A look at what the OTS recommendations might mean for life insurance policies
In July of this year, following its first report in November 2018, the Office of Tax Simplification (OTS) published its second report on the simplification of inheritance tax (IHT). This report sets out a number of recommendations for 'a more coherent and understandable structure of the tax'.
Here, I have looked at the recommendations in respect of life insurance policies being paid free of IHT, even if not in trust, considering what this may mean along with any future clarification that may be needed.
Life policies are a useful way of providing a sum which, if written into trust, can be paid very quickly after a person dies. Currently, individuals are advised to put a life policy in trust so that the proceeds don't form part of their estate and become subject to IHT. This also means that the beneficiaries don't have to wait until probate is granted before getting access to the proceeds.
The OTS has suggested that certain life policy proceeds should not be taxable as part of an individual's estate, whether the policy is written into trust or not. This is a welcome move for IHT purposes, particularly for those individuals who haven't put their life policy in trust and don't realise that, as a result, the proceeds will form part of their estate. But if a trust isn't used, the money won't usually be available until probate is granted, which can take many months.
Some trusts provide flexibility for the trustees to change their beneficiaries, enabling them to accommodate people's changing personal circumstances. For example, a trust can avoid money being paid to a beneficiary at a time when they have marital or financial problems or where it creates an avoidable tax problem for them.
Therefore, even if this recommendation is implemented, individuals should still consider the use of a trust and seek the appropriate advice.
What other issues could there be?
The OTS has limited this recommendation to plans with a fixed term. Their thinking being that these don't include any investment element unlike other types of policy, such as whole of life or endowments. However, this overlooks the fact that almost all new whole of life policies issued since the implementation of the retail distribution review (RDR) also have no investment element and provide no surrender value.
Many of these are for relatively small sums, so are unlikely to be subject to IHT. But it would be quite easy for a fairly modest amount of cover to push the value of an estate over the nil rate band for IHT leading to a tax liability. Whilst a policy taken out today may not do that - in a few years' time the situation could be very different (through say an increase in property value or an inheritance). The likelihood of them remembering that the policy they have isn't exempt is low at best. In addition, policyholders could inadvertently end up with a liability on their policy that had no value while it was in force. Having a two-tier system where some policies are exempt and others are not adds further complication and potentially leads to decisions as to which policy to take out being led by the tax treatment instead of the real need for cover.
The recommendation is also only in relation to benefits paid on death. But this overlooks the fact that almost all life policies also pay on diagnosis of terminal illness, typically where life expectancy is less than 12 months. This means that these benefits would still be part of the policyholder's taxable estate and, as they're terminally ill, they'll probably have no opportunity to either gift the money in a tax efficient way or spend all of it before they die.
You may think that the policyholder could choose not to claim in these circumstances. But HMRC could claim that this is an omission to exercise a right and treat them as having received the benefit anyway and therefore the exemption wouldn't apply.
A further potential issue is that there's no mention by the OTS of any change to the treatment of the payment of premiums where the policy's still written in trust for the reasons mentioned above. Whilst currently, in most cases, these would be exempt either under the £3,000 annual gifts or gifts from normal expenditure rules, this isn't always the case and IHT could be payable on the premiums while you're still alive if the total of chargeable lifetime transfers in the last seven years exceeds the nil rate band. It seems somewhat odd that by not writing a policy in trust, the death benefit would be paid free of IHT and as no gift of the premiums has been made they would also be free of IHT. But writing the policy in trust would still potentially lead to a charge to IHT during your life. The OTS has also suggested quite significant amendments to these rules, the effects of which would need to be taken into account which we'll look at in a separate article.
The recommendations therefore lead to many questions and issues that need to be thought through properly before any change is made. The last thing anyone would want is to replace one set of rules with another that just changes where the complications lie rather than removing them altogether.
Ian Smart is product architect at Royal London
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