STEP

Title Research

Perplexing variations

  • Author : Steve Haggett
  • Date : September 2010
ABOUT THE AUTHOR: Stephen C Haggett TEP is Director of Private Client Services at H & C Lawyers

F or those unfamiliar with the subject, the concept, at first glance, appears to be a very simple one. For sometime, the law has allowed certain post-death tax saving arrangements to be made enabling beneficiaries under a will (or the intestacy provisions) to vary their interest by ‘redirecting’ their inheritance. This has usually been accomplished by a Deed of Variation (DOV).

Many advisors may have assumed that the need for such variations have considerably diminished, particularly since the introduction of the transferable nil rate band between married couples or civil partners in their estate planning.

However, variations may still be highly attractive for a number of reasons and their potential use requires careful consideration as part of a family’s longer term strategic tax and financial planning.

Whilst this article will focus on post-death variations, advisors will need to appreciate that such arrangements may prove to be too late in the context of asset protection.

Care fee planning, cohabitation, second marriages, financial and wealth management concerns, etc, may become, over time, a factor for many families and arguably there can be no substitute for perhaps flexible will trust arrangements. The absence of such planning may prove devastating and advisors could face demanding questions from both families and professional negligence lawyers.

This article will illustrate the potential use of variations by reference to a family case study. Whilst the names maybe fictitious, the facts are largely based on an actual client scenario, although these have been updated to take into account current tax rates and exemptions.Client study: The Wiseman Family

Mr and Mrs Wiseman were a retired couple with two adult daughters and a grandchild. Mrs Wiseman survived her husband by approximately six years and on his death their combined asset wealth was roughly GBP700,000, which had increased to GBP1.1 million by the time of the widow’s death. This comprised the family home (GBP350,000), an equity portfolio (GBP500,000) plus a City-based property (GBP250,000), which had been inherited from an elderly sibling.

Whilst the planning was largely motivated by inheritance tax (IHT) there were also various non-tax factors, including the youngest daughter’s acrimonious divorce and who for a period lived in the City property as a result.

The clients also found the property a useful retreat on their regular pilgrimages to London.

Practitioners will be familiar with the legislation introduced by the Finance Act 2008 allowing the estate of the surviving spouse (or civil partner) to claim, from 9 October 2007, the IHT exemption unused upon the first to die: the concept of the transferable nil rate band.

As a result many clients appear to have envisaged a return to much simpler estate and succession planning. Clients may now assume (or have been advised) that only a simple will needs to be made, leaving everything to the survivor on the first death in the knowledge of a 100 per cent uplift in the surviving estate’s nil rate band (individual IHT exemption and for 2009/10 and 2010/2011 GBP325,000). This assumes that there are no complicating factors such as gifts with reservation of benefit or failed life time gifts (potentially exempt transfers), etc.

Such couples might feel that they can now happily die in the perhaps mistaken belief that such simple will planning does not prejudice the IHT burden or expose their wealth to other perils.

In the absence of any planning, the effect of such simple wills in the context of our client family can be illustrated by the calculation at Table A which shows the IHT position on Mrs Wiseman’s death.

Before October 2007, Mrs Wiseman’s advisors might have suggested a variation to her late husband’s will to carve out a nil rate band discretionary trust to preserve the benefit of his IHT exemption, assuming their estate planning had not already employed such arrangements.

Is this now unnecessary after October 2007?

Arguably, suitable trust arrangements provide enormous flexibility enhancing a degree of security in carrying out the clients wishes. Considerable IHT savings can also be achieved.

In the context of our sample clients, with careful planning equity based assets were appropriated into a discretionary trust created on Mr Wiseman’s death to the value of his then available NRB (GBP285,000). The portfolio subsequently increased in value to GBP450,000 by the time of his widow’s death. The resultant IHT position (and tax saving) is shown in Table B.

Greater opportunities may present themselves if assets can be appropriated during a recessionary dip in the global economic cycle.

This was a second trust for the family as the London property had been redirected into a discretionary trust under a variation to the sibling’s will. The IHT result of this can be illustrated in Table C, which shows the reduced tax liability on Mrs Wiseman’s death.

It is worth remembering that in the ‘real world’ it is not possible to vary a person’s will and therefore any variation is treated as a gift on the part of the beneficiary redirecting their inheritance. However, variations have for some time provided a unique tax planning opportunity particularly in the context of IHT planning, although myriad taxes will play a part in the overall financial jigsaw puzzle, which need to be considered. Non-IHT taxes will be considered in a future article.

Table A
Mrs Wiseman’s personal estate at her death (no planning)
GBP
Main home
350,000
City property
250,000
Investment portfolio
500,000
1,100,000
Less IHT exemptions
650,000
Net taxable estate
450,000
IHT payable @ 40%
180,000
Table B
Mrs Wiseman’s personal estate at her death
GBP
Family home
350,000
London property
250,000
Investment portfolio (balance)
50,000*
650,000
Less IHT exemptions
325,000
Net taxable estate
325,000
IHT payable @ 40%
130,000
NB *GBP450,000 sheltered within husband’s discretionary trust
Table C
Mrs Wiseman’s personal estate at her death
GBP
Family home
350,000
Investment portfolio*
50,000
400,000
Less IHT exemptions
325,000
Net taxable estate
75,000
IHT payable @ 40%
30,000
NB *GBP450,000 sheltered within husband’s trust
GBP250,000 property sheltered within sibling’s trust
Variations: inheritance tax treatment

Assuming a beneficiary varies in accordance with the conditions set out under S142(1) Inheritance Tax Act (IHTA) 1984 then the results can be extremely favourable indeed. It is commonly said that the terms of any variation are ‘read back’ into the deceased’s will. HMRC accept S142(1) includes all IHT legislation and encompasses the reservation of benefit legislation found in the Finance Act 1986.

It is therefore possible for a beneficiary to redirect their inheritance into a discretionary trust for a wide class of discretionary objects and for such property not to be caught by these rules even if the original beneficiary (or spouse) continues to derive a benefit from it. In theory there is also nothing to prevent the original beneficiary from being one of maybe several trustees and therefore have some control over these arrangements. Although in our family scenario relevant property trusts have been created such settlements will not be ‘settlor interested’ for IHT purposes and will be treated as having been made by the deceased.

There are however various conditions for S142(1) to apply. For instance any variation must be in writing and made within two years of the deceased’s death. Since 2002 no formal election needs to be submitted to HMRC, although the instrument of variation must contain a statement that the provisions of S142(1) are intended for the Act to apply. A failure to contain such a statement would invoke the reservation of benefit rules and lead to the creation of a relevant property trust on the part of the original beneficiary. Other conditions also apply.

Clients may find it very beneficial to employ the flexibility exploited by the Wiseman’s in preserving all available nil rate bands, enabling trusted advisors and families to take all potential factors (fiscal and non-tax alike) into account at the relevant time.

For example, consideration will need to be given as to whether certain decisions are made within two years of the deceased’s death because of the provisions of S144 IHTA. These rules allow trustees of a discretionary will trust to exercise their powers of appointment within two years of death to ensure ‘reading back’ for IHT purposes, i.e. by ignoring the relevant property trust. Appointments can be made outright or to create a qualifying interest in possession.

Powers exercised outside this period do not give rise to the creation of an immediate post death interest with the trust remaining within the discretionary regime. Changes to the underlying beneficial interests can therefore be made within the trust with this being a non-event for IHT purposes as a result of the Finance Act 2006.

Conclusion

Whilst there are traps for the unwary, the advantages of preserving all available nil rate bands as part of a family’s longer term holistic planning can yield enormous tax benefits. It also enables a substantial degree of flexibility by allowing trusted advisors and trustees to manage, protect and distribute wealth. Even for clients of modest wealth, this can help prevent the desecration of hard earned family assets particularly against the rising costs of care and the growing tide of divorce and other associated risks now faced by many families.


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