AF5 Training Material Inheritance Tax

AF5 Training Material Inheritance Tax

AF5 Technical Paper - Inheritance Tax (IHT) Potential exam marks available based on previous experience - 15-20% Inheritance Tax If past experience is anything to go by, your AF5 exam will have questions on IHT and the implications for your clients. This is probably the most tested area in the AF5 exam both from a financial planning and technical aspect. Therefore make sure you spend enough time properly reviewing this area, making yourself aware of the types of questions previously tested in the exam and, importantly, the structure of the answers the examiner is looking to test. On calculations specifically, there have only ever been a few exams that have actually asked for some sort of IHT calculation. We will provide a calculation in our AF5 solution. This generally gives us an indication if a calculation question will come up. We have broken this down into the following key areas: IHT - Quick re-fresh IHT Calculations Business Property Relief IHT Recommendations and Justification IHT and Domicile issues

IHT - Quick Re-fresh This is a tax payable on death but is also applied to lifetime gifts. IHT is payable on transfers in excess of the nil rate band. For the 2011/12 tax year this is 325,000. Each individual has their own nil rate band so in effect a married couple have a total allowance of 650,000. Transfers on or within 7 years of death Value Rate % 0-325,000 Nil Over 325,000 40% Also, there could be other chargeable transfers (e.g. payments into a discretionary trust) Value Rate % 0-325,000 Nil Over 325,000 40% Any unused nil rate band on an individual's death can be transferred to the estate of a surviving spouse or civil partner. Transfers A lifetime transfer could be any one of the following: Exempt Potentially Exempt Transfer Chargeable, but not taxable Chargeable and Taxable Exempt Transfers An exemptions means that the transfer does not count as chargeable and is therefore not taxed nor included in any calculations. Exemptions can include: Transfers between spouses and civil partners during lifetime and on death. Annual 3,000 gift exemption - only applies on lifetime gifts. Small Gift exemption up to 250 per tax year to any person - can be used any number of times to different donees and only applies to lifetime gifts. Also, note it cannot be used as part of a larger gift - i.e. cant use annual exemption and small gift exemption to same donee. Gifts our of normal expenditure - these are gifts from income, made from their normal expenditure and do not effect standard of living of the donor.

There are also other specific gifts - Gifts on marriage - 5,000 parent, 2,500 if ancestor, 2,500 if bride or groom and 1,000 for anyone else per tax year. All gifts to charities and political parties are exempt as are gifts for the National benefits (e.g. National Trust ). Gifts in active service - if you die in active service of the armed forces no IHT is applied. Potentially Exempt Transfers (PETs) This is a lifetime transfer by an individual to: another individual a Bare Trust A Disabled Trust. On making a PET, no tax is chargeable at the time the gift is made, the gift goes not have to be reported to HMRC and if the donor survives 7 years the gift becomes fully exempt from IHT. Death within 7 years If the donor dies within 7 years of the PET, the gift becomes chargeable and the donee is liable to pay the tax. Tax is charged on the value of the PET at the date it was made - not at the date of death. The level of IHT payable may be reduced by Taper Relief depending how long it has been since the PET was made and the donor died as follows: Years between gift and death % charge to full IHT rate More than 3 years, but less than 4 years 80% (e.g. 40% x 80% = 32% IHT charge) More than 4 years, but less than 5 years 60% More than 5 years, but less than 6 years 40% More than 6 years, but less than 7 years 20% Note that Taper Relief reduces the amount of tax payable, not the value of the gift. Gifts into Trusts Two types of gifts into Trusts are PETs. Other gifts are chargeable at the lifetime rates when they are made unless they are otherwise exempt - i.e. fall into the nil rate band. The two type of trusts that qualify as PETS are: Bare Trusts Disable Trusts

Chargeable Lifetime Transfers (CLT) A CLT is a gift that is not exempt and not potentially exempt. The most common CLT is a gift into a Trust other than those mentioned above. A CLT results in a tax charge if it takes the donor's 7 year cumulation over the nil rate band (NRB). Tax is payable at 20% on the excess over NRB No further charge of donor survives 7 years. If the donor dies within 7 years of making CLT, tax at the death rates will apply retrospectively to the transfer. Tax is recalculated using the value of the gift and the previous 7 years cumulation at the date of transfer, using the death rates of tax in force at the date of death. If tax was paid when the CLT was made this is allowed as a credit against any further tax liability. Taper relief applies in the same way as for PETs, reducing the value of the gift from 3 years onwards. If no tax liability was due when the CLT was paid, this will be because it was within the NRB and therefore it is unlikely any further IHT will be due. However, PETs in previous years will use up the NRB which could create a CLT. For the purposes of this exam, we think this should be enough background information on IHT. Any other specific information, if required, will come out in our solution. IHT Tax Calculations In our opinion, previous candidates have awarded too much of their time worrying about the finer detail of IHT calculations. This is not a tax exam so this is not an area of focus for the examiner. However, we have seen a couple of questions on tax calculations and these are easy marks if you not what you are doing. We have provided below some example IHT Calculations:

Calculate, showing all your workings, the value of your clients estate The following is an example of an IHT calculation. The key message is that you need to set this out in order so you can understand how the nil rate bands are being used and also note any assets that should not be subject to IHT. Asset Husband Wife Total Current Account 8,320 1,000 9,320 Cash ISA 2,000 2,000 Portfolio of UK Equities 62,000 62,000 Main residence 365,000 365,000 730,000 Corporate bond OEIC 40,000 40,000 Chattels 40,000 40,000 80,000 Total 515,320 408,000 923,320 Liabilities Net Estate 515,320 408,000 923,320 IHT NRB (2 full nil rate bands available at 325,000 each) -650,000 Joint estate potentially liable to IHT at 40% 273,320 Assumptions All assets pass to surviving spouse on first death - assuming a Will is created to this effect. All pension benefits are written into trust

Business Property Relief (BPR) This has been touched upon in a couple of exams and is worth you spending a moment to understand the basic principles. BPR is a relief for the transfer of business of assets. The property has to be owned for 2 years before the transfer qualifies for BPR. Non Qualifying assets Certain assets do not qualify and these include: Business that consist wholly or mainly dealing in securities, stocks and shares, land and buildings - i.e. broadly investment companies. Not available if the property is subject to a binding contract of sale at the time of transfer - e.g. on company shares if the personal representatives are obliged to sell and the remaining shareholders obliged to buy - a common situation with small companies. Certain assets will be disregarded including assets not used in the last 2 years of the business and assets not needed for future use of the business at the time of transfer - this is to stop people claiming against large cash holdings which are not genuine business assets. What is the relief? It is 100% for: Interest in unincorporated business - sole traders and partnerships. Shareholdings of any size in unquoted and AIM companies. The idea is that it preserves family businesses so they can be passed on to future generations without any IHT charge. It is 50% for: Controlling shareholdings in fully listed companies Land, buildings, plan or machinery used wholly or mainly for a company controlled by the transferor or where the transferor has been a partner in a partnership. Explain the key aspects of Business Property Relief as they relate to your clients. (8)

(note - from the factfind we established that the client owns 98% of his own business with his sons owning the balance. The company is a Limited Trading company) Answer: BPR at 100% is available for unquoted (trading) companies. This will reduce the value for IHT to nil assuming the company is trading at the time of transfer. BPR at 50% for assets such as buildings owned by the transferor and used in the business they control. BPR is available if the current owner gives away his shares during lifetime or leaves them in his will. IHT Recommendations In the real world you might get into a detailed analysis of a clients particular situation and you might consider writing some investments into Trust, perhaps doing a Loan Trust or a Discounted Gift Trust. However, unless this is something that specifically comes up in the exam (e.g. the client is looking for income then you might talk about Loan Trusts etc), if you're asked to comment on or recommend and justify certain solutions for the client, then it is likely that this will be more generic and include areas such as: Ensure Wills are in place that are up to date and accurately reflect the clients current wishes and are efficient for IHT purposes. Ensure all pension benefits have a death benefit nomination or written into Trust in order that benefits are paid outwith their estate. Ensure all life policies are written into Trust for the benefit of their children (or similar) and that this has the benefit of ensuring benefits are not subject to IHT on their estate. Arrange suitable life insurance (typically a whole of life plan) to cover the IHT liability and written into trust to ensure proceeds to increase estate. Make use of the annual gift exemptions. Detail and justify the recommendations you would make in respect of each of the following financial objectives. No calculations required. (a) Mitigate IHT due on their estate (12) (note from fact find we have a husband and wife around aged 50 in good health with IHT liability that they wish to plan for. They have existing pension plans and life policies - none of which are nominated or in Trust)

Answer Place death benefits of existing pension plans in trust or make death benefit nominations to remove proceeds from estates. Existing life policies should be put into a discretionary trust for the children and/or each other to take benefits out of the estate. They should discuss with parents the possibility of gifting that skips a generation from their parents to their children to avoid increasing their IHT Estate. They should set-up whole of life plans to meet IHT liabilities on death. Plans should be written in a discretionary Trust. Premiums for the whole of life plan should be classed as gifts out of normal expenditure and be exempt from IHT. They should use annual gift allowances. Detail and justify the recommendations you would make in respect of each of the following financial objectives. No calculations required. (a) Mitigate IHT due on the wife's estate assuming she is pre-deceased by her husband. (14) (note from fact find - The clients are in their early 60s, there are pension benefits owned by the husband, the wife will need income as the husband is main earner, both are in good health. Answer Establish Spousal bypass Trust for pension death benefits to ensure proceeds don't form part of wife's estate. Single premium investment into a Loan Trust to generate income for wife whilst still retaining access to capital. Any growth in this investment is immediately outwith wife's estate. PETs fall out of clients estate after 7 years. Effect a joint life, second death Whole of Life policy. Put under a discretionary trust to meet further IHT liabilities - ideally make sum assured indexing. Premiums can be gifts out of normal expenditure. Ensure they use annual gift exemptions.

Explain the following key aspects of IHT as they relate to your clients situation: (a) the use of Life Assurance policies in connection with IHT planning. (10) (note from factfind - currently own a joint Whole of Life plan, surrender value 3,000 and not written in Trust. Does not satisfy their total current IHT liability. No particular health concerns) Answer Existing WOL plan should be written in Trust for the benefit of children/grandchildren therefore removing it from the estate. This will be treated as a gift however, only 3,000 and likely to be within annual gift allowance. They could purchase a new life policy to provide additional cover for their IHT liability and be placed in Trust to avoid entering into their estate. Sum assured should equal IHT liability. Premiums may be exempt under the normal expenditure rules. IHT and Domicile Issues Individuals who are domiciled in the UK are liable to IHT on all their property whether it is situated in the UK or anywhere else in the world. However, if a person is domiciled outside of the UK, IHT only applies to property situated in the UK. Like with income tax and CGT, you can be deemed domicile for IHT purposes. In general you are deemed domiciled in the UK, if you have been resident in the UK for at least 17 out of the last 20 years. When an individual who is domiciled, resident and ordinarily resident outside the UK dies, any foreign current bank account held with any recognised UK bank, is left out of the estate for IHT purposes. If you are non-uk domiciled with UK assets, you are liable to IHT on your UK Assets. In the case of a husband and wife where one of them is non UK domiciled, their nil rate band allowance is restricted to 55,000. Explain the following aspects of IHT as they relate to your clients (a) domicile, with reference to their retirement plans to move to Spain. (8)

(note from fact find - clients are UK domiciled but plan to move to Spain) Answer They are UK domiciled and are subject to IHT on their worldwide assets. Individuals who are not UK domiciled are only subject to IHT on their UK assets. They may be able to acquire Spanish domicile if they severe all links with the UK by demonstrating that they will live in Spain permanently. They must live outside the UK for at least 3 years and then become non UK domicile in order for only their UK assets to be liable to IHT. Summary There will be IHT questions in the exam you will be sitting. It's very difficult to study for these until we know the precise details from the factfind and thus the reason you've bought our solution. You should make yourself familiar with some of the areas we've addressed in this note so that you can concentrate on the specific points once the solution is issued. What will you get in the solution? In our AF5 solution, we will provide IHT calculations so we know the clients current position. We will also look at some of the planning opportunities in order to satisfy the clients objectives.