Inheritance tax (IHT) has, over the past decade, become a major political issue. What was once seen as a tax that was only of concern to the seriously rich now touches more and more families each year. As a result, an increasing range of schemes are being marketed to help mitigate this burden, taking advantage of a number of tax reliefs that, when used properly, can considerably reduce the exposure of an estate to IHT.

The starting point with IHT planning is the threshold at which it starts to bite into an estate. When you die, your whole estate is, in theory, subject to IHT. Displaying typically bureaucratic logic, the amount below the current IHT threshold is known as the ‘nil rate band’, which means the level of the tax is zero. Anything above this level – £300,000 for the current tax year, rising to £312,000 in 2008/09 – is subject to tax at
40 per cent.

Thresholds rising slowly
Chancellor Alistair Darling’s much publicised – and subsequently much derided – proposal in his Pre-Budget Report to allow married couples a joint £600,000 IHT threshold (rising to £700,000 by 2010) simply reflected a situation that actually already existed. Each individual has their own IHT threshold, transfers on death between spouses are not currently subject to IHT and, in his final Budget in March 2007, Gordon Brown had already set out a series of annual increases in the threshold.

It remains to be seen whether the details of his proposal will remain unaltered when Darling finally gets to deliver the real thing in a few weeks’ time, but the intention appears to be to create a form of ‘married couple’s IHT allowance’, which enables them to pass the full value of both their thresholds to their heirs should they die at different times. One of the problems with the current situation is that, if one spouse leaves a significant amount of their estate to their partner, the surviving spouse will only have their own exemption to protect the combined estate from tax when they die.

Other allowances
However, it is important to realise that, even before you approach the IHT threshold, there are many other allowances that can reduce the value of an estate for IHT purposes. Most of these involve giving money to someone else. In addition to the exemption for gifts between husbands and wives, there is no IHT on gifts in relation to marriage (up to certain limits). Gifts to charities attract a similar exemption, and there is a further annual exemption limit of £3,000 on more general gifts (see the box opposite).

Then there are the potentially exempt transfer (PET) rules. These allow larger gifts to be made out of the estate. As long as these gifts are genuinely ‘lifetime transfers’ to third parties, they will ultimately fall outside your estate for IHT purposes. The reason they are referred to as ‘potentially exempt’ is that the donor has to survive for seven years from the date of the gift for it to be fully exempt from IHT. Liability reduces on a sliding scale if the donor dies within the seven years.

Trusts still valid
For many years, more sophisticated IHT planning was based on the use of trusts, which effectively put assets outside the investor’s estate. The difficulty with this process is that, theoretically, it means that the investor should no longer benefit from any assets removed from the estate in this way. So one of the key considerations in IHT planning is to strike a balance between removing assets from the IHT net and retaining control over them.

Until recently, a common solution was to use ‘interest in possession’ trusts, which enabled the investor to retain some control of their assets even after they had gifted them to a trust, using the PET rules to eventually remove them from the estate. However, in his 2006 Budget, Gordon Brown changed the rules so that gifts to interest in possession trusts no longer qualified as PETs.

It is still possible to use other forms of trust for effective IHT planning, particularly where they are used in conjunction with life assurance–based investments. They work on
the principle of writing a life insurance policy in trust, which will pay out a lump sum on death to meet the IHT liability, leaving the remainder of the estate intact.

The two forms of trust most relevant are the ‘bare’ trust and the ‘discounted gift’ trust.
The bare trust has the attraction of simplicity but you lose control of the assets. Under trust law, if you make a gift to a trust you cannot take any benefit from it yourself. You also have to name the trust’s beneficiary at the outset and they can demand that the trustees pay the benefits over to them at any time.

The discounted gift trust attempts to address these drawbacks. The gift to the trust makes use of the PET rules to remove the capital from your estate after seven years. The third option is a loan trust, where the gift to the trust is paid back over time.

There is also the option to use a ‘deed of variation’. Basically, this enables
somebody who is in receipt of an inheritance to put it into a trust. This prevents it from being included in their estate for IHT purposes. However, this must be done within two years of the original inheritance being received.

Do the basics first
Graham Barber, head of financial planning at Rensburg Sheppards, says that ‘Invariably, you will go through the basic IHT planning process of looking at the will first. You should take a look at making gifts out of normal expenditure. This is often overlooked, but can actually be the most important aspect of IHT planning. In certain circumstances, the traditional interest in possession trusts are still useful, especially where you are dealing with larger estates or you have second marriages and you
want to make sure there is provision for the children.’

He adds, ‘After using these planning methods, we would look at investment-based solutions, such as the use of discounted gift arrangements and AIM [Alternative Investment Market] portfolios. Discounted gift trusts are probably most useful where people are concerned about receiving income and, if it is
in an offshore wrapper, then that can be managed without any CGT constraints. Having gone through all of that, you should look at funding life assurance policies to meet
the IHT liability.’

David Knight, research director at BDO Stoy Hayward, agrees, ‘The most important thing is to do all of the basic planning first, before looking at the investment options. Investments are important, but the best option is to use up all
of the allowances. You should be thinking about how trustees will be investing the money before you look at these packaged products.’

He adds, ‘One option is some form of insurance-based plan. Most providers of offshore funds now do discounted gift trusts either with a bare trust wrapper or as a discretionary trust. There was some concern as to what a bare trust could actually be used for following the changes announced in the 2006 Budget. But HMRC seems quite happy to allow bare trusts in this form of IHT planning.’

Knight explains, ‘Essentially, you can put assets in a bare trust as long as you do not want to make any changes. If this is likely then you need to put it into a discounted gift trust that will ultimately give back your capital at five per cent a year. If you live for 20 years, the money will come back into your estate eventually, which is why HMRC doesn’t object to it. But if you die in the meantime, your heirs will get an immediate IHT benefit.’

He points out that ‘There are some much more sophisticated types of scheme, for example from Isle of Man Assurance and Canada Life, where it is possible to create insurance policies in a bond wrapper, which allows the settler of the trust to have some flexibility in terms of access and can also be used by beneficiaries. These would give you much more flexibility.’

Business property relief
There is another group of investments that makes use of the exemption from IHT
that attaches to investments qualifying for business property relief (BPR). These include things such as agricultural land, forestry and suitably qualifying companies listed on AIM and the Enterprise Investment Scheme (EIS).

Knight explains that ‘BPR has the advantage of giving very quick IHT relief, as you only have to survive for two years. You retain control, so you do not have to put these assets into your will until the very last minute. The downside is that there is a risk element.’
He adds, ‘The BPR tax rules were designed for entrepreneurs passing on family companies, but because many AIM shares are included in these reliefs, they have become attractive to a wider audience. There are other BPR-based solutions. For example, using an EIS or an EIS portfolio seems to make sense, although the danger is that HMRC might decide that that is not playing by the EIS rules. But it is a good way of getting BPR without exposing yourself to the uncertainties of AIM.’

Henry Dent of Punter Southall Financial Management says, ‘AIM portfolios tend
to be offered by the classic discretionary management stockbroking firms. People are starting to come up with more innovative schemes that seek to use these rules in more creative ways. This was really sparked by the fact that traditional trust planning has been so hammered recently that people are having to look for alternatives.

‘Underlying it all is the fact that the Government is not going to allow you to have an IHT saving unless you are prepared to take a significant risk with your capital.’

Kate Tidbury, who manages AIM portfolios for Close Investments’ clients, feels
that ‘The AIM portfolios will appeal to people who are used
to investing in equities. We are investing in small growth companies and, as long as
this fits with their investment strategy, it shouldn’t be a problem. The specific aim is to invest in IHT qualifying stocks that we feel are going to be around for a while and that we are happy to buy and hold.’

She adds, ‘We run the service to mitigate investment risk and IHT liability. The portfolios have 30 holdings and are run with as little turnover as possible. Investors should appreciate that the tax authorities don’t see these as portfolios but as 30 individual holdings, which we believe to be a reasonable number. Some will do very well and some will bomb, but most of them will at least hold their value.’

Speed and control
One of the major attractions of the AIM portfolio approach is that it significantly reduces the time that it takes to remove assets from your estate down to just two years. Of possibly even greater significance than that is the fact that, in an AIM portfolio, the investor retains access to all of their investments.

Dent feels that ‘The type of clients who would look to use AIM portfolios in IHT planning would either be those too old for seven-year planning or those who want to retain control of their investments. This is just about the only form of IHT planning where the investor retains complete control of their investments.’

Kate Tidbury says, ‘The advantage is that it only takes two years to remove AIM shares from your estate and you do not need to give anything away. People retain control of their investments, which means they can get their money out if they need to. However, you do not get tax relief for nothing, and AIM stocks invariably are higher risk. Also, to qualify for the tax relief, investments must be in trading companies, so resources stocks, for example, are not eligible.’

She adds, ‘AIM has 12 per cent of its companies in oil and gas, another 17 per cent in mining and around 12 per cent in real estate, much of which are ineligible for the
IHT portfolios. So these portfolios are not going to track the index. However, that still means that something like over half of AIM stocks are eligible, and a number of new trading companies are currently planning flotations.’

Dealing with the risks
Tidbury also argues that concentrating on more liquid AIM stocks and keeping turnover to a minimum helps to reduce the risks. ‘We tend to go for the larger, more liquid stocks, and preferably those paying a dividend. We also tend not to invest in new issues, as
we like companies to have at least one or two sets of results before we invest in them.’
She adds, ‘There will be some turnover, of course. For example, we have two companies at the moment that are subject to takeover, while Genus has just gone to the Full List. That did very well indeed for our investors but we had to say goodbye to it, and if these market conditions persist, there will be more. Turnover is usually due to these types of events, takeovers and flotations.’

Nevertheless, investors who are using AIM investments to shelter IHT must be prepared for a higher level of risk. Dent points out that, ‘Investing in AIM is highly speculative and you should only do so after taking proper advice. The major issues facing investors who are opting for the AIM portfolio route are the level of risk, probable illiquidity – you cannot, of course, always sell when you want to – and the fact that these stocks can often have little or no dividend. So you will be giving up a lot of potential income from your investments.’

He adds, ‘There are alsocosts involved with the setting up and management of an
AIM portfolio, typically an upfront charge of around five per cent and, because these portfolios are relatively difficult to research and deal and manage, they will probably charge another two per cent a year or more, which is higher than is usual for a managed fund.’

Dent adds, ‘There may well be administration charges on top, so these schemes could easily cost up to 11.5 per cent in the first two years, which can eat into the IHT savings to a very significant degree. And, if you then do not live for the two-year period, there is no advantage to doing it anyway. It could be that you die within two years and all you have done is landed your heirs with risk assets, to very little benefit.’

Liquidity constraints
As the AIM portfolio approach becomes more popular, there is a danger that there might not be enough good investment ideas to go round. Rensburg Sheppards’
Barber says, ‘With AIM portfolios, there is possibly an issue with finding sufficiently good-quality investments. As these things get bigger, stock selection is very important. You have to ensure that you have good quality companies. The key is to keep
an eye on the quality of the investment portfolio. It is very easy for people to concentrate so much on the tax planning that they forget to look at what they are actually investing in.’

And David Knight cautions, ‘You have to say that AIM is slightly risky at the moment. The changes to the VCT rules mean that there will not be as much money being put into AIM stocks, and the proposed CGT changes mean that, as of 6 April 2008, AIM shares will not be as attractive as they once were.’

He adds, ‘Otherwise, things such as trading companies are an option, for example Close offers one of these schemes (see box on page 28) and SPREFS has just brought one out. They can be very useful as part of your portfolio, especially if you do not want to put all your eggs into one basket. Forestry is a much longer-term investment, but it can still be useful for investors with very large estates.’

It is, however, possible to take steps to reduce the risks inherent in AIM investment. Punter Southall’s Dent feels that ‘It is always worth looking at those schemes that will offer you some form of insurance. There are two types: the first insures against your dying within the two-year qualifying period and the second insures against any capital loss on the portfolio. Typically, this will cost you approximately two per cent of the value of your portfolio every year.’

Dent adds, ‘Of course, the irony of this is that people considering this type of investment may not find it so easy to get insurance, so it may cost them more than two per cent, but it is still something that it worth considering.’