IHT Planning for those with cash: Access to original capital required : the role of Loan Trusts
Tony Wickenden, Managing Director at Technical Connection, explains the role of Loan Trusts.
Quite often an individual is aware that they have a potential liability to inheritance tax -“IHT”- (for most couples, on the death of the second of them to die) and would like to take some steps to mitigate this but feel unable to lose access to the assets or cash to be used in planning . For those with available cash, or cash that can be accessed, this is where a Loan Trust could be appropriate. By using a Loan Trust, the individual or couple may achieve a gradual reduction in their estate for IHT purposes, ensure that all of any growth in the value of the invested cash is outside of the estate while retaining access to their original capital.
A typical Loan Trust is based on an individual establishing a trust with the intention of making a loan to the trustees, then executing a loan agreement with the trustees and transferring the funds to the trustees as a loan. In order to avoid any negative IHT consequences, the loan is specified to be interest free and repayable on demand. The trustees then invest the funds, usually into an investment bond, and hold the bond as a trust asset. As stated, the loan is interest free and repayable on demand and whenever the settlor requests a repayment of part of a loan, the trustees make a withdrawal from the bond and repay the amount requested. Once all the loan has been repaid, the rest of the trust fund can (but doesn’t have to) be passed to the trust beneficiaries. If at any time the settlor/lender requires repayment of the whole of their outstanding loan then the trustees could fully (or partially) encash the bond to release sufficient funds to make the loan repayment
In the past, another version of the arrangement used to be popular, based on an initial (usually small) gift and a much larger loan. Here the settlor would make a small gift (usually being an exempt transfer for IHT), which would be invested separately from the amount lent. However, once it was clear that this step (i.e. a small gift) was not in fact necessary to create a valid trust, most of the Loan Trusts have been based on a much simpler, streamlined “loan only” arrangement.
Whilst the IHT gift with reservation provisions can neutralise the IHT benefits of a trust fund where the settlor can benefit, these rules will not apply to Loan Trusts because the settlor's right to have their loan repaid does not amount to a reservation of benefit. Their right to repayment is in their separate capacity as a creditor rather than a settlor.
Of course, a practical pre-condition for this strategy to work is that the individual has (or can access) the cash available to make the loan which can then be invested. You cannot lend an existing bond.
Loan Trust in practice
As mentioned above, under a typical Loan Trust the settlor starts by declaring a trust
without any assets being transferred to the trustees at outset. Instead the trust is declared in anticipation of money being transferred to the trustees by way of a loan. This makes the “set up” process really simple. However, for a trust to be legally valid, it must hold trust property. In effect, when the settlor and the trustees of the Loan Trust execute the trust deed, they are creating a receptacle for the future receipt of the loan money. When the loan is made and the loan moneys invested in a bond with the trustees holding the bond as the legal owners, the trust will become properly constituted.
In practice, although the bond application will be made by, and the bond will be issued to, the trustees, the settlor would usually make the payment (of an amount equivalent to the loan and in satisfaction of the loan) directly to the bond provider.
Loan repayments may be requested by the settlor from time to time when they require funds. The trustees will have to make part withdrawals from the bond to facilitate repayments. If withdrawals are kept within the 5% annual cumulative allowances, there will be no immediate income tax liability. It’s important to remember though that if the payment of adviser charges is facilitated through the Bond these will need to be taken into account in determining how much of the 5% allowance is available to cover the withdrawal of funds to meet loan repayments.
It is, of course, possible that the settlor will request a repayment (resulting in a withdrawal by the trustees) of more than is covered by the available 5% allowances in a policy year. Where the withdrawal exceeds the cumulative unused annual allowances, a chargeable event gain may arise, taxed in the usual way. In some cases it may be worth encashing some whole policy segments instead to generate the sum required.
The trust fund (subject to the settlor’s right to have their loan repaid) is held for the beneficiaries and the settlor has no access to it. There are different versions of Loan Trust on the market, depending on the nature of the trust in relation to this gifted part. Under a bare (absolute) Loan Trust, there will be a named beneficiary or beneficiaries entitled to the residual fund. Discretionary Loan Trusts are more popular as they offer flexibility to the trustees (usually taking account of a non- binding “expression of wishes” by the settlor) to decide which of the potential beneficiaries should benefit. The chosen beneficiary(ies) would normally only receive the value of the trust fund following the death of the settlor.
A Loan Trust may be set up on a "single settlor" or "joint settlors" basis (by a married couple or civil partners), although in the latter case the loan agreement will need to include additional provisions dealing with how the loan is made, how any repayments should be made and what happens if one of the settlor/lenders dies. Potential complications may arise if the couple were to divorce and for this reason Loan Trusts are more often than not made on single settlor basis.
Under a typical loan-only trust, the settlor does not make any gift at all when the Loan Trust is set up so there are no IHT implications resulting from the establishment of a Loan Trust.
Under current law, the loan itself, even though it is interest free, does not involve any element of gift as long as it is repayable on demand.
If the trust is a discretionary trust, it is potentially subject to the periodic and exit charges, however, for the purpose of any calculations, most importantly in establishing the value of the trust fund, the amount of the outstanding loan is ignored so in practice it is unlikely that the fund held for the beneficiaries would suffer actual IHT charges.
If large sums are being invested, use of several trusts established on separate days, in most cases, each having its own nil rate band, utilising the so called “Rysaffe” principle will offer additional IHT planning possibilities.
Other tax implications
As long as the underlying investment is a bond (UK or international) and the withdrawals funding loan repayments are kept within the 5% allowances, there will be no income tax implications during the settlor’s lifetime. After that, the usual rules for the taxation of bonds will apply with any gains usually being assessed on the settlor if alive and UK resident.
This income tax simplicity is the reason why Loan Trusts work best with bonds. However, it is also possible to use a different investment vehicle such as collectives, although in such a case the trust will be classed as “settlor-interested“ trust by virtue of the settlor’s loan (despite the settlor being excluded from all benefit under the trust). This means that although the trustees of a Loan Trust based on a discretionary trust would have to pay income tax on the trust income (as it arises) at the trust tax rates, all trust income would be taxed on the settlor, with the trustees effectively paying income tax on the settlor’s behalf. The settlor would receive a tax credit for the tax paid by the trustees and if this exceeds his actual tax liability, he can claim a refund of the excess tax, which then has to be paid back to the trustees. Clearly this would involve a lot more administration than with a trust based on a bond.
Capital gains tax
Capital gains tax is not relevant to investment bonds but would be relevant if the investment is in collectives. Here the assessment is on the trustees as the settlor-interested provisions do not apply for CGT purposes.
Pre-Owned Asset Tax (POAT) provisions
Under the Loan Trust the settlor cannot benefit in any circumstances from the trust fund therefore POAT cannot apply. HMRC confirmed in 2005 that POAT does not apply to Loan Trusts.
Disclosure of tax avoidance schemes (DOTAS) provisions
HMRC has confirmed that as the settlor’s estate is not reduced by the granting of the loan (the outstanding loan remains in the settlor’s estate) and the IHT saving is only “hoped for” (if the investment value rises), loan trust (and gift are loan trust) arrangements are not notifiable under IHT DOTAS hallmark.
Trust registration service (TRS)
Since 1 September 2022, the trust will need to be registered within 90 days of its creation, as will any changes to the trust details and/or circumstances.
A Loan Trust is an excellent, tried and tested, method of allowing an investor to undertake a degree of lifetime IHT planning with their investment and achieve a gradual reduction of their estate without losing access to the funds available for investment as well as leaving a residual fund for their beneficiaries after their death. However, it is important to remember that whilst any investment growth will be outside of the settlor’s estate immediately, to achieve further IHT mitigation, loan repayments need to be taken and spent by the settlor. If a settlor has not needed any loan repayments for a number of years, then perhaps the arrangement should be reviewed to determine whether the settlor still requires access to the entire loan. To the extent that access to the amount lent is not required the loan could be written off. This would itself constitute a chargeable or potentially exempt transfer dependant on whether the trust was (respectively) a discretionary trust or a bare trust. Another alternative would be for the lender to take the loan repayments and gift the cash within their IHT exemptions to further reduce their IHT exposure.
In practice, it appears that many clients establishing Loan Trusts die with some (sometimes all) of the loan outstanding. Ideally the settlor should include in their will a provision specifying who should inherit the right to any outstanding loan, otherwise it will pass to the residual beneficiaries. Often the executors dealing with the estate of the deceased settlor are unsure how to deal with such a loan and they will need advice on this. Frequently the beneficiary under the will may not need the cash and would be happy to keep the bond instead. The key point to remember is that the bond, or bond segments, should never be assigned in satisfaction of the loan as such an assignment will itself constitute a chargeable event for income tax.