Part 1

Potentially Exempt Transfers, Gifts With a Reservation and Capital Gains Tax

There are two other Inheritance Tax rules which are very important for lifetime estate planning; these are Potentially Exempt Transfers (known as P.E.Ts) and Gifts with Reservation (G.W.R's).

Before Inheritance Tax was introduced in 1986 gifts made during your lifetime, above the Nil Rate Band, were subject to Capital Transfer Tax (C.T.T.) at the time they were made. Although the lifetime C.T.T. rates were lower than the death rates the fact that lifetime tax would become payable on substantial gifts limited the scope for significant estate planning.

On the other side of the coin it was possible, under C.T.T., to gift assets outside of one's estate for C.T.T. purposes but still be able to benefit from those assets in the future. This was usually achieved by the use of trusts.

Under Inheritance Tax two main changes were introduced,

The first were Potentially Exempt Transfers which enable certain gifts to be made of unlimited amount (with no lifetime Inheritance Tax payable) which will be completely free of Inheritance Tax if the donor lives for seven years.

The other was the introduction of the Gift with Reservation rules, which mean that for a transfer to be effective for Inheritance Tax. purposes the donor cannot be in a position to benefit from the assets he or she has gifted. The most important example of this is where parents give their home to their children but continue to live in it. See below for more details.

I Potentially Exempt Transfers

The main transfers which rank as P.E.Ts are gifts to individuals but gifts to some types of trust also qualify;

When a gift ranks as a P.E.T. then no Inheritance Tax is payable when the gift is made and it is completely free of tax if the donor then survives seven years.

If death occurs within seven years then tax may become payable at the death rate but reduced by the following scale (this is known as tapering relief).

(i) If tax is ever payable on the P.E.T. it is based on the value of the gift at the time it was made not on the value at the date of death or whatever else triggered off the tax payment;

The main advantage of this is that if an asset is likely to increase in value in future years you can freeze the value for tax purposes by giving it away now rather than later. House prices in recent years are a good example of this. But if the value of the asset goes down this can be a disadvantage. Some share prices are examples

(ii) The reduction (shown above) is of the tax payable on the gift not the value of the gift. .

Basically if the tax payable would have been, say £100,000, then after 4 years the tax liability has gone down to 80% and the tax payable then would be £80,0000 See the scale above.

If you do the same calculations using the value of the gift itself the end result is often the same but not always. It depends on how the gift was affected by other factors such as gifts already made to other people and the effect of IHT fee allowances. See (iii) below

(iii) In working out the tax on the P.E.T. and on the estate, any P.E.Ts made within seven years of death are deemed to form the bottom of the estate and will therefore be set against the Nil Rate Band. This can have unexpectedly unfortunate results and leave some beneficiaries paying more than their fair share of Inheritance Tax

Example

Mrs. Peters, a widow, has two children Sandra & Hazel. Her estate totals £600,000.

Sandra wants money to buy a house so in 2007 Mrs. Peters makes a gift (a P.E.T.) of £300,000 to her.

In 2008 Mrs. Peters dies, leaving the balance of her estate, also £30,000, to Hazel.

You might think each daughter would end up with the same but not so.

The Inheritance Tax position is as follows:

The P.E.T. to Sandra is still treated as part of her mother’s estate (because of death within seven years) but no tax is payable since it is equal to current the Nil Rate Band of £300,000 (the amount a person can leave before IHT becomes payable) so Sandra pays no tax and ends up with the whole £300,000.

But the £300,000 legacy to Hazel will all be taxable at a rate of 40% (the Nil Rate Band having been used by Sandra’s P.E.T.) Hazel will therefore end up paying Inheritance Tax of £120,000 (40% of £300,000 ) and will be left with just £180,000.

In this example the P.E.T. rules have not saved any tax but simply shifted responsibility for paying it from the two daughters equally to just one of them

This clearly illustrates the importance of taking the widest possible view when estate planning and thinking through the effects of lifetime gifts on any gifts in a will.

II Gifts with reservation

Very important when thinking of giving away your home to children during your lifetime.

As already mentioned rules were introduced, when Capital Transfer Tax was changed to Inheritance Tax, which mean that if a gift is to be effective for Inheritance Tax purposes then the donor cannot benefit from any of the property gifted.

If the gift is of the parents home, by continuing to live in it, even if only for a few days a year, the parents retain an interest in the property and the Inland Revenue would treat it as if it was still theirs for Inheritance Tax purposes on their death.

There are ways of transferring a property to children and to continue living in it. They are a little complicated to set up but can result in a very significant tax saving. If you would like more information on this point please let us know.

Another drawback of giving away a property to a child but staying in it is that the property may become subject to Capital Gains Tax when it is finally sold or given away by the child. If the arrangement is not carried out carefully there is a risk of paying Inheritance Tax on the parents death and capital gains tax on the ultimate sale as well. A double tax burden.

An advantage of transferring the property into the children’s name is that done in good time it can protect the home against claims for Nursing Home or residential care Home fees. (The longer the time gap between transferring the property and going into a Home the better. It can still be done almost at the last minute but a more complicated procedure is required to protect the property from being taken to pay the cost of care home fees). Other conditions also need to be considered. For more information about this contact us )

As mentioned whilst the donor cannot be in a position to benefit in any way from property that is gifted, nevertheless, by using trusts, the spouse, (the widow or widower) can be a potential beneficiary under a trust without infringing the gift with reservation rules.

This is a particularly valuable option for those people who are wealthy enough to be reasonably confident that they can begin to give some of their money to other members of the family ( often to their children ) but want to have the security of knowing that if they need to get some of the money back for some reason they still can

For example a husband could put money into a trust and if the correct type of trust was used this would be considered a P.E.T. If he then lived for another seven years the whole of the gift could be Inheritance Tax free.

The type of trust used for this arrangement is usually a “Discretionary Trust”. For example, the husband may say that the trust can benefit his wife, children or grandchildren at the discretion of the trustees.

If after his death his widow did not need any of the trust money back she can leave it in the trust for the other members of the family.

But if she did need it the trustees could at their discretion pay some of it to her.

How this would affect IHT on her own estate in due course would depend on what assets she leaves at that time.

The tax situation on trusts is very complicated and changes regularly. This is an example only and may not apply to you. If you are interested in the use of a trust you will need individual advice from us which takes into account your personal circumstances and the tax situation at that time.

III Capital Gains Tax (C.G.T.)

The sale or giving away of most types of assets can incur a C.G.T. charge at the time of the gift.

There is an annual CGT free allowance which for 2007/08 is £9,200

For example, if you own shares which have significantly gone up in value, selling them or giving them away could trigger off a CGT bill for you on any gain over £8,200.

BUT some assets are exempt from CGT . The main example is your home provided it is your “principal private residence” A second home would not be CGT free

Giving away the family home

Your own principal private residence is CGT free. If you give it to your children but they continue living elsewhere it will not be their principal private residence.

This means that from the day you give it away, it stops being CGT free. Although you will not have to pay any CGT at the time of the gift, your children could be charged CGT when they eventually sell it if it had increased in value from when you gave it to them

C.G.T. on gifts can be deferred if the gift is made to a discretionary trust.

Some gifts are not subject to C.G.T. e.g. cash, insurance policies

Potential C.G.T. liability is wiped out on the death of the owner of the asset and is replaced by a potential Inheritance Tax liability

All these points need to be considered when assessing the advisability of making lifetime gifts.

Life assurance and pension policies

I Life assurance

There are two main uses for life assurance policies:

Firstly to provide a sum payable on death,

Secondly, as a savings/investment vehicle to provide a sum of money payable at a future date.

There are many other types of policy often providing a mixture of benefits, including critical illness and disability benefits. It is beyond the scope of this booklet to look at all the different types of policy but there are some very important points concerning inheritance planning.

The first, and most important point where the main purpose of the policy is to provide a sum on death, is whether, when death occurs, the sum assured is payable to the estate of the person who has died or to some other named person as trustee.

If the sum assured is payable to the estate of the deceased then it will be added to his other assets and will be subject to Inheritance Tax like any other asset if the estate exceeds £300,000.

(If all the estate is passing to a surviving spouse then no Inheritance Tax will be payable at that time (because of the spouse exemption, see above)

In order to avoid the insurance money becoming part of the estate and liable to Inheritance Tax the policy should be written in a trust. In this way the sum assured will be payable to the trustees for the benefit of the beneficiaries and will be outside of the estate of the deceased and thus free from Inheritance Tax.

If it is appropriate the spouse can be included as a beneficiary in the trust and this will provide flexibility on the destination of the sum assured. By the use of a trust the need for probate is avoided and thus money can become available quickly at a time when it might be most needed. It is essential that there are additional trustees other than the lives assured.

If a policy is written in trust the premiums will count as gifts but will probably be covered by either the annual exemption or gifts out of normal expenditure exemption.

Normally, where appropriate, policies should be written in trust at the outset, but policies already in force can be put into trust. In the latter case there will be a gift equal to the open market value of the policy at the time, subject to a minimum of the premiums paid, (special rules apply for term assurance policies).

II Pension policies/schemes

Many pension schemes and pension policies provide death benefits if death occurs before retirement. If these benefits are held on discretionary trusts then they will fall outside of the client's estate and be free of Inheritance Tax.

With group pension schemes and many personal pension policies the benefits will automatically be held on trust; but this is not the case for retirement annuity policies (old style personal pension policies) and some personal pension policies. There are two steps to be taken in this regard.

Firstly, ensure that all pension death benefits are held on trust. If they are not then this can be set up now.

Secondly, and very importantly, a nomination form should be lodged with the trustees to tell them how the benefit is to be payable e.g. '50% to my wife, and 25% each to my two children'. Whilst this nomination, or expression of wish, is not binding on the trustees they will in normal circumstances follow it. In the absence of such a nomination they will typically pay all the benefit to the widow/widower.

For wealthier people, significant Inheritance Tax. benefits can be achieved by thoughtful use of pension death benefits, for example, if a widow/widower does not have immediate need for the funds they could be paid into a trust thus keeping it outside of the estate, but providing access to the capital if needed.