Darling incentivises the wrong investors

Margaret Coles is a fit and healthy 73 year old widow.  Her late husband used his Inheritance Tax Nil Rate Band by leaving a holiday property to his children. She remains fairly well off with a house, various investments including an ISA portfolio, a healthy sum on deposit and two pensions.  Her son, Raymond, helps his mother to manage her financial affairs and has suggested she take immediate advantage of the new ISA limit for older persons announced in Alastair Darling’s recent Budget. He thinks there will be a stockmarket recovery within the next few months and believes she should capture the maximum benefit by adding to her substantial ISA portfolio by investing her 2009/10 ISA allowance now.

The primary benefit of placing investments within an ISA ‘wrapper’ is that they are then permanently exempt from Capital Gains Tax (CGT) and from higher rate Income Tax. But how beneficial are these concessions in general and, in particular, to Mrs Coles? Anecdotal evidence from advisors indicate that a high proportion of ISA holders could easily hold and manage their investments perfectly well and effectively tax-free by utilising their existing annual CGT allowances. Most ISA investors, such as Mrs Coles, are not higher rate Income Tax payers and so will not suffer any further tax on dividends/distributions. So, are they needlessly investing in ISAs?

The only real beneficiaries of these tax-exempt investments are either:

•  (a)those taxpayers who invest in cash or fixed interest investments (not equities or mixed funds) and who benefit from exemption from standard rate Income Tax on those specific investments, or
•  (b)higher rate taxpayers who are already utilising their annual CGT allowances.

For these two groups the continuing concessions are very good news. In particular young, dynamic, higher-rate taxpayers saving on a monthly basis into high growth funds for school fees and other medium term commitments, and doing so with the added benefit of pound cost averaging, are likely to benefit most. Whilst Mrs Coles is interested in boosting her flagging income, which has fallen with interest rates over the last year or so, she is certainly not in the second group. Even in her search for income the benefits of Income Tax relief on currently miniscule yields are not great.

In reality the Treasury is actually misleading naïve investors into thinking there are substantial tax benefits in retaining ISA portfolios into one’s dotage, while simply ensuring that it can continue to collect large amounts of IHT from the unwitting and unprepared elderly investor. Arguably investors from their mid-sixties onwards who believe they will have an IHT liability should no longer be holding ISAs and certainly should not be buying more. What so many of them do not realise is that they will suffer a punitive IHT sting at death, whereby at the top end they and their families potentially lose a colossal 40% of their hard-earned savings. This loss completely dwarfs the often marginal annual tax benefits resulting from the ISA wrapper.

So what can Mrs Coles do to avoid IHT on her accumulated savings? The answer is simple, she should encash her ‘tax-free’ ISA and supplement the proceeds to a total of £325,000 by selling a portion of her stockmarket investments and then make a gift of the total sum to her chosen beneficiaries via a flexible reversionary trust. Although gifts into such trusts constitute an IHT taxable transfer there will be no tax so long as the gift is within the current Nil Rate Band for IHT – £325,000 per person.

Such gifts then fall out of account after 7 years and so there is an opportunity for each taxpayer to make gifts up to this level every 7 years. Mrs Coles has a life expectancy of some 13+ years and so should easily survive the first 7 year inter vivos period and might even survive a second. Even should she not survive to see her gift fall out of account, any growth (recovery) enjoyed by the gifted assets will occur outside her chargeable estate.

A good flexible IHT gift trust will offer Mrs Cole’s trustees extraordinary ongoing flexibility over the trust whereby she can be supported with regular or occasional ‘reversions’ to top up her conventional income. In her case she will certainly need to replace income from her surrendered ISAs (Capital Gains Tax exempt) and part of her share portfolio (which she was able to dispose of within her annual CGT allowance and without incurring Capital Gains Tax).  Since the assets will have been placed within a gift trust then it is proper that drawings or reversions from the trust should be made available to replace that sacrificed income. The trust wording is sufficiently flexible to also allow the trustees to continue to look after the needs of her children and grandchildren in exactly the same kind of way as before the gift.

Assuming she does live those 7 years then she will have dramatically reduced the potential IHT liability on her death.   Moreover her ‘income’ is maintained and, via her trustees, she retains tremendous flexibility over the future return of funds from the flexible trust.  The table shows that at current levels her family is likely to benefit from a tax saving of some £130,000 which completely dwarfs any conventional’ benefit she is likely to receive from her ISAs.

 

Paul Wilcox
Chairman & Technical Director, WAY Group.

Posted on 24th April, 2009 | Tags: Budget 2009, IHT, IHT Mitigation, Inheritance Tax Nil Rate Band, ISAs |
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A tale of IHT mitigation

John and Frances Greening are facing a major dilemma regarding the death of Frances’ widowed mother in January 2008. Frances is the sole beneficiary of her mother’s Will and she was left a substantial inheritance which has unfortunately fallen in value very dramatically in the intervening period. John and Frances have been working their way through the probate process and suddenly realise that they are caught out by the credit crunch from settling the estate in the most effective manner. They are having difficulty raising funds to pay the Inheritance Tax in order to achieve the very probate which will allow them to sell assets to pay the tax. The assets in question have fallen so much in value that the effective rate of tax they could finish up having to pay is much higher than the 40% normally payable upon death. Frances’ father died nine years ago and utilised the whole of his Nil Rate Band.

There are three different problems here which combined are putting this couple in a very difficult position indeed. The challenges are:

• Mum lived in the suburbs of London in a house valued (at the date of death) at about £1.3 million. In addition she had other, financial, assets totalling a further £0.4 million. Based on a Nil Rate Band of £300,000 (as at January 2008) this would incur IHT of £560,000. So they have to find a lot of cash to pay the IHT in order to be able obtain probate to sell any assets.
• The value of the house has probably fallen by some 30% since her death and the value of the share portfolio (which was weighted towards banks with a generous exposure to builders and mining stocks) has fallen by nearer 50%. The theoretical values are therefore now £910,000 for the house and £200,000 for the shares. The house is unlikely to be saleable since similar properties in her area are just not moving. The IHT based on these lower values would be £324,000 – a huge £236,000 less than on the death values.
• There is an HMRC concession whereby falling asset prices can be re-based for probate purposes but only if they are sold by the executors within a specified period after death – 48 months for property and a challenging 12 months for other assets. To sell, the executors must have obtained probate. This is only achievable if the full tax is paid in advance and a re-base claim then made later when the assets are sold at lower prices.

The Greening’s have less than 2 months to sell the shares to establish a lower re-base value. If they manage to achieve this they will probably be well advised to re-invest any proceeds in Frances’ name straight away, to make sure they do not miss any subsequent recovery. But this assumes that they achieve probate and to do so they must pay any tax due. With Capital Gains Tax now at 18% it is better for any recovery to happen in Frances’ name rather than with the executors where any recovery will fix the IHT on the gain at 40%.

Fortunately, there is also the property instalments concession which they can use to avoid paying the full tax on Mum’s house immediately. They will have to pay 10% of any tax due to achieve probate and can then pay the remainder in another nine annual instalments with interest. This means that they can take their time selling the property and to claim any re-basing (if the house does not climb back above January’s value) so long as they sell by January 2012.

So what does this now all look like in terms of what they must do before January to achieve the optimum results – remembering that probate can take some time even once the application is in and the tax is paid? They will have to pay the full tax on the ‘other assets’ and the first instalment of tax on the property (plus a little bit of interest which becomes payable from 6 months after the date of death) before they can have access to the shares to sell them before the 12 months is up. They must work very fast to get the probate application in to make sure they get probate in time.

The calculation looks something like this:
Total Assets (£1.7m) less the Nil Rate Band (£0.3m) at 40% gives the total tax payable (the £560,000 mentioned above). This gives a marginal rate of IHT of 32.94%. This rate is applied to the separate assets, so they will have to pay £131,765 on the ‘other assets’ (32.94% of £0.4m) and £428,235 on the house (32.94% on the £1.3m) but need only pay 10% of this immediately. So to obtain probate they must submit the necessary forms and make a payment of tax on account of £174,588 (£131,765 plus £42,823).
They have to find this cash from somewhere and in the present climate that will not necessarily be easy because there are no assets available to charge to a bank (until after probate). Assuming they can raise this cash, obtain probate in time and sell the shares before the first anniversary of Mum’s death, then they can ask for the share valuations to be re-based onto an actual basis. They will then be able to obtain a partial refund from HMRC following a new calculation, as well as being able to repay the bridging finance from the share proceeds.

The new calculations will then look like this:
Total Assets (£1.5m now that the share values have been re-based) less the Nil Rate Band (£0.3m) at 40% gives the total tax payable (£480,000). This now gives a marginal rate of IHT of 32%. This rate is applied to the separate assets, so they should have paid £64,000 on the ‘other assets’ (32% of £0.2m) and £416,000 on the house (32% on the £1.3m) of which only 10% was payable immediately. So their initial tax bill should have been £105,600 and not the £174,588 they actually had to pay on account. So they should receive a refund of almost £69,000 at that point.

These potential calculations are repeated all over again if and when Mum’s house is sold for less than the original probate value. Again, there is some sense in pursuing this because John and Frances will receive an IHT refund at 40% on any reduction whilst only suffering CGT at 18% were they to reinvest and enjoy an increase in property prices.

This whole scenario simply underlines the benefit of removing assets from one’s chargeable estate early enough to avoid all of these probate challenges, quite apart from the general benefits of avoiding as much of this heinous tax as possible.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 2nd February, 2009 | Tags: IHT Mitigation |
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IHT and the Glenrothes effect

Labour’s surprise victory in the Glenrothes by-election (7th November 2008) has rekindled that party’s hopes of achieving re-election sometime in 2010. The reasons for the unexpected vote of confidence in Labour probably include Gordon Brown’s new reputation as financial crisis Superman as well as the apparent policy vacuum from Cameron and his front bench colleagues in relation to the current banking and economic chaos.

There has recently been some question about the future of Inheritance Tax (IHT) planning for Mr and Mrs Average. For a brief interlude the combination of falling house prices, falling stockmarket values and the promise of a couple’s £2 million Nil Rate Band from the Tories seemed to make IHT planning for all but the very wealthy somewhat less urgent.

This view is completely misplaced and has to be challenged because taxpayers need very little encouragement to be completely complacent about a tax which they will never suffer but which brings great difficulty to the next generation. An interesting and extremely difficult by-product of the recent fall in asset values, particularly house prices, is that many taxpayers that have died over the last year or two left taxable assets which have subsequently fallen dramatically in value before they were able to be sold to pay the tax.

Imagine someone having died early this year with a sizeable share portfolio focused on banks, builders and mining companies. They may be required to pay 40% tax on assets which have subsequently fallen in value by 90%. To put that into context the tax on an investment portfolio of, say, £300,000 might be £120,000 (at the full 40% assuming their Nil Rate Band was exhausted elsewhere) and yet the related portfolio may have fallen to only £30,000 in value after the dramatic market falls of the last few months. How can you realise £120,000 of tax from a portfolio worth only £30,000 – what a horrendous side effect of the recent market debacle.

This has been exacerbated for tax on properties where beneficiaries are faced with a market which has not only tumbled but in many cases has become completely static so that properties cannot be sold at all. In both of these cases there is an HMRC concession to re-base the value but it requires a sale of the assets in question by the executors within a set time period (12 months for shares) and only after the full tax has been paid to facilitate probate – so a major cash flow challenge especially in the current banking climate.

This whole new scenario is an added incentive to make sure that assets are transferred outside a taxpayer’s estate more than seven years before their demise to remove the relevance of pre and post death values. If the whole value is beyond the reach of the taxman then no tax will have to be found and therefore there will be no forced sale of assets.

So what chance is there that IHT is a thing of the past for most of us? Shadow Chancellor George Osborne was recently compromised into a confirmation of the impact of Alistair Darling’s moves on transferability of Nil Rate Bands between spouses and civil partners. Transferability combined with the Tories’ Autumn 2007.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 2nd February, 2009 | Tags: Glenrothes by-election, IHT Mitigation |
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