Practice Trends: Wealthy Clients

Alistair Darling's first Pre-Budget Report on 9 October has caused some consternation amongst certain taxpayers, their advisers and the press.

This article examines some of the proposed changes to the Inheritance Tax ("IHT") regime which would affect married couples and couples in a registered civil partnership. It also provides a brief guide to some of the basic IHT planning opportunities that remain where both partners are UK domiciled and UK resident for tax purposes.

Whilst there has been a simplification of IHT planning for couples whose main asset is the family home (referred to in this article as the "average couple"), for others (being those who have significant assets in excess of the family home (referred to in this article as "HNW")), IHT planning will continue to be necessary.

In this article, couples are assumed to be husband and wife but the same principles apply to registered civil partners. In addition, it is assumed that the husband predeceases the wife but, again, the same analysis would apply if the wife were to predecease her husband.

The Nil Rate Band Changes
The Chancellor's move to increase the IHT Nil Rate Band ("NRB") to £600,000 has received significant press coverage. In fact, the "increase" only applies to married couples (and registered civil partners) by combining both spouses' NRBs on the second death.

The "increased" NRB can be illustrated as follows:

In May 2007, the husband died leaving everything to his wife. The husband did not have any interest in a trust and made no lifetime gifts in the seven years prior to his death. The husband did not use any of his NRB, so the wife's executors will be able to claim a 100% increase in her NRB on her later death. Assuming the NRB rises to £600,000 by the date the wife dies, her total NRB will be £600,000 plus a further £600,000. Provided that the wife did not have an interest in a trust and had not made lifetime gifts during the seven years prior to her death, there would be no IHT to pay, provided that the value of her estate has not risen above £1,200,000 million by the time she died.
If the facts were the same but the husband left a legacy to his children of £100,000 and everything else to his wife when he died, a different result occurs. The husband's unused NRB was therefore £200,000, so the wife's executors will be able to claim an increase in her NRB on her later death of 66.6% (ie £200,000 / £300,000). Assuming the NRB rises to £600,000 by the date the wife dies, her total NRB will be £600,000 plus £400,000. Provided that the wife did not have an interest in a trust and had not made lifetime gifts during the seven years prior to her death, there would be no IHT to pay, provided that the value of her estate has not risen above £1,000,000 by then.
If the facts were the same as in the first example but instead the husband made a £300,000 gift in his will (for example, by providing for an NRB trust in his will), there would be no unused NRB available on his death. IHT would be payable on the value of the wife's estate that exceeds her sole NRB of £600,000 (although the assets comprised in the husband's earlier gift (or NRB discretionary trust) should be ring-fenced).

Previously, the starting point for most IHT NRB planning for married couples was equalisation of estates, holding jointly owned property as tenants in common and utilising as far as possible the husband's NRB on death. It would seem that these principles are now largely redundant because, if the wife dies after 9 October 2007, the new increased NRB can be claimed by her executors even if her husband had died before 9 October, provided that he had not used his entire NRB on death and regardless of the assets that comprised his estate.

How easy it will be for such executors to claim the increased NRB remains to be seen as it may be difficult to work out how much of a husband's NRB was available if, for example, he had made lifetime gifts within the seven years prior to his death, especially if he died some time ago and the records have since been lost or destroyed.

NRB Trusts in Wills
The changes to the NRB rules would seem to make life a lot simpler for the average couple, as, prior to the changes, they had to structure the ownership of their home carefully and undertake confusing, complicated and often artificial planning in order to protect the value of their home from IHT following the second death.

In particular, the proposed changes seem to mean that incorporating NRB gifts in spouses' wills in order to use up both spouses' NRBs is now unnecessary from an IHT perspective. Previously, if a husband left his entire estate on his death to his wife, his NRB would have been wasted. In order to avoid this, the husband would often leave assets up to the value of his NRB on death to a discretionary trust, potentially ring-fencing assets up to the value of his NRB from IHT on his wife's subsequent death.

Where both spouses are still alive, it may not be absolutely necessary to re-write wills which already contain NRB discretionary trusts. If the trustees appoint the trust assets in favour of the wife at least three months after the husband's death but before the second anniversary of his death, this would normally be treated for IHT purposes as if the assets had simply been left to the wife outright, such that spouse relief is still available and the NRB has not been used up. However, it may be prudent to revisit any existing wills (and letters of wishes) to ensure that executors/trustees do not make any costly mistakes.

Some spouses may also worry that the Chancellor (and his successors) may not necessarily increase the NRB as quickly as inflation and/or the value of the assets that would be the subject of the trust. If this is the case, they may prefer the husband's NRB to be used entirely following his death. Another concern is that the rules could change again such that the benefit of the NRB which was available on the husband's death may disappear altogether.

Moreover, some spouses may still wish to make gifts of up to the NRB or incorporate NRB discretionary trusts in their wills in an attempt to protect the devolution of (part of) their estate. A husband may worry that his wife may re-marry, leave her estate to their children at too young an age or simply spend the inheritance she has been left. Of course, the same (if not better) protection may be effected by the husband leaving his entire residuary estate on the terms of a life interest trust for his wife. That way, following his wife's death (if the trustees have not used their overriding powers of appointment in the meantime), all of the assets should pass on the terms of the husband's will whilst the wife's estate should still benefit from the increased NRB.

Lifetime Gifts
Whilst the average couple might now be less susceptible to IHT, the same cannot be said for HNWs. They should continue to make lifetime gifts wherever possible (hoping to survive these gifts by seven years). They should also consider reducing their estates by making "regular payments out of ordinary income" as, if effected properly, these payments should not use any part of their NRB.

Lifetime Gifts to Trusts
Since the Finance Act 2006, lifetime gifts to most trusts (if these are in excess of the settlor's available NRB) suffer IHT at 20% on creation (with additional tax becoming payable if the settlor dies within seven years). Additional IHT at a maximum of 6% is payable on the value of the trust fund every ten years and every time assets leave the trust under the "relevant property" regime.

Whilst these tax charges have put many HNWs off creating new lifetime trusts, provided that any gifts made to a trust are made from the settlor's available NRB at the time of the gift, there should be no IHT to pay on these gifts, at least for the first ten years (when the settlement's IHT rate is re-set, depending on the extent to which the value of the trust fund exceeds the NRB in place at that time). If both spouses create trusts every seven years they can effectively reduce their combined estates by £600,000 (at current rates) every seven years, whilst ensuring that not only the devolution of those assets is protected but that their capital growth will be ring-fenced outside of their estate.

During marriage it is possible for both spouses to continue to use both of their NRBs in this way. Unfortunately it is not possible for the wife to use the increased NRB during her lifetime following her husband's death. From the draft legislation it seems that the increased NRB can only be "claimed" by the executors of the wife's estate and they must do so within two years of her death. It would seem therefore that the increased NRB is not available for those wishing to make lifetime gifts to trusts in excess of their own single nil rate band, without incurring an immediate charge to IHT.

Conclusion
The changes simplify the IHT position for the average couple because the wife's executors can now claim the husband's unused NRB on her death. Couples who have not taken IHT planning should no longer lose out, as the percentage of the husband's unused NRB will be available on his wife's death, at the rate applicable at that time, if greater. As such, it would seem that there would no longer be any need for the average couple to undertake IHT planning, at least in relation to the utilisation of both their NRBs.

It is still important for most couples to have up-to-date valid wills in place, however, and many may still wish to make NRB gifts in their wills, especially where these will be funded from assets expected to increase in value significantly (at a faster rate than the annual increases in the NRB). Those wishing to use the combined NRB on the second death who have existing wills containing NRB discretionary trusts do not necessarily need to alter their wills immediately. However, the average couple who incorporated NRB trusts in their wills purely for the purposes of IHT mitigation might want to remove these trusts to avoid any confusion or complications following the husband's death and to make the administration of the husband's estate simpler (and cheaper).

However, the changes should not significantly affect the way in which HNWs undertake lifetime IHT planning and/or settle assets on trust, and will trusts should remain a popular method of protecting the devolution of estates.
One final important point to note is that this article is based on the information and draft legislation which is available at the time of writing. As has been seen recently, the goalposts can be moved very quickly and so it is always possible that this area of the tax system may change again before the Finance Bill 2008 receives Royal Assent. Given the administrative complexity that is likely to be faced by executors claiming increased NRB for the estates of wives whose husbands died many years ago, many may feel that this new system is unlikely to last long in its proposed form.

Sarah Bridge