TECHTALK OCTOBER 2017 ISSUE 6 VOLUME 16 PROTECTION SPECIAL EDITION

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1 TECHTALK OCTOBER 2017 ISSUE 6 VOLUME 16 PROTECTION SPECIAL EDITION

2 EDITOR Paul Rutkowski Paul is a senior manager within Scottish Widows, having joined the Group in He has over 20 years of experience across a broad spectrum of financial services roles including workplace pensions, individual pensions, proposition management and business development. CONTRIBUTORS Bernadette Lewis Bernadette joined the group in She has over 35 years experience in Financial Services with both intermediaries and providers. She has broad and deep technical experience across pensions, protection, tax and trusts. Johnny Timpson Johnny Timpson is Scottish Widows protection specialist. Johnny is a member of the Income Protection Task Force, the IPTF Welfare Working Group, Seven Families project team, Building Resilient Households Group and Cii Insuring Women s Futures Advisory Panel. Thomas Coughlan Tom has spent over 15 years in technical roles. He has wide experience including the provision of technical support to financial advisers covering life, pensions and investment compliance. He currently specialises in pension planning. Chris Jones Chris joined the group in He s worked in a number of technical roles in marketing, product development and technical support. His recent focus has been on pensions taxation and the new pension reforms. Jeremy Branton Jeremy has over 25 years experience working for financial services providers in a number of technical and advisory roles in life, pensions and protection. Having joined the group in 2006 he now specialises in corporate pensions, with particular focus on pensions reform. CONTENTS 4 RESIDENCE NIL-RATE BAND: TAPERING, TRANSFERABILITY AND TRUSTS Bernadette Lewis As well as the news that it s possible to use discretionary will trusts with the RNRB, this article looks at valuing the estate for tapering plus the role of lifetime gifting and the interaction of tapering and the transferability provisions TRUST BASICS: BARE, DISCRETIONARY, FLEXIBLE AND SPLIT Bernadette Lewis A round up of useful trust basics applicable to both family protection policies and investment bonds set up in trust. MORTGAGE SAFETY NET BENEFIT BECOMES A LOAN AND CHARGE Johnny Timpson The changes to Support for Mortgage Interest benefit coming into effect from April IHT TAPER RELIEF AND PROTECTION Thomas Coughlan A detailed look at the operation of PETs, CLTs and taper relief and how a tax liability can be covered with a protection policy. RELEVANT LIFE COVER Chris Jones With the Lifetime Allowance (LTA) at just 1m, more and more clients could exceed this limit in the event of a death claim. Relevant Life Cover can often help. BUSINESS PROTECTION PLANNING TIPS Jeremy Branton Summarising how key person cover can be established for different business entities. AN INTRODUCTION TO THE RESIDENCE NIL-RATE BAND Jeremy Branton We outline the key points of the IHT RNRB, which came into effect on 6th April 2017.

3 WELCOME TO THE PROTECTION SPECIAL EDITION OF TECHTALK As the first Techtalk that I have edited, I m thrilled with the quality of the content that we have put together for you in this edition. The edition is focussed on the varied needs around protection advice, for example mortgage protection, inheritance tax planning or small businesses. The articles will have particular interest for protection specialist advisers, but we ve created the content to ensure all advisers will find something of interest in here. If you glance across to the contents page, you ll find a full list of the articles and authors for this edition, including a brief summary of each article. A couple of key highlights that I d like to draw out firstly, all advisers I m sure will be interested in the news that it s possible to use fully discretionary will trusts for residence nil-rate band planning. For the details, see Residence nil-rate band: tapering, transferability and trusts. As legal experts are already aware, this planning relies on using section 144 of IHT Act But as there s plenty of guidance to the contrary out there, be reassured that HMRC s inheritance tax manual confirms this works. We also welcome another terrifically interesting article from our guest contributor Johnny Timpson where he explains the April 2018 changes to Support for Mortgage Interest state benefit. Please remember the Financial Planning team isn t just responsible for bringing you Techtalk. Advisers and paraplanners can access a wide range of supporting material produced by the same team. Just visit the Scottish Widows Adviser Extranet and go to the Financial Planning page: financial-planning Finally, if you d like to find out more about the Scottish Widows Protect range, please get in touch with your usual Scottish Widows contact, or go to: products/protection Enjoy the read. Paul Rutkowski

4 RESIDENCE NIL-RATE BAND: TAPERING, TRANSFERABILITY AND TRUSTS Bernadette Lewis This article focusses on three aspects of the residence nil-rate band (RNRB): valuing the estate for tapering and a surprising opportunity for lifetime gifting the transferrable RNRB including the interaction with tapering will trust planning less restrictive than you might think. If you re new to the topic, or just want a refresher on the rules, you ll probably find it helpful to read Jeremy Branton s article An introduction to the residence nil-rate band first. RNRB TAPERING The RNRB is tapered by 1 for every 2 the deceased s inheritance tax (IHT) estate exceeds the taper threshold. This is 2 million up to 2020/2021 and then increases in line with the consumer prices index (CPI). RNRB tapering is based on the value of the death estate including any trust funds that fall into the estate and after deducting allowable liabilities. Importantly, this valuation ignores any exemptions and reliefs, and also any lifetime gifts made in the seven years before death. So calculating a client s potential IHT liability may now require two steps first establishing if their RNRB is likely to be tapered, then estimating their IHT liability on death. 4 techtalk

5 Example Nick was divorced when he died in 2017/2018 and his estate didn t benefit from any transferrable RNRB or NRB. He left 100,000 to charity and everything else to his son including AIM shares qualifying for 100% business property relief. He d made no lifetime gifts in the previous seven years. Nick s death estate exceeded the 2 million RNRB taper threshold by 290, ,000 / 2 = 145,000. This exceeded the 100,000 RNRB for 2017/2018, tapering his RNRB to nil. Estate valuation for RNRB taper House Nick occupied as his home 950,000 AIM shares 300,000 Other investments 500,000 Cash ISA 400,000 Chattels 140,000 Estate on death 2,290,000 When it came to calculating the IHT due on Nick s estate, the exempt charity bequest and business property relief were taken into account, along with the full standard NRB. The IHT liability was 626,000. IHT due on Nick s estate Estate on death 2,290,000 Exempt transfer to charity ( 100,000) Business property relief on AIM shares ( 300,000) Taxable estate on death 1,890,000 Nil rate band ( 325,000) 40% IHT due on: 1,565,000 IHT 626,000 techtalk 5

6 RNRB TAPER AND LIFETIME GIFTING Surprisingly, the RNRB tapering provisions mean that lifetime gifting can lead to IHT savings even when there s no likelihood of the donor surviving seven years. Outright gifts or transfers into trusts can both be considered. Of course, the anticipated IHT savings might be offset by legal fees, disposal costs or capital gains tax (CGT) liabilities. Example Let s change Nick s situation, so his death followed a terminal illness diagnosis giving him time to review his IHT planning. Four months before he died, he gifted 300,000 from his cash ISA to his son. His 3,000 annual IHT exemptions for 2017/2018 and also 2016/2017 were available, making his failed potentially exempt transfer (PET) 294,000. Gifting cash outright meant no legal fees, disposal costs or CGT implications. The lifetime gift kept Nick s death estate within the 2 million taper threshold. His estate benefitted from the full RNRB for 2017/2018 because he left a home worth more than 100,000 to a direct descendant. Estate valuation for RNRB taper House Nick occupied as his home 950,000 AIM shares 300,000 Other investments 500,000 Cash ISA 100,000 Chattels 140,000 Estate on death 1,990,000 The failed PET reduced the standard NRB available to set against Nick s death estate. Nil rate band 325,000 Failed PET ( 294,000) Nil rate band available to estate 31,000 However, regaining the full RNRB resulted in an overall IHT saving of 42,400 his estate was liable to 583,600 IHT rather than 626,000. IHT due on Nick s estate Estate on death 1,990,000 Exempt transfer to charity ( 100,000) TRANSFERRABLE RNRB AND TAPERING The transferrable RNRB allows the second spouse to die s legal personal representatives to claim any unused percentage of the RNRB from the first spouse to die s estate. This also applies to civil partners. If someone s been widowed more than once, their estate can benefit from multiple unused RNRBs up to an additional 100%. It doesn t matter when the first spouse died, although the second spouse has to die after 5th April It also doesn t matter whether or not the first spouse to die s estate included a qualifying property. However, the tapering rules certainly complicate matters compared with the transferrable standard NRB rules. FIRST SPOUSE DIED BEFORE 6TH APRIL 2017 the remaining available percentage of the first spouse to die s RNRB is based on a deemed 100,000 RNRB tapering applies if the first spouse s death estate exceeded 2 million as tapering won t apply in most cases, the second spouse to die s estate will normally benefit from 100% transferrable RNRB. FIRST SPOUSE DIES FROM 6TH APRIL 2017 the remaining available percentage of the first spouse to die s RNRB is based on the amount of the RNRB in the tax year they die tapering applies if the first spouse s death estate exceeds the threshold in the tax year they die the first spouse s transferrable RNRB is reduced if they leave a qualifying property (or a share in one) to direct descendants. SECOND SPOUSE TO DIE S RNRB IS CALCULATED AS FOLLOWS the second spouse to die s RNRB is based on (RNRB for tax year they die) + (available percentage of first spouse s RNRB x RNRB for second spouse to die) tapering applies next, if the second spouse s estate exceeds the threshold the second spouse s RNRB is restricted if the qualifying property left to their direct descendants is worth less than their available RNRB (subject to downsizing provisions). Business property relief on AIM shares ( 300,000) Taxable estate on death 1,590,000 Residence nil rate band ( 100,000) Nil rate band ( 31,000) 40% IHT due on: 1,459,000 IHT 583,600 6 techtalk

7 Example June and Luke were married when Luke died in 2015/2016. He left his entire 1.1 million estate to June. He hadn t made any lifetime transfers in the previous seven years. Therefore, his estate is now treated as making no use of his deemed 100,000 RNRB as well as no use of his 325,000 NRB. June dies in 2018/2019 with a 2.2 million estate. Her will hasn t been reviewed since the introduction of the RNRB and leaves her home worth 420,000 to their child and her two nephews in equal shares. She hasn t downsized. The RNRB will be 125,000 in 2018/2019 June s RNRB including the transferred percentage from Luke s estate will be 125,000 + (100% x 125,000) = 250,000 her tapered RNRB will be 250,000 - ( 2,200,000-2,000,000 / 2) = 150,000 however, she s leaving just one third of her 420,000 home to a direct descendant so her RNRB will be restricted to 140,000. The nil rate band available to June s estate including the unused 100% from Luke s estate will be 325,000 + (100% x 325,000) = 650,000. So the total nil rate band available on June s death will be 790,000. It s more complex where tapering applies on the first death, or on both the first and second deaths: Example Moira and Lydia are civil partners. Moira dies in 2018/2019 leaving her 2.2 million estate to Lydia, so Moira makes no use of her RNRB or her NRB. the RNRB at the date of Moira s death will be 125,000 her RNRB after tapering will be 125,000 - ( 2,200,000-2,000,000 / 2) = 25,000 Moira s unused percentage of the RNRB will be 25,000 / 125,000 = 20%. Lydia dies in 2019/2020 when her estate is worth 2.3 million and she leaves her 1.6 million home to their children. the RNRB will be 150,000 in 2019/2020 Lydia s RNRB including the transferred element will be 150,000 + (20% x 150,000) = 180,000 Lydia s tapered RNRB will be 180,000 ( 2,300,000-2,000,000 / 2) = 30,000. The nil rate band available to Lydia s estate will be 325, % x 325,000 = 650,000. So the total nil rate band available on Lydia s death will be 680,000. RNRB AND WILL TRUSTS At first sight, the RNRB will trust legislation appears restrictive. However, it s actually possible to use flexible interest in possession trusts, and even fully discretionary trusts. Clients will normally need specialist legal advice taking account of the complex legislation and their personal circumstances. However, financial advisers can offer professional legal connections their own expertise when it comes to the financial fact finding element the RNRB taper and downsizing provisions introduce into will trust planning. Where this section refers to trusts created in wills, this also includes trusts created by deeds of variation validly using section 142 IHTA TRUSTS SPECIFICALLY COVERED IN THE RNRB LEGISLATION A direct descendant of the deceased is treated as if they d directly inherited the deceased s home if they do so as the beneficiary of four specific types of settlement : immediate post death interest (IPDI) trusts disabled persons trusts section 71A bereaved minors trusts section 71D trusts. IMMEDIATE POST DEATH INTEREST TRUSTS The RNRB is available if a direct descendant of the deceased acquires a qualifying interest in possession in the deceased s home via an IPDI trust. So what s an IPDI trust? IPDI trusts can only be created upon death either by a will, or if a statutory trust is created as a result of dying intestate. IPDI trusts fall into a special IHT category which means these trusts can be flexible, but always fall into at least one beneficiary s IHT estate and are not subject to IHT periodic and exit charges. IPDI trusts include life tenant trusts created by wills. There are lots of variations, but at their simplest, one beneficiary the life tenant has a qualifying interest in possession. This is because they have the right to live in the trust property or receive the trust income for life. The trust fund falls into their IHT estate. Other beneficiaries the remaindermen become absolutely entitled to the trust property when the life tenant dies. In Scotland, the equivalent beneficiary classes are the liferent and fiars. It s also possible to create very flexible IPDI trusts in wills. Again, there are many variations but there must be at least one beneficiary with a qualifying interest in possession. This can be created by giving them the immediate but revocable right to the trust income, or to live in the trust property, so that the trust fund falls into their IHT estate. These trusts also have potential beneficiaries. The trustees have discretionary powers to appoint trust property to any of the beneficiaries. The RNRB should be available provided the trust property is a qualifying residence and the original qualifying interest in possession beneficiary is the deceased s direct descendant. techtalk 7

8 If an IPDI trust is created to use the RNRB and this affects your clients, the next issue for their legal advisers to confirm is whether any RNRB will be available when the life tenant or other qualifying interest in possession beneficiary dies. It s an important consideration as the value of the trust fund will be in their IHT estate. DISABLED PERSON S, SECTION 71A AND SECTION 71D TRUSTS These trusts are relatively uncommon but in summary: disabled person s trusts not only have to be for a disabled person, but also meet specific criteria in IHT Act 1984 section 71A bereaved minor s trusts must be established by a deceased parent s will, intestacy or the criminal injuries compensation scheme for their minor child, who must become absolutely entitled by age 18 other conditions also apply section 71D trusts must be created by a parent s will or the criminal injuries compensation scheme and their child must become absolutely entitled by age 25 other conditions also apply. A client s legal advisers should be able to confirm whether their will trust falls into any of these categories. DISCRETIONARY WILL TRUSTS AND OUTRIGHT APPOINTMENTS USING SECTION 144 IHTA 1984 The RNRB legislation certainly appears restrictive in terms of will trust planning options. However, section 144 IHT Act 1984 means the RNRB can be available even when using a discretionary will trust. This is confirmed in HMRC s Inheritance Tax Manual at IHTM RNRB AND PROPERTY ALREADY IN TRUST Clients occupying a home owned by a trust should check their RNRB position with their own legal advisers, as this will always depend on the specific trust provisions. If someone s home is a trust asset when they die and they have a qualifying interest in possession in that trust, the value of their home is in their IHT estate. Whether the RNRB is available depends on the trust provisions. A direct descendant of the deceased beneficiary must become entitled to the property as a result of their death in a way that meets the legislative conditions. Where the RNRB is available on a beneficiary s death, so is downsizing relief. If someone s home when they die is a property held in a discretionary trust, the value of their home isn t in their IHT estate. The RNRB won t be available even if the trustees make an outright appointment of the property out of the trust to the deceased s direct descendants. FURTHER INFORMATION HMRC provides a good summary of the rules at There are also useful linked case studies. For more detailed information, see also HMRC s Inheritance Tax Manual starting at IHTM As just one example, the trustees can meet the RNRB requirements by making an outright appointment within two years of death of the deceased s home out of a discretionary will trust to a beneficiary who s the deceased s direct descendant. Provided the appointment is made within two years of death, section 144 applies effectively treating the beneficiary as if they d been left the property directly by the deceased under the original will provisions. The discretionary will trust approach offers maximum flexibility at least for those willing to give their trustees control over their estate. The client can indicate who they want to inherit and how much importance to put on IHT efficiency through their choice of potential beneficiaries and a non-binding letter of wishes. The executors/ trustees can then take account of the family s circumstances and the IHT rules in place when the client dies. BARE TRUSTS While settlement and trust are often treated as meaning the same, there are subtle differences. It should be possible to use bare will trusts for RNRB purposes, as they aren t treated as settlements in the IHT legislation. The beneficiary should be treated as if they d directly inherited the property. 8 techtalk

9 TRUST BASICS: BARE, DISCRETIONARY, FLEXIBLE AND SPLIT Bernadette Lewis A useful round up of trust basics applicable to both family protection policies and investment bonds. techtalk 9

10 INITIAL GIFTS AND REGULAR PREMIUMS BARE TRUST Bare trusts are the simplest form of trust. They re also known as absolute or fixed interest trusts and while there can be subtle technical differences, these terms are interchangeable for the purposes of this article. The settlor the person creating the trust makes a gift into the trust which is held for the benefit of a specified beneficiary. If the trust is for more than one beneficiary, each person s share of the trust fund must be specified. For lump sum investments, after allowing for any available 3,000 annual exemptions, the balance of the gift is a potentially exempt transfer (PET) for inheritance tax (IHT) purposes. As long as the settlor survives for seven years from the date of the gift, it falls outside their estate. The trust fund falls into the beneficiary s IHT estate from the date of the initial gift. With loan trusts, there isn t any initial gift the trust is created with a loan instead. And with discounted gift plans, so long as the settlor is fully underwritten at the outset, the value of the initial gift is reduced by the value of the settlor s retained rights. When family protection policies are set up in bare trusts, regular premiums are usually exempt transfers for IHT purposes. The normal expenditure out of income exemption often applies, so long as the cost of the premiums can be covered out of the settlor s excess income in the same tax year, without affecting their normal standard of living. Where this isn t possible, the 3,000 annual exemption often covers some or all of the premiums. Any premiums that are nonexempt transfers into the trust are PETs. Special valuation rules apply when existing life policies are assigned into family trusts. Generally speaking, the transfer of value for IHT purposes is treated as the greater of the open market value and the value of the premiums paid up to the date the policy is transferred into trust. There s an adjustment to the premiums paid calculation for unit linked policies if the unit value has fallen since the premium was paid. The open market value is always used for term assurance policies that pay out only on death, even if the value of the premiums paid is greater. DISCRETIONARY TRUST With a discretionary trust, the settlor makes a gift into trust and the trustees hold the trust fund for a wide class of potential beneficiaries. Technically this is known as settled or relevant property. For lump sum investments, the initial gift is a chargeable lifetime transfer (CLT) for IHT purposes. It s possible to use any available 3,000 annual exemptions. If the total nonexempt amount gifted is greater than the settlor s available nil-rate band there s an immediate IHT charge at the 20% lifetime rate or effectively 25% if the settlor pays the tax. The settlor s available nil-rate band is essentially the current nil-rate band less any CLTs they ve made in the previous seven years. So in many cases where no other planning is in place, this will simply be the current nil-rate band, which is 325,000 up to 2020/2021. The residence nil-rate band isn t available to trusts or any lifetime gifting. Again, there s no initial gift when setting up a loan trust, and the initial gift is usually discounted when setting up a discounted gift plan. Where a cash gift exceeds the available nil-rate band, or an asset is gifted which exceeds 80% of the nil-rate band, the gift must be reported to HMRC on an IHT 100. When family protection policies are set up in discretionary trusts, regular premiums are usually exempt transfers for IHT purposes for the reasons explained earlier. Any premiums that are non-exempt transfers into the trust will be CLTs. The special valuation rules for existing policies assigned into trust outlined earlier apply in the same way. FLEXIBLE TRUST WITH DEFAULT BENEFICIARIES This type of trust is similar to a fully discretionary trust, except that alongside a wide class of potential beneficiaries, there must be at least one named default beneficiary. Flexible trusts with default beneficiaries set up in the settlor s lifetime from 22nd March 2006 onwards are treated in exactly the same way as discretionary trusts for IHT purposes. Different IHT rules apply to older trusts set up by 21st March 2006 that meet specified criteria and some will trusts, but further discussion is outside the scope of this article. SPLIT TRUST Split trusts are often used for family protection policies with critical illness or terminal illness benefits in addition to life cover. Split trusts can be bare trusts, discretionary trusts, or flexible trusts with default beneficiaries. When using this type of trust, the settlor/life assured carves out the right to receive any critical illness or terminal illness benefit from the outset, so there aren t any gift with reservation issues. In the event of a claim, the provider normally pays any policy benefits to the trustees, who must then pay any carved out entitlements to the life assured and use any other proceeds to benefit the trust beneficiaries. If terminal illness benefit is carved out, this could result in the payment ending up back in the life assured s IHT estate before their death. A carved out terminal illness benefit is treated as falling into their IHT estate once they meet the conditions for payment. So not claiming the benefit doesn t do anything to solve this problem. 10 techtalk

11 ONGOING TAX IMPLICATIONS BARE TRUST With a bare trust there are no ongoing IHT reporting requirements and no further IHT implications. With protection policies, this applies whether or not the policy can acquire a surrender value. Where the trust holds a lump sum investment, the tax on any income and gains usually falls on the beneficiaries. The most common exception is where a parent has made a gift into trust for their minor child or stepchild, where parental settlement rules apply to the income tax treatment. Therefore, the trust administration is relatively straightforward even for lump sum investments. Where relevant, the trustees simply need to choose appropriate investments and review these regularly. DISCRETIONARY TRUST As well as the potential for an immediate IHT charge on the creation of the trust, there are two other points at which IHT charges will apply. These are known as periodic charges and exit charges. Periodic charges apply at every 10 yearly anniversary of the creation of the trust. Exit charges may apply when funds leave the trust. The calculations can be complex but are a maximum of 6% of the value of the trust fund. In many cases they ll be considerably less than this as in simple terms, the 6% is applied on the value in excess of the trust s available nil-rate band. However, even where there is little or in some circumstances no tax to pay, the trustees still need to submit an IHT 100 to HMRC. Under current legislation, HMRC will do any calculations required on request. For a gift trust holding an investment bond, the value of the trust fund will be the open market value of the policy normally its surrender value. For a loan trust, the value of the trust fund is the bond value less the amount of any outstanding loan still repayable on demand to the settlor. For discounted gift schemes, the value of the trust fund normally excludes the value of the settlor s retained rights and in most cases, HMRC is willing to accept pragmatic valuations. For example, where the settlor was fully underwritten at the outset, and is not terminally ill at a 10 yearly anniversary, any initial discount taking account of the value of the settlor s retained rights can be recalculated as if the settlor was 10 years older than at the outset. If a protection policy with no surrender value is held in a discretionary trust, there will usually be no periodic charges at each 10 yearly anniversary. However, a charge could apply if a claim has been paid out and the funds are still in the trust. In addition, if a life assured is in severe ill health around a 10 yearly anniversary, the policy could have an open market value close to the claim value. If so, this has to be taken into account when calculating any periodic charge. Where discretionary trusts hold investments, the tax on income and gains can also be complex, particularly where income producing assets are used. The trustee rates of tax are currently 45% on interest and rent, 38.1% on dividends and 20% on capital gains (2017/2018). Many of these complications can be avoided by investing in life assurance investment bonds as these are non-income producing assets and allow trustees to control the tax points on any chargeable event gains. FLEXIBLE TRUST WITH DEFAULT BENEFICIARIES All post 21st March 2006 lifetime trusts of this type are taxed in the same way as fully discretionary trusts for IHT and capital gains tax purposes. For income tax purposes, any income is payable to and taxable on the default beneficiary. However, this doesn t apply to even regular withdrawals from investment bonds, which are non-income producing assets. Bond withdrawals are technically capital payments even though chargeable event gains are subject to income tax. As with bare trusts, the parental settlement rules apply if parents make gifts into trust for their minor children or step-children. BENEFICIARIES, CONTROL AND FLEXIBILITY BARE TRUST With a bare trust, the trustees look after the trust property for the known beneficiaries, who become absolutely entitled to it at age 18 (age 16 in Scotland). Once a gift is made, or a protection trust set up, the beneficiaries can t be changed and money can t be withheld from them beyond the age of entitlement. This aspect makes them unattractive to many clients, who d prefer to retain a greater degree of control. For cases where the beneficiaries are already adults it could even be argued that there isn t really a trust at all where lump sums are invested. This is particularly true with a straightforward gift trust. However, when used as part of loan trust or discounted gift trust planning, there can still be some advantages, as the beneficiaries will normally agree to wait to obtain the benefits. If a beneficiary does use their right to demand their share of the trust assets, the trustees are obliged to make payment after having secured the settlor s rights. With a loan trust, this means repaying any outstanding loan. With a discounted gift trust, it means securing the settlor s right to receive their fixed payments for the rest of their life. With protection policies in bare trusts, any policy proceeds that haven t been carved out for the life assured s benefit under a split trust must be paid to the trust beneficiary if they re an adult. Where the beneficiary is a minor, the trustees must use the trust fund for their benefit. For example, if the proceeds are used to repay a surviving parent s mortgage, it s likely the minor beneficiary s financial interest would need to be secured in some way on the property. techtalk 11

12 Difficulties can arise if it s discovered that a trust beneficiary has predeceased the life assured. In this case, the proceeds belong to the legatees of the deceased beneficiary s estate, which can leave the trustees with the job of tracing them. The fact that beneficiaries are absolutely entitled to the funds also means the trust offers no protection of the funds from third parties, for example in the event of a beneficiary s divorce or bankruptcy. DISCRETIONARY TRUST As you would expect from the name, these trusts give the trustees discretion over who benefits and when. The trust deed will set out all the potential beneficiaries and these usually include a wide range of family members, plus any other individuals the settlor has chosen. This gives the trustees a high degree of control over the funds. The settlor is often also a trustee to help ensure their wishes are considered during their lifetime. In addition the settlor can provide the trustees with a letter of wishes identifying who they d like to benefit and when. The letter isn t legally binding, but can give the trustees clear guidance which can be amended if circumstances change. The settlor might also be able to appoint a protector, whose powers depend on the trust provisions, but usually include some degree of veto. This degree of control is attractive to many. Family disputes are not uncommon and many feel they d prefer to pass funds down the generations when the beneficiaries are slightly older than 18. A discretionary trust also provides greater protection from third parties, for example in the event of a potential beneficiary s divorce or bankruptcy, although in recent years this has come under greater challenge. SIMPLICITY VERSUS CONTROL AND FLEXIBILITY Essentially these types of trust offer a trade-off between simplicity and the degree of control available to the settlor and their chosen trustees. For most, control is the more significant aspect, especially where any lump sum gifts can stay within a settlor s available IHT nil-rate band. Keeping gifts within the nil-rate band and using non-income producing assets such as investment bonds can allow a settlor to create a trust with maximum control, no initial IHT charge and limited ongoing administrative or tax burdens. In other cases, for example, grandparents funding for school fees, the bare trust may offer advantages. This is because tax will fall on the grandchildren and most of the funds may be used up by the age of 18. The considerations are slightly different when considering family protection policies, where the settlor will often be dead when policy proceeds are paid out to beneficiaries. A bare trust ensures the policy proceeds will be payable to one or more individuals, with no uncertainty about whether the trustees will follow the deceased s wishes. However, this can also mean that the only solution to a change in circumstances, such as divorce from the intended beneficiary, is to start again with a new policy. Remember that settlors are often excluded from benefitting under discretionary and flexible trusts. Where this applies, this type of trust isn t suitable for use with joint life, first death protection policies if the primary purpose is for the proceeds to go to the survivor. FLEXIBLE TRUST WITH DEFAULT BENEFICIARIES When it comes to beneficiaries and control, there are no significant differences between fully discretionary trusts and this type of trust. There will be a wide range of potential beneficiaries. In addition, there will be one or more named default beneficiaries. Naming a default beneficiary is no more binding on the trustees than providing a letter of wishes setting out who the settlor would like to benefit from the trust fund. The trustees still have discretion over which of the default and potential beneficiaries actually benefits and when. Some older flexible trusts limit the trustees discretionary powers to within two years of the settlor s death, but this is no longer a common feature of this type of trust. 12 techtalk

13 SUMMARY OF THE KEY DIFFERENCES Bare trust After allowing for any available 3,000 annual exemptions, initial gift is a PET. No immediate IHT consequences of making the gift. Regular premiums are usually exempt under normal expenditure out of income and/or 3,000 annual exemptions and PETs to the extent they re not exempt. Minimal trust administration and no ten year charge or exit charge. Beneficiaries must be named at the outset and it s not possible to change them or to benefit anyone yet unborn. Lack of flexibility beneficiaries are absolutely entitled to the trust fund and can demand it at any time once they reach age 18 (16 in Scotland). Trust fund is in beneficiaries estates for IHT purposes. No protection against claims by third parties (for example on divorce or bankruptcy of beneficiary). Discretionary trust / flexible trust with default beneficiaries (created since 22nd March 2006) After allowing for any available 3,000 annual exemptions, initial gift is a CLT. Immediate charge to IHT if amount of gift exceeds settlor s available nil-rate band. Regular premiums are usually exempt under normal expenditure out of income and/or 3,000 annual exemptions and CLTs to the extent they re not exempt. Settled property regime applies with reporting requirements and ten year charge and exit charge. Flexibility maintained as beneficiaries can be changed according to circumstances and future generations catered for. Control in trustees hands as they have discretion over who benefits and when sometimes subject to a protector s approval. Trust fund is not in any individual s estate. Greater protection from third parties as beneficiaries benefit only at the discretion of trustees. Note: this guidance doesn t cover business protection trusts or relevant life policy trusts. techtalk 13

14 MORTGAGE SAFETY NET BENEFIT BECOMES A LOAN AND CHARGE Johnny Timpson We explain the changes to Support for Mortgage Interest benefit coming into effect from April Welfare safety net provision in the form of Support for Mortgage Interest (SMI) assistance has been available within our benefit system to support owner occupier claimants mortgage interest payments since However, a statutory instrument introducing The Loans for Mortgage Interest Regulations 2017 was laid before Parliament on the 6th of July and outlines the most significant reform to mortgage safety net provision in almost 70 years. SMI currently contributes towards interest on a claimant s qualifying mortgage while they re in receipt of Income Support, income-based Jobseeker s Allowance, income-related Employment and Support Allowance or Pension Credit. The support is limited to mortgage interest of up to 200,000 for working age claimants or 100,000 in the case of claimants receiving Pension Credit. Working age claimants serve a 39- week qualifying period and SMI ensures that homeowners receiving these benefits are protected from repossession during periods of unemployment, sickness or retirement. Note, however, that it is not available if the claimant s household has more than 15,000 in savings and when SMI is replaced by Universal Credit, a non-earnings rule will apply meaning that when a party to the mortgage continues to receive earned income, no support will be available. From April 2018, however, the Government plans to make SMI a loan, with a charge being taken on the property. This means that homeowners have to pay back the amount of mortgage interest that the State paid for them either when they return to work, when they sell their home or on the claimant s death. 14 techtalk

15 The prime objective of SMI has been to provide short-term help to prevent repossession, with the DWP making a contribution towards mortgage interest payments directly to mortgage lenders while claimants take steps to move back into work. The reform will apply from 5th April 2018 to current SMI benefit claimants and they will receive a letter by February 2018 telling them about the reform, the switch from a benefit to a loan, and the options available to them. It will also apply to new claimants from the same date. The current SMI limits and 39-week waiting period will remain as is now with interest payment support being paid directly to the SMI claimant s lender. But with SMI becoming a loan, a third party administered charge will be taken on the property. SMI loans will carry a six-monthly reviewable interest rate equal to the forecast gilt rate (this is typically lower than the market and currently 1.7%). The amount of SMI paid to any claimant, plus interest on that loan, would be recouped from the equity in the property when it is sold, when there s a transfer of ownership (e.g. on death) or is repaid voluntarily when the claimant returns to work. If there is insufficient equity in a claimant s property to repay the whole SMI loan, the balance would be written off. The rationale for this mortgage safety net reform is that the growth of interest-only mortgages, together with households taking mortgages increasingly into retirement, makes the provision of SMI under the current non-repayable benefit basis, where the owner occupier continues to benefit from any capital appreciation in the property, increasingly unsustainable. This is especially so if rates increase. It s also unfair to the taxpayers who cover the cost, many of whom are renting and unable to buy a home of their own. Importantly, without the policy change, there s an incentive for households to allow the taxpayer to take the burden of their mortgage without taking steps to repay it themselves. This major reform of the mortgagors welfare safety net gives good reason to review the resilience and finance protection needs of all mortgage clients, new and old. Further information on SMI and entitlement can be found at techtalk 15

16 IHT TAPER RELIEF AND PROTECTION Thomas Coughlan Inheritance tax is commonly referred to as the death tax but its effects can be felt during lifetime and because of actions taken during lifetime. This is due to the tax treatment of lifetime transfers, which can result in a liability, which is sometimes reduced by taper relief. The two main types of lifetime transfers are potentially exempt transfers and chargeable lifetime transfers referred to as PETs and CLTs. PETs are lifetime gifts made directly to other individuals, which includes gifts to bare trusts. A similar lifetime gift made to most other types of trust is a CLT. These rules apply to non-exempt transfers: gifts to a spouse are exempt so are not subject to inheritance tax (IHT). Where a PET fails to satisfy the conditions to remain exempt because the person who made the gift died within seven years its value will form part of their estate. Survival for at least seven years, on the other hand, ensures full exemption from IHT. A CLT is not conditionally exempt from IHT. If it is covered by the nil-rate band and the transferor survives at least seven years it will not attract a tax liability, but it could still impact on other chargeable transfers under the 14-year-rule, which is not covered in this article. A CLT that exceeds the available nil-rate band when it is made results in a lifetime IHT liability. Failure to survive for seven years results in the value of the CLT being included in the estate. If the CLT is subject to further IHT on death, a credit is given for any lifetime IHT paid. 16 techtalk

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18 THE TAXATION OF POTENTIALLY EXEMPT TRANSFERS Following a gift to an individual or a bare trust, there are two potential outcomes: survival for seven years or more; and death before then. The former results in the PET becoming fully exempt and it no longer figures in the IHT assessment. In other cases the amount transferred less any IHT exemptions is notionally returned to the estate. Anyone utilising PETs for tax mitigation purposes, therefore, should consider the consequences of failing to survive for seven years. Such an assessment will involve balancing the likelihood of surviving for seven years against the tax consequences of death within that period. Example Jacqueline, a widow, has an estate worth 2 million. She wants to reduce the value of her estate to minimise IHT. After the 3,000 annual exemption is accounted for, she gifts 500,000 to her daughter, Chloe. Her financial adviser recommends this course of action because she is 68 and in good health and, therefore, likely to survive for seven years. She is not entitled to a transferable nil-rate band. If she does survive for seven years her taxable estate will be valued (ignoring growth for simplicity) at: Total assets 1,500,000 1 x nil-rate band ( 325,000) Taxable estate 1,175,000 But if Jacqueline had died within seven years her taxable estate would have been valued at: Failed PET 500,000 Plus total assets 1,500,000 Less 1 x nil-rate band ( 325,000) Taxable estate 1,675,000 As in real life, death for PET purposes is an all or nothing thing. Failure to survive for the required seven year period results in the full value of the transfer being notionally included within the estate; survival beyond then and nothing is included. This oft misunderstood point is crucial. It is taper relief which reduces the IHT liability (not the value transferred) on the failed PET after its full value has been returned to the estate. The value of the PET itself is never tapered. The recipient of the failed PET is liable for the IHT due on the gift itself and benefits from any taper relief. The IHT due on the PET is deducted from the total IHT bill and the estate is liable for the balance. Another important aspect of the IHT rules is that lifetime transfers are dealt with in chronological order upon death: earlier transfers are dealt with in priority to later ones, all of which are considered before the death estate. If a lifetime transfer is subject to IHT because the nil-rate band is not sufficient to cover it, the next step is to determine whether taper relief can reduce the tax bill for the recipient of the PET. No relief is available if death is within three years of the lifetime transfer. Survival for between three and seven years and taper relief at the following rates is available: 3 4 years 20% 4 5 years 40% 5 6 years 60% 6 7 years 80% We will continue with the example of Jacqueline and Chloe to see how taper relief is applied, assuming she died between 5 and 6 years after the PET was made. Example Jacqueline s taxable estate was: Failed PET 500,000 Plus total assets 1,500,000 Less 1 x nil-rate band ( 325,000) Taxable estate 1,675,000 The failed PET is dealt with before the estate. Failed PET 500,000 Less 1 x nil-rate band ( 325,000) Taxable amount 175,000 The failed PET is greater than the nil-rate band available to Jacqueline so is subject to IHT, which is payable by Chloe as the recipient of the failed PET: IHT liability 175,000 x 40% = 70,000 Jacqueline died between 5 and 6 years after the gift, so 60% taper relief is available to Chloe: Taper relief 70,000 x 60% = 42,000 Tax liability on failed PET: 70,000-42,000 = 28,000 In this example, the failed PET has used up the full nil-rate band, which leaves none remaining for offset against the rest of the estate this will be subject to 40% inheritance tax: 1.5 million x 40% = 600, techtalk

19 THE TAXATION OF CHARGEABLE LIFETIME TRANSFERS The tax treatment of CLTs has some similarities to PETs but with a number of differences. When a CLT is made, it is assessed against the donor s nil-rate band. If there is an excess above the nil-rate band it is taxed at 20% if the recipient pays the tax or 25% if the donor pays the tax. The same seven year rule that applies to PETs then applies. Failure to survive to the end of this period results in IHT becoming due on the CLT, payable by the recipient. The tax rate is the usual 40% on amounts in excess of the nil-rate band, but taper relief can reduce the tax bill and credit is given for any lifetime tax paid. Example If, instead of making an outright gift to another individual, Jacqueline had after the annual exemption gifted 500,000 to a discretionary trust, this would have been a CLT and the tax outcome would have been different. Lifetime tax Transfer of value 500,000 1 x nil-rate band ( 325,000) Taxable 175,000 Lifetime tax is due at 20% ( 35,000), which is usually payable by the trustees. However, the settlor can pay the tax, but it must be met out of separate funds and the liability will be 25%. (The higher percentage arises because of the loss-to-the-estate principle, which seeks to charge tax at 20% on the overall reduction in the estate value: 175,000 x 100/80 = 218, % of the gross amount is 43,750, which is 25% of 175,000.) We ll assume the trustees paid the lifetime tax in this example. If she survives for seven years her taxable estate will be valued (ignoring growth for simplicity) at: Total assets 1,500,000 1 x nil-rate band ( 325,000) Taxable 1,175,000 If Jacqueline had died within seven years her taxable estate would have been valued at: Failed CLT 500,000 Plus total assets 1,500,000 Less 1 x nil-rate band ( 325,000) Taxable estate 1,675,000 We ll assume Jacqueline died between 3 and 4 years after she made the CLT. The failed CLT is dealt with before the estate. Failed CLT 500,000 Less 1 x nil-rate band ( 325,000) Taxable amount 175,000 The failed CLT is greater than the nil-rate band available to Jacqueline so is subject to IHT on death, payable by the trustees out of the trust fund: IHT liability 175,000 x 40% = 70,000 Jacqueline died between 3 and 4 years after the gift, so 20% taper relief is available to the trustees: Taper relief 70,000 x 20% = 14,000 Tax liability on failed CLT: 70,000-14,000 = 56,000 Less lifetime tax paid: 56,000-35,000 = 21,000 The CLT also uses up the full nil-rate band, so none remains available for offset against the rest of the estate this will be subject to 40% inheritance tax: 1.5 million x 40% = 600,000. USE OF PROTECTION POLICIES TO COVER AN IHT LIABILITY The seven year rules that apply to PETs and CLTs potentially increase the IHT bill for those that fail to survive for long enough after making a gift of capital. If IHT is due in respect of the failed PET in and of itself, it s payable by the recipient. If IHT is due in respect of a CLT on death, it s payable by the trustees. Any remaining IHT is payable by the estate. The potential IHT difference can be calculated and covered by a level or decreasing term assurance policy written in trust for the benefit of whoever will be affected by the IHT liability and in order to keep the proceeds out of the settlor s IHT estate. Which is more suitable and the level of cover required will depend on the circumstances. If the PET or CLT is within the nil-rate band, taper relief will not apply. However, this does not mean that no cover is required. Death within seven years will result in the full value of the transfer being included in the estate, with the knock-on effect that other estate assets up to the value of the PET or CLT could suffer tax that they would have avoided had the donor survived for seven years. A seven-year level term policy will generally be the most appropriate type of policy in this situation. Any additional IHT is payable by the estate so a trust for the benefit of the estate legatees will normally be required. techtalk 19