rise and currency fluctuations can also affect performance.

 

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Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.

Canada Life International Limited and CLI Institutional Limited are Isle of Man registered companies authorised and regulated by the Isle of Man Financial Services Authority.

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Stonehaven UK Limited and MGM Advantage Life Limited, trading as Canada Life, are subsidiaries of The Canada Life Group (U.K.) Limited. Stonehaven UK Ltd is authorised and regulated by the Financial Conduct Authority. MGM Advantage Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority.