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Christian Ward describes an investment and trust strategy with potential IHT efficiency.

Introduction to Flexible Reversionary Trusts

The perfect inheritance tax (IHT) planning solution for most people is one which can provide the IHT saving of an outright gift, whilst still allowing the donor unconditional access to their capital and any income. This is the classic objective of wanting to ‘have your cake and eat it’.

No solution actually allows you to achieve this; rather certain compromises must be accepted in order to gain the IHT efficacy, whilst retaining access to the capital without raising the ire of HMRC. Insurance based schemes such as discounted gift trusts (DGTs) [For further information on Discounted Gift Trusts themselves, see Arnold Aaron's article The Discounted Gift Trust - Ed.] and loan trusts are commonly recommended in this situation, but is there a more suitable option?

The advantages of a flexible reversionary trust (FRT)

• Removes the entire value of the gifted capital from the donor’s estate after seven years.
• Couples can gift up to £650,000 (2009/10).
• The donor retains potential access to the gifted capital and any capital growth throughout their life.
• Has the flexibility for capital to be paid to beneficiaries at any stage.
• The donor is not forced to take an income or receive an unwanted return of capital.
• Can be utilised with unit trusts/OEICs as well as onshore or offshore life assurance policies.
• Uses acceptable planning techniques which HMRC have confirmed are not caught by either the gift with reservation of benefit (GROB) or pre-owned assets tax (POAT) legislation.
• Has been utilised for nearly twenty years and proven to be a tried and tested structure.
• Is simple and easy to administer.

Neither DGTs nor loan trusts provide this combination of IHT savings, flexibility and donor access.

How does it work?

The settlor (donor) invests into a series of single premium endowment policies which each have set maturity dates as selected by the settlor. It is also possible to utilise unit trusts (see below). The settlor then gifts the policies or units into an interest in possession trust for specified beneficiaries, usually children or grandchildren – beneficiaries' entitlements can also be changed in the future. Although the settlor gifts the policies, he retains the right to receive the maturity proceeds (reversion) of each policy if he is alive on each maturity date. The maturity proceeds will include the original capital and any investment growth. All other benefits will be held on trust for the beneficiaries.

The initial transfer into trust is deemed to be a chargeable lifetime transfer for IHT purposes. If the investment is below the settlor’s remaining nil rate band (a maximum of £325,000 for 2009/10), no immediate tax is due. Any excess over the nil rate band would suffer a 20% tax charge, which effectively limits the maximum investment to £325,000 per person.

If the settlor survives for seven years from the initial transfer the full value of the initial transfer will not form part of the settlor’s estate on death (subject to the interaction with any future gifts). Any investment growth within the trust is outside of the settlor’s estate from day one.

The flexibility and IHT efficacy of the FRT comes about through the existence of wide powers vested in the trustees. The trustees can:

• Partially or fully defer the maturity of any policy to a future date.
• Partially of fully defeat any maturity by surrendering the policy and paying the benefits to beneficiaries.

What might happen in practice?

The settlor invests £200,000 into 100 separate policies of £2,000 each with ten policies scheduled to mature each year for ten years. The settlor does not expect to need any access to the capital in the foreseeable future but is concerned about the long-term. The trustees decide to exercise their powers and defer the policies due to mature each year for a further ten years. What has been achieved?

After seven years the entire amount of the initial transfer no longer forms part of the settlor’s estate, yet the settlor retains potential access to the maturity proceeds of all 100 policies over the following ten years. In this example neither the settlor nor beneficiaries have received any payments, yet the trustees retain the flexibility to allow policies to mature and revert to the settlor, or they can appoint monies to beneficiaries if necessary.

Crucially, the deferral of any policy to a future date or the appointment of capital to beneficiaries is not deemed to be a further transfer of value on the settlor for IHT purposes.

What is the benefit of the FRT over DGTs and loan trusts?

No automatic return of capital

A paradox of a DGT is that although the discounted value of the initial transfer falls outside the settlor’s estate after seven years, the annual payments to the settlor will simply accumulate in his estate unless spent. The same issue applies to loan trusts where little inheritance tax saving will be achieved until the loan starts to be repaid.

There is no requirement to take a fixed repayment of capital from the FRT as the trustees can defer any reversions without any IHT implications. 

No restriction to a fixed income

A major disadvantage with DGTs is that access to capital is lost and the income level must be fixed at outset. This can present problems over long periods of time where the settlor relies on the income. An income set at 5% of the initial fund value will fall by 47% in real terms with an inflation rate of 3% over twenty years. Why commit to a fixed income when you don’t have to?

The FRT allows the settlor to structure the policy maturities or reversions in line with their expected needs. Also, each reversion will include any investment growth so an element of inflation-linking is built in.

Is a discount important?

In contrast to a DGT, no discount applies to the initial investment into an FRT. However, a discount is not necessarily useful for all clients. Where the settlor does not intend to transfer more than their nil rate band into trust and they have a life expectancy far greater than seven years, then a discount will not provide any great benefit as long as the settlor does in fact survive for seven years. After seven years, the initial transfer will be exempt from IHT whether it is made via an FRT or a DGT. 

Elderly clients with short life expectancies making investments above the nil rate band are the biggest beneficiaries of discounts, but paradoxically the elderly gain the lowest discounts because of their lower life expectancies.

Ease of appointing capital to beneficiaries

A unique feature of the FRT is the ability of the trustees to appoint capital to any potential beneficiary at any stage without the potential IHT complications of DGTs and loan trusts. Any appointment will not be a further transfer of value for IHT purposes on the settlor. Appointments from DGTs and loan trusts are problematic – some DGTs do not allow payments to beneficiaries during the settlor’s lifetime. Furthermore, where the settlor gives up a right to income or a loan repayment this would be a further IHT transfer of value by the settlor – the FRT avoids any such issues.

Choice of investment holding structure

Structures such as DGTs, FRTs and loan trusts have always been the preserve of life assurance companies. However, their use is not restricted to life assurance bonds. One FRT provider allows the trust to be established with unit trusts/OEICs. This can be particularly favourable for long-term growth investments with the new flat capital gains tax rate of 18%. This compares to the maximum rate of 40% which may be payable with an offshore life assurance bond when higher rate tax is due.

Where the endowment policy version is utilised, the payment of any policy maturity proceeds to the settlor will trigger a chargeable event. The tax charge will be calculated in the normal manner for life assurance policies. With DGTs, if the payment to the settlor is within the 5% per annum withdrawal allowance any tax charge is deferred until a chargeable event occurs or twenty years has passed, whichever occurs sooner. This can create a favourable tax outcome depending upon the settlor’s and future beneficiaries’ tax positions.

It is therefore imperative that a detailed tax comparison is undertaken to see whether the life assurance policy or unit trust route provides the best investment holding structure for you and your specific circumstances.

HMRC treatment

The introduction of the Pre-Owned Assets charge (POAT) demonstrated the Government’s intention to attack what they deem to be unacceptable tax avoidance. The FRT, which has been utilised since the early 1990s, uses tried and tested principles.

Importantly HMRC have confirmed their treatment of the FRT:

• The settlor’s right to receive the reversions is not a gift with reservation of benefit.
• Any reversions to the settlor will not incur an exit charge or periodic charge within the trust.
• The deferral of any reversions will not be a further chargeable transfer on the settlor.
• The FRT will not be subject to a pre-owned assets charge.

Who will benefit from using the FRT?

The FRT is not just an alternative to a DGT and loan trust. As it avoids the inflexibility of the DGT and relative ineffectiveness of a loan trust, it is suitable for a far broader range of situations.

It is ideal for clients who are highly likely to survive for seven years and who do not require an immediate income or fixed repayment of capital. Someone transferring £325,000 into an FRT will save £130,000 of IHT, as long as they survive for seven years and the value of their estate on death remains above the nil rate band. Younger clients could establish a new FRT every seven years and make further savings. Ten year periodic and exit charges can be applied to trusts, but it is often possible to reduce or even prevent these from being applied by establishing more than one trust at outset.

It is also possible to use the FRT with the normal 'expenditure out of income' exemption. This allows those with a surplus income to make gifts which are immediately exempt from IHT.

The flexibility and IHT efficacy of the FRT hinges on the ability of the trustees to defer or defeat the reversions to the settlor. Those wanting to ensure that under no circumstances can the trustees (who are selected by the settlor) defeat the reversions/payments to the settlor, will not find the FRT suitable.

Conclusion

The FRT is not a panacea for IHT planning. You should always receive coherent estate planning advice which takes into account your overall circumstances and objectives. This often requires co-ordinated advice from your legal, tax and financial advisers. When consulting financial advisers make sure you seek independent advice as those companies providing tied or multi-tied advice do not currently provide an FRT.

The advantages of FRTs are particularly apparent in today’s economic conditions. Many people will avoid outright gifts because of falling asset and capital values. The FRT can facilitate IHT mitigation whilst not giving up access to the capital. If your finances recover you can use the FRT to pass monies to your beneficiaries in later years, but if not, then the reversions can be paid to you. The FRT allows a full range of liquid asset classes to be held in trust, including cash holdings – there is no requirement to invest in equity investments.

This article is based upon a text which appeared in Taxation Magazine on 19th March 2009.