Trusts and their role in reducing Inheritance Tax on insurance benefits have come under the spotlight following recent Government changes to the rules. Kirstie Redford investigates
For many advisers, a conversation about critical illness cover, term assurance or whole of life (WOL) cover is not complete without approaching the subject of trusts. This type of arrangement has traditionally saved clients money by allowing them to escape Inheritance Tax (IHT) on the benefit paid out, while speeding up and simplifying the administration for trustees and beneficiaries.
However, new laws set to come into force mean that advisers will now have to tread more carefully when explaining the benefits of trusts to clients as part of their protection review.
Budget deal
In this year's Budget, Chancellor Gordon Brown set out proposals for new legislation aimed at cracking down on people using interest in possession (IIP) trusts or accumulation and maintenance trusts to avoid IHT. The rules will form part of the eagerly awaited Finance Act, which has just received Royal Assent.
The bad news is that clients who have a life policy or protection policy in trust or who are planning to put one into trust could now be affected by new tax charges.
The good news is that the regime will not affect everyone.
As with most legislation - and particularly that involving tax - the rules are not straightforward. There is still some confusion over how the regime will pan out, as the final version of the Finance Act is yet to be published. However, this complexity and uncertainty also means that the need for advice has never been greater to help guide clients.
So, what do advisers need to know? Firstly, policies written in trust from 22 March 2006 are potentially subject to a 20% charge when first set up if the value of assets transferred into trust is above the IHT threshold - currently £285,000.
Secondly, the trust including the policy will be valued every 10 years under the new rules. If the value of the policy is over the current IHT threshold at the 10-year review, it will be subject to a 6% tax charge.
Matt Brunwin, pension and tax consultant at IFA Bestinvest, explains: "For new plans taken out in trust, premiums should come below the nil-rate band or it will be viewed as a chargeable lifetime transfer."
You could view the 10-year review rule as a bit of a lottery. Indeed, for life policies, the difference between dying one day and the next could change the amount of tax due considerably.
"Ordinarily, WOL or term policies do not hold any value while the policyholder is still alive. If you are alive there is no value so there is no tax to pay as you are below the nil-rate band, but if you die before the 10-year anniversary, you could have to pay," says Brunwin.
Taking the example one step further, if a policyholder dies after five years, distributes the money and winds up the trust before the 10-year anniversary, there would also be no charges to pay.
On the other hand, if it is deemed appropriate to keep the policy in trust after death, the decision would then have to be made over whether the benefits of keeping the trust outweighed the charges that would be made at the next 10-year anniversary.
On a more positive note, clients who had a policy written in trust before 22 March 2006 will not be subject to the new regime even if their policy value is above the IHT threshold.
Future premiums paid into policies written in trust before 22 March 2006 will continue to be treated as potentially exempt transfers - as was the case before this legislation - and will not be classed as chargeable lifetime transfers.
But there is a catch - if the policy is over the nil-rate band and the policyholder makes any changes to their policy after 6 April 2008, it could then be subject to the new tax charges - unless the original policy terms permit the changes.
Changing a policy to include a new beneficiary is common. So clients wanting to change their policy due to the birth of a child, for example, or to remove a beneficiary due to divorce, could face the 10-year periodic charge if the policy value is over the IHT threshold.
Ian Smart, technical product manager at Bright Grey, explains: "If the existing policy is over the nil-rate band, advisers need to warn clients about the charges, should they make changes to their policy in the future."
Of course, all of these changes do rest on the policy being valued over the IHT threshold. Unless you have taken out a policy for over £285,000 after Budget Day, no charges will apply.
Rule of law
There are some other exceptions to the new rules, which include trusts created on the death of a parent for their minor children, who become absolutely entitled to the assets of the trust at 18, and trusts created for disabled people.
Bare trusts will also sit outside the new regime. In a bare trust, each beneficiary has an immediate and absolute right to both capital and income and the trustee has no discretion over what income to pay the beneficiary. If this type of trust is suitable for the needs of the client, the Government has made it clear that all future bare trusts will not be affected at all by the changes.
Bright Grey's Smart says that most life offices are also looking to introduce discretionary trusts as another option to an IIP trust.
"In a discretionary trust you can list classes of beneficiaries such as 'my children' and 'my spouse', which makes the administration much easier, means you don't have to make changes to policies, and saves clients from having to make hard decisions about who their specific beneficiaries will be," he says.
Even so, the Association of British Insurers (ABI) is still lobbying the Government to change the legislation. Lucy Butler, spokesperson for the ABI, says the rules are still not clear and there is detail missing from the Treasury.
"There are question marks around whether existing policies will be affected - it is a horrible mess. We are still trying to get clarity on a number of issues from the Treasury and we are so far very disappointed with the outcome," she says.
Cash cow
Despite the Government insisting the changes will affect only a very small number of wealthy people and raise just £15m a year in revenues, industry experts are predicting the regime will have a much wider reach.
Research from Skandia shows that at least 500,000 clients of financial advisers already have policies under trust with benefits that exceed the nil-rate band for IHT.
Michael Warburton, senior tax-partner at adviser firm Grant Thornton, agrees that the Government has underestimated how many people do need protection policies for sums over this threshold.
"The Government says these changes will only affect rich people. However, the standard advice is to insure yourself for an equivalent amount to 10 years' salary. An annual income of £28,500 is little more than the national average wage, so do not assume it will just affect the rich," he says.
This certainly creates a huge opportunity for advisers to ensure clients are not caught out by the new tax rules. Also, industry experts are not predicting that we will see a fall in the number of trusts being written in light of this legislation.
If a plan is not written in trust it will, after all, form part of the client's estate on death and as a result could be subject to IHT at the full rate of 40%. And remember, trusts do have other advantages.
"Writing the policy in trust still avoids having to wait for probate and sort out the IHT liabilities before the estate is paid out. This can take years, during which time the family is left with no money," says Smart.
"Trusts are not just there for tax avoidance. Other benefits still exist. So do not let the tax tail wag the financial planning dog," he adds.
Kirstie Redford is a freelance journalist
Tax treatment of a life policy written in trust
X took out life cover of £400,000 in 2003. The interest in possession beneficiary is X's spouse Y. If X dies in 2011 there are no IHT consequences for X's estate. The plan pays out to the trustees. The trustees exercise their power of appointment and replace Y as the interest in possession beneficiary with Y's son, Z. Under the rules before 22 March 2006 this would trigger a potentially exempt transfer by Y. Under the new regime Y would make a chargeable transfer and the trust fund would become 'relevant property'. There would be a charge of 20% on the excess over Y's nil rate band. The trust fund would then be subject to periodic and exit charges. The 10-year 'clock' would start on the date the trustees exercise their power.
Source: Bright Grey