Example 3 - Investment / inheritance tax planning

A 64 year old lady, Mrs Z, was referred to us for help in reviewing her financial affairs. It transpired that what she needed as a matter of priority was advice concerning an Equitable Life With Profits Investment Bond which had been effected under a gift/loan scheme some six years previously. This was the largest of several investments she held with Equitable.

Essentially, the scheme operated as follows: Mrs Z made a gift of £1 into a trust of which her two children were trustees. She subsequently made an interest free loan to the trustees of £125,000 (repayable on demand) which was invested by the trustees in an Equitable Life With Profits Bond in her and their names.

The £125,000 loan was to be repaid gradually by means of annual withdrawals taken by the trustees. Under the legislation governing the tax treatment of such bonds, 5% withdrawals (as a % of the original bond purchase price) could be taken each year (and was taken) without any immediate liability to tax. Withdrawals in excess of this could also be made without liability to further tax, depending on Mrs Z's income position in the year of encashment. In practice, her income position was some way short of the higher rate tax threshold which provided plenty of scope for the trustees to repay the loan at a faster rate than 5% p.a., should this have been deemed appropriate, without giving rise to any additional tax liability.

In this way, over the previous 6 years, Mrs Z has been receiving tax-free "income" from this bond (in repayment of the loan) - since inception, the trustees had repaid £37,050 of the original £125,000 loan and the intention was for Mrs Z will to continue to receive "income" until such time as the balance of the outstanding £87,950 loan had been repaid. At the point of full loan repayment, any residual bond value would fall outside Mrs Z's estate. The purpose of these types of arrangement is to provide a simplified mechanism for providing income (so-called) from a lump sum investment whilst ensuring that any investment growth on the lump sum is non-aggregable with the settlor's estate for inheritance tax purposes.

In Mrs Z's case, the bond had a current value of £120,000, (£32,050 of which lay outside her estate for inheritance tax purposes).

IAS advice

We established that the particular bond involved was designated by Equitable as a "Series 2" bond and, as such, because it had already been running for 5 years, could be surrendered on its following policy anniversary without the normal "Market Value Adjustment" penalty applying. In view of this important fact, IAS felt it would be appropriate to surrender this bond and to explore reinvestment options, notwithstanding the Equitable compromise proposals in the background. IAS was able to establish that given Mrs Z's overall income position and the "top-slicing" taxation rules applying to bonds on encashment, that no higher rate income tax liability would arise on surrender.

On looking at the original Equitable policy trust, IAS established that there was nothing preventing the trustees from maintaining the existing trust and reinvesting the proceeds in a bond offered by another provider. On balance, IAS took the view that it was appropriate to retain the prevailing bond investment structure, using the existing trust, with the attendant inheritance tax advantages. IAS suggested that the trustees simply reinvest the £120,000 surrender proceeds in another insurance company investment bond, and continue taking regular withdrawals until such time as the outstanding loan expired.

IAS recommended going forward that the trustees pursue a unit-linked, rather than a with profits, approach to investment and agreed with them an underlying fund split with them to suits their temperament. This remains predominantly equity weighted.

Importantly, IAS was able to negotiate enhanced investment terms with the new bond provider ensuring that the trustees faced no initial reinvestment costs (i.e. the £120,000 invested in the new bond would have had an immediate realisation value of not less than £120,000 if transferred immediately).

Mrs Z was extremely pleased with the outcome. IAS were able to retain the original trust structure of the existing arrangement, maintaining equivalent "income" generating and inheritance tax saving properties by simply switching bond providers, at no cost to the trustees either in terms of higher rate income tax or initial investment charges. IAS also achieved another key aim of Mrs Z which was to reduce her overall exposure to Equitable Life.