Trust us

Most people already know that the Chancellor’s pre budget report in October scored an own goal in its attempt to simplify capital gains tax. In the case of inheritance tax (IHT), a tax which given the cost of collection has more to do with politics than UK fiscal and economic need, the announcement of transferable allowances, for married couples and those in civil partnerships, has the appearance of a marginally benign, relatively pointless, headline seeking measure.

Actually it is yet another measure aimed at discouraging middle wealth individuals from tax planning, and likely if anything to increase the tax take. The discouragement can be seen from the undoubtedly more attractive proposition (at least from the survivor’s perspective) that if a couple’s joint estate ends up in the hands of the survivor, on the survivor’s death a double IHT allowance will be available. No complicated trusts or loss of control over part of the estate for the survivor to worry about. The likelihood of an increase in the tax take is explained below.

Nil Rate Trusts

Growth in house prices and disposable wealth has meant that increasingly middle wealth individuals have recognised the need to tax plan for IHT. Many have wills which use the nil rate band for IHT, on the first death, by creating a nil rate band trust. Those who hadn’t got round to doing that wrongly think the Chancellor’s announcement means there is now no need to do anything.

Actually relying on the use of a transferable allowance rather than making use of nil rate band trust planning is likely to give rise to a bigger IHT bill.

Nil rate trusts work by slicing off the tax free capital on the first death into a trust established for the benefit of the survivor and the couple’s other heirs. The trust fund is a rainy day fund for the survivor. To the extent that if it is not used, the trust capital will grow in value according to the nature of the assets in the trust – and it is a reasonable expectation that the growth will outstrip the official rate of inflation.

Depending on the length of the survivor’s remaining life, what is moved out of the tax net on the survivor’s death is thus likely to be an increasing percentage of the couple’s estate.

Transferable allowances, the new measure, work by applying to the estate of the survivor the percentage of allowance unused on the first death. The annual change in value of the allowance broadly reflects no more than the official rate of inflation.

For example…

A comparison between two couples shows the effect. Each couple have a joint estate worth £1m. Each Husband dies now and each Wife dies 10 years later. By that time the tax threshold has increased to £600,000 (i.e. a 100 per cent increase) and each estate has become worth £2.25m (i.e. a 125 per cent increase).

Couple A made Wills leaving everything to each other. On second death the IHT bill would be £600,000.

Couple B have Wills incorporating nil rate band planning using a trust. The tax on second death and termination of the associated trust would be about £634,000, a saving of £25,000. The difference becomes more marked as the difference between the rates of growth increases.

Additionally the trust could have been used by Mrs B to make gifts to the heirs, which if made by Mrs A would increase the tax bill in the event of her death within the ensuing seven years.

So relying on the transferable allowance can be predicted to reduce the proportion of a couple’s capital moved away from tax on the survivor’s estate.

Its gets worse. The unused allowance is lost to the survivor if he/she remarries. Again, taxpayers encouraged by this new measure to think they do not need tax planning advice are unlikely to recognise this consequence.

Here then is the real point – what looked like a beneficial measure, even if only mildly so, is actually a wolf (well a fox at least) in sheep’s clothing. Clever? Could be. Cunning? More like it. Politically astute? Well the jury’s out on that one, but not judging from what my clients say.

Simon Leney is a partner at Cripps Harries Hall