UK: Financial Tax Planning A Briefing On Topical Issues

All Change We Review The Pre-Budget Report And Take Stock Of The New Rules
Last Updated: 19 December 2007

As well as our view on the Pre-Budget Report, we analyse tax relief on overseas pensions, weigh up asset types, examine protected rights and explore annuity options. There’s also our guides to green investment, grouped pensions and life policy trusts.


This year’s Pre-Budget Report defied expectations and included major changes to tax rules. We explore the key areas affected.

Back in October, speculation over an imminent general election was dominating the headlines. So it was generally expected that the Pre-Budget Report (PBR) statement would be truncated. Even when it emerged there was to be no the PBR was still expected to be a nonevent as the Chancellor would have had no time to prepare the full version. So it was something of a shock to find that, not only was it a full-blown report, but it also contained major changes to inheritance tax (IHT), capital gains tax (CGT) and the rules for residence and domicile.

Inheritance tax

New rules for married couples

The Government has come under considerable pressure regarding the rising IHT bills faced in particular by Middle England, in light of increasing house prices. This pressure increased following the Phizackerley case judgment, where it was held that tax planning, designed to ensure that the nil-rate bands of both husband and wife were utilised, had come unstuck.

In the PBR the Chancellor proposed new rules for married couples (and civil partners) whereby the proportion of the IHT nil-rate band not used on the death of the first spouse can be carried forward and added to the other spouse’s nil-rate band on their death.

The new rules apply where a widow or widower dies on or after 9 October 2007. However the IHT calculation will take account of any unused proportion of nilrate band unused by their spouse even if they died prior to 9 October 2007.

This could lead to practical difficulties where executors have to produce evidence of the unused nil-rate band, particularly where the first death occurred many years ago.

Furthermore, many married couples already have wills that provide for a discretionary trust (nil-rate band trust) to be set up on the first death to ensure that both nil-rate bands are used. The new rules may render these clauses unnecessary, although it is not possible to generalise and the circumstances of each case will need to be looked at carefully.

If a husband and wife are both alive and have wills that include a nil-rate band trust, they should consider whether it would be advantageous to change them. It is good practice for wills to be reviewed on a regular basis and this proposed change gives a fresh opportunity to do so. If the will remains unchanged there will still be a degree of flexibility at the time of the first death, and it should be possible to take advantage of the new rules providing certain steps are taken.

Capital gains tax

Unwelcome news for business owners

The Chancellor announced that from 2008/09, CGT will be charged at a flat rate of 18%. This is good news for individuals who have invested in residential property and quoted shares. However, as indexation and taper reliefs disappear, many owners of business assets will see their effective rate of CGT increase from 10% to 18%.

With this in mind, business owners considering selling their business might want to finalise a sale before 5 April 2008, or perhaps transfer exposed assets to a family trust, pending a sale after the new CGT rules come in. Individuals selling shares in small and medium-sized companies will frequently be offered a deal including cash, deferred consideration, shares in the purchasing company and/or an earn-out. If so, great care will need to be taken when structuring these deals in order to crystallise gains before 5 April 2008.

Where a sale was concluded before the PBR, there may well have been deferred consideration in the form of loan notes which are not redeemable until after 5 April 2008. The planning opportunities are limited in these cases, but the possibility of renegotiating or selling the notes to a third party needs to be considered quickly.

In cases where assets were acquired before April 1998, the base cost for CGT purposes is increased by an allowance for inflation known as indexation allowance. For married couples or civil partnerships it would be possible to lock in the existing relief by means of an inter-spouse transfer.

Overall, it is important you act quickly to ensure gains are crystallised on the right side of 5 April 2008.


All change on arrival and departure

Two key factors determine whether an individual is resident in the UK for tax purposes. They must be present in the UK for 183 days or more in any tax year; or visit the UK on average for 91 days or more over a four-year period.

For many years, HM Revenue & Customs (HMRC) ignored the days of arrival and departure in the relevant calculations, as laid down in its booklet IR20. However, in a recent tax case, HMRC argued that this rule did not apply to every individual.

Unfortunately, the law determining whether an individual is resident in the UK is based on case law, much of which was decided before 1930 when life was somewhat different. Other countries have very specific residence tests which provide certainty, but there are no signs that the UK authorities intend to follow their lead in the foreseeable future.

The Chancellor proposes to deal with the resulting confusion by counting the days of arrival and departure as days spent in the UK.

The new rules are likely to have a serious impact on the City of London as a place to do business because they will potentially restrict overnight visits to the UK to less than four per month. It will be interesting to see how this influences the business behaviour of those most affected.


When the levy breaks

Individuals who are able to show that they are domiciled outside the UK are able to claim the remittance basis of taxation for income and capital gains.

This was the subject of much press coverage prior to the PBR, fuelled by proposals from the Conservative Party that anyone on the remittance basis should be required to pay a special levy.

So it was not surprising to find the Chancellor proposing a special levy of £30,000 per annum, payable by any non- UK domiciled individual who wants to continue using the remittance basis of taxation once they have been resident in the UK for more than seven tax years. In addition, anyone claiming the remittance basis will lose their automatic entitlement to income tax and CGT allowances and exemptions.

There will be practical difficulties for individuals who are already taxed on their unremitted income overseas, as the levy will not be available for the purposes of double tax relief.

The remittance basis

Under the current system it is possible to remit income free of UK tax, provided the remittance takes place in a tax year after the source of that income has ceased. For example, with bank interest, capital is kept in one account and interest in another. If the capital account is closed, funds can be remitted from the income account in a subsequent tax year without a tax charge. There is also a flaw in the legislation that enables individuals to opt in and out of the remittance basis when appropriate. The rules allowing this planning are to be changed and, as a consequence, the remittance basis will no longer be favourable for a large number of nondomiciled individuals.

The proposals extend far beyond income tax as they also intend to address the alienation of gains using offshore structures. This is a highly complex area, and the form of any new legislation could have wide ranging implications, particularly if it affects gains made before the rules actually change.

Much lobbying is currently taking place from all quarters, not least to point out the difficulties of administering the rules, but also whether the uncertainty will drive investment capital away from the UK.

It is imperative for anyone likely to be affected by any of these changes to take advice about the implications, and speak to their usual Smith & Williamson adviser as soon as possible..


Following the article in our summer newsletter concerning transfers out of UK pensions into overseas schemes, we outline the new rules governing tax relief on payments into these schemes, known as migrant member relief.

Until 5 April 2006, individuals working for a non-UK resident employer who were not UK domiciled, received tax relief on contributions into "correspondingly approved pension schemes", provided that they were paid out of earnings from that employment. HMRC would generally give corresponding approval to schemes, after which time contributions could be made into them.

It was a condition under the old rules that payments were made in similar circumstances to those which would give rise to a tax deduction into a UK scheme, and they were therefore limited to 15% of pensionable earnings up to the pensions cap. The overseas scheme also had to provide relevant pension benefits, similar to those available from a UK scheme.

One advantage of corresponding schemes was that the earnings cap was not applicable to employer contributions. These were merely limited by actuarial considerations which, in some circumstances, allowed fairly sizeable contributions to be paid on behalf of the individual, which, in turn, were not subject to UK tax.

The new rules

Following the introduction of pensions simplification on 6 April 2006, the old rules were changed significantly to bring them into line with the revised annual allowance rules for payments into UK pension schemes. In simple terms, these allow individuals to get tax relief on contributions up to the lower of £225,000 (in 2007/08) and their earnings into a pension scheme. If this amount is exceeded, a tax charge applies to the excess.

The new rules are designed to mirror the rules which apply to UK individuals, while allowing individuals coming to work in the UK to remain members of their overseas pension schemes.

Any individual with relevant earnings, whether or not they are UK domiciled, can claim migrant member relief for contributions into overseas pension schemes, provided that they are Qualifying Registered Overseas Pension Schemes (QROPS). Employers may also claim a deduction for contributions made to such schemes in respect of employees who are eligible for migrant member relief. The lifetime and annual allowance provisions apply to such contributions, as do unauthorised payment charges to certain payments made by overseas schemes to individuals who have received migrant member relief.

Finally, it should be noted that, in certain circumstances, individuals who were previously entitled to corresponding relief, but who are not entitled to migrant member relief, can continue to receive corresponding relief, subject to the conditions referred to above.

Qualifying for relief

To qualify for the new relief, individuals must not have been tax resident in the UK when they became members of the QROPS, and the relevant contributions must be made during a period of tax residence which began when they were members of the scheme. Individuals should have been entitled to a tax relief on contributions to the scheme in the overseas country in which they were resident immediately before coming to the UK. Alternatively, they should have been so entitled in any overseas country where they were then resident in the ten years before they became UK tax resident. It is also necessary for individuals to notify scheme managers of their intention to claim migrant member relief.

For an overseas pension scheme to get qualifying status it must meet certain qualifying conditions, notably that the scheme manager has told HMRC that it is an overseas scheme and that it has provided the requisite supporting documentation. Scheme managers must provide HMRC with the names of any relevant migrant members who have received benefits and notify members that information about payment of their benefits will be given to HMRC.

In summary, the new rules offer individuals the opportunity to continue paying into overseas pension schemes when they return to, or enter the UK for the first time, provided that QROPS status applies. However, ensuring that all of the necessary formalities are in place requires careful co-ordination.

If you require further information or assistance, please speak to your usual Smith & Williamson contact.


The Private Investor’s Choice Of Asset Classes

Investors have a wide range of possible asset classes to choose from. We weigh up the options.

Faced with the prospect of investing for the future in a pension, for school fees or just protecting against inflation, investors have to consider the relative merits of a wide range of asset classes, each with their own risk and return characteristics. Not only are there the traditional asset classes of equities, bonds and cash, but alternative investments which might be beneficial to a diversified portfolio.


Cash, the benchmark asset class, is viewed as a risk-free investment but it will always be subject to the eroding effects of inflation. Measured by the Consumer Prices Index, inflation is currently running at around 2%. In addition, the proposed changes in the October Pre-Budget Report mean that interest paid to higher-rate taxpayers will be taxed at a higher rate than capital gains from next year.

Fixed interest

UK Government bonds (or gilts) are an alternative to cash. These pay interest regularly and have the advantage of a predetermined redemption value. While returns are subject to inflation risk, investors can opt for index-linked bonds where income payments and capital are increased in line with the Retail Price Index. Gilts are attractive because much of their return comes in the form of taxfree capital gain. Corporate bonds are also available, in both conventional and index-linked forms, but investors should demand a better return for the higher risk associated with corporate debt.


For capital growth, equities have proven to be the best-performing asset class over the long term and should be the core of any investment portfolio. During each of the last four years, equity markets have returned approximately 9% after inflation, while gilts and cash have returned 1.5%. Since 1900, the average annual return after inflation has been 7% for equities, 2% for gilts and 1% for cash. The superior performance of equities is achieved because their dividend payout tends to at least match earnings growth and inflation over time.

Private equity

While equities, bonds and cash tend to constitute the major part of an investment portfolio, it can be beneficial to add a range of alternative asset classes in order to support investment returns in differing market conditions. Private equity encompasses a broad spectrum of investments, from start-up to mature companies, and often relies on debt which can introduce a higher level of risk. However, the core concept of taking companies private with the objective of improving their performance remains sound and is the basis upon which private equity aims to outperform quoted equity over the long term. Furthermore, due to the longer-term investment horizons of private equity, this asset class should, in theory, provide returns which are not directly correlated to quoted equities.

Commercial property

Commercial property has also produced returns with a low correlation to returns on equities. The potential for growth in capital and income will always be influenced by economic conditions, as well as supply and demand. An increasingly broad selection of property funds enables investors to focus their attention on particular countries, regions or property types in search of the most favourable outlook.

Hedge funds

An asset class with returns that are truly uncorrelated to equities is hedge funds. They are rapidly evolving and while the risk profiles and investment activities of funds can vary enormously, their common denominator is usually the aim to deliver a consistent performance regardless of prevailing market conditions. There are a number of different types of hedge fund strategy and while reliance on a single one can create undue risk, some funds of hedge funds incorporate a range to mitigate this.

Commodities and gold

Returns from commodities are also uncorrelated to equities. Commodity prices often behave in a way that is unrelated to economic growth and the direction of interest rates. Furthermore, commodities are physical assets and their values contribute to inflation. While it is possible for private investors to achieve exposure to commodities through equities, this introduces equity market risk. But the increasing number of innovative investment products, such as exchange traded funds, means that private investors can now gain direct exposure to commodity prices. Gold stands out as the ultimate store of value. Its price tends to perform well when the US dollar is in a weak phase, but it has also risen in value in times of inflation and geopolitical uncertainty. In this way, it can act as a hedge against weakness in other areas of a portfolio.

Asset allocation

An overall asset allocation strategy will depend upon an investor’s age, attitude to risk and requirements for income or capital appreciation. At Smith & Williamson, we may incorporate alternative asset classes into our investment portfolios as they can reduce overall volatility. As we enter a period of greater uncertainty and risk in the economy and markets, they could prove to be a useful addition to investment portfolios.


We Analyse The Recent Changes To Protected Rights And How They Affect Investors.

It is estimated that around ten million pension savers have accrued an element of ‘protected rights’ following a decision to contract out, or forfeit their entitlement to, the State Earnings Related Pension Scheme (SERPS) – or, from 6 April 2002, the State Second Pension (S2P).

Since the introduction of contracting out in 1978, protected rights have been governed by the Department for Work and Pensions (DWP). While the rules have been relaxed recently, they limit the investment of National Insurance rebates to insurancebased funds and restrict the timing and form of pension they can provide.

Until 5 April 2005, retirees could not draw their protected rights before the age of 60 and had to purchase an escalating annuity using unisex annuity rates, with a 50% survivor pension built-in for married members.

Disappointment at rule changes

On 6 April 2005, the requirement to purchase an escalating annuity was removed, and 12 months later the minimum pension age was reduced to age 50 (55 from 6 April 2010), under the pensions simplification reforms. Furthermore, retiring members can now take up to 25% of their protected rights funds as a tax-free lump sum for the first time.

Despite this gradual relaxation and significant lobbying by the pensions industry, the DWP has not permitted protected rights the same investment flexibility given to all other pension funds under the simplified regime.

This has forced investors to remain in closed or poorly-performing insurancebased funds. This has been particularly disappointing for the many savers who consolidated their pension funds into a Self-Invested Personal Pension (SIPP), as they had to retain a satellite protected rights fund, over which they have little investment control.

Better news

It was widely anticipated within the pensions industry that the investment rules would be relaxed from 6 April 2007, but the necessary amendments failed to materialise. Nevertheless, in June 2007, the House of Lords voted in favour of the DWP’s plan to remove the existing restrictions. As a result, draft regulations are expected by the end of 2007, and selfinvestment of protected rights is expected to be available from the end of 2008.

If you hold a protected rights fund and would like to consider how best to invest it, please speak to your usual Smith & Williamson contact.


Traditional Annuities Are Not As Popular As They Once Were, But Shouldn’t Be Written Off. We Explore The Options Available.

More and more retirees are moving into income drawdown with the intention of taking an alternatively secured pension (ASP) from the age of 75. But the alternative – the traditional and once compulsory annuity – is still around and has developed significantly over the last decade.

Conventional annuities

Conventional annuities provide an income for life, but the level depends upon the fund size, the age and sex of the annuitant, prevailing annuity rates – which are determined by long-term gilt yields – mortality assumptions, and the type of annuity selected.

Conventional annuities can be guaranteed for up to ten years. If the annuitant dies, payments continue until the end of the guaranteed period. Annuities can be established on a single or joint-life basis so that the annuitant’s income, or a proportion thereof, can be paid to a spouse or civil partner on the annuitant’s death. Payments can be level or escalate at a rate of 3% or 5% per annum.

The cost of building in a guarantee is relatively low, but purchasing a spouse’s pension or some form of escalation can have a significant impact on the annuitant’s starting income. For instance, a 65-year-old male building in a two-thirds pension for his 62-year-old wife will see a 10% reduction under current rates.

Indexed-linked annuities

Rather than escalating at a fixed percentage, conventional annuities can rise in line with movements in the Retail Price Index (RPI).

As annuities are generally backed by indexed-linked gilts, the starting pension will be significantly lower than the level option. For example, RPI-linking currently reduces the initial pension for a 65-yearold male by 35%.

Capital protected annuities

Pensions simplification introduced capitalprotected annuities as an alternative to guarantee periods. On death before 75, capital-protected annuities provide a lump sum equivalent to the original purchase price less the gross income received, which is then subject to a 35% tax charge. The cost of capital protection depends on the age of the annuitant and this option is currently provided by relatively few insurers.

Enhanced annuities

Enhanced annuities have been available since 1995 and offer higher pensions for individuals with particular medical conditions or lifestyles. Initially they were aimed at smokers, but they now also cater for diabetes sufferers, blue-collar workers, the obese and, most recently, those living in postcodes where mortality rates are higher than the national average.

Although underwriting in this sector is automated around a points system and rarely requires specific medical evidence, the differences in annuity rates are worth exploring. For instance, a 65-year-old male smoker could expect a 6% higher pension than the conventional alternative.

Impaired life annuities

Taking out an impaired life annuity involves a detailed investigation of the annuitant’s medical history and possibly a medical examination. Where an individual qualifies, the increase in annuity rate can be significant and will be reflective of both the annuitant’s reduced life expectancy, as well as that of his/her spouse or civil partner if a joint-life annuity is selected.

Where retirees would qualify for an impairment, they might place greater importance on maximising the death benefits available, which could lead them away from an annuity purchase and towards income drawdown or phased retirement. Also, where life expectancy is below 12 months, serious ill-health commutation becomes an option.

With-profits and unit-linked annuities

With falling conventional annuity rates, many retirees have turned to investmentbased annuities which rely on future investment returns to provide and maintain a higher level of income.

With-profits annuities emerged in the late 1990s and provide an income linked to the insurer’s with-profits fund. The starting income will depend on the bonus rate assumption made, and then on whether the assumed rate is met. If bonuses exceed the assumed rate, the annuitant’s pension will increase, and if not, the income will fall, although never below a predetermined base level which will be paid for life, irrespective of performance. Unit-linked annuities are linked to individual funds and are potentially more volatile than their with-profits counterparts.

With-profits and unit-linked annuities are growing in popularity, but the potential for a rising income must be carefully balanced against the possibility of a reduction. These are not without risk and are not appropriate for everyone. The latest offerings in this growing area are annuities which provide a minimum income guarantee as well as investment links, the performance of which have the potential to boost annuity levels in the future. As ever, seeking advice is imperative.

Guaranteed annuities

Finally, before making any decisions about annuity purchases or the other options available to you when you draw benefits, ensure you check to see whether your pension plan has a guaranteed annuity built into it. These can be up to 60% higher than those available for similar annuities on the open market and are generally found in older with-profits pension contracts.

For advice regarding annuity options, please speak to your usual Smith & Williamson contact.


Take Advantage Of A Complimentary Initial Consultation To Assess Whether A Review Of Your Pension Plans Is Likely To Be Beneficial.

As retirement draws closer, people’s thoughts turn to whether their savings will be sufficient to provide them with enough income and capital when they finally retire.

It is common for individuals to collect a number of pension plans throughout their life, from employers or their own pension plans. These accumulated plans are not always managed efficiently and tend to be forgotten until they mature. Bearing in mind the amount that can be gathered in pensions during a lifetime, it is important that the investment and contribution strategy is continually assessed.

To keep on top of pension plans (in particular the suitability of investments and the adequacy of contributions), our pension review service will:

  • analyse the costs and investment performance of pension plans, relative to their peers
  • give an analysis and critical review of the asset allocation of pension investments across all the pension plans held
  • recommend how the asset allocation of pension investments might be adjusted based on risk profiles and the number of years to retirement
  • provide projections of the value of pensions at selected retirement dates to assess the levels of income that they might produce
  • assess whether the current level of pension contributions is sufficient

The service can also be extended to include other savings and sources of income. If you would like a complimentary initial consultation to assess the benefits of a full review, please get in touch with your usual contact at Smith & Williamson.


More And More People Are Ethically And Environmentally Aware. We Look At The Impact On Investment Choices.

The increase in the number of ethical investors mirrors the burgeoning interest in ethical consumerism in general. People are better informed about the impact that their spending and investments can have, and are using this information to invest in accordance with their conscience.

SRI explained

Socially responsible investment (SRI) involves evaluating the ethical, social and environmental achievements of companies, alongside their financial performance. There are currently three main approaches to investing ethically.

  • Negative screening is the most common approach and involves avoiding companies that do not meet the ethical criteria of the investor.
  • Positive screening involves investing in companies with ethical business practices that promote desirable goals
  • The engagement approach usually takes the form of dialogue between the investor and the company, with a view to prompting change in corporate behaviour.

Continued growth

Consumer awareness of ethical issues has fuelled the growth of SRI, with more ethically-minded trusts entering the market. Due to a combination of public activism and an increasing awareness of ethical issues, it is anticipated that the pressure on companies to implement SRI policies will grow. Leading companies such as Vodafone and Marks & Spencer now have clear policies in place, with commitments to high ethical standards and delivery statements in areas such as energy and climate change.

New ideas and approaches, like the introduction of dark and light green funds, are changing the way ethical funds are perceived. As a result, these specialist funds are likely to develop a significant presence within portfolios.

Dark green funds use the strictest criteria, suited to investors with strong ethical beliefs. Managers of these funds usually employ the negative screening approach. Light green funds make use of the positive approach to portfolio selection and prefer investment in companies that have shown an improvement in their environmental or social policies. Past performance suggests that some ethical funds have equalled or beaten their conventional counterparts, and new industry developments may strengthen this record

Reaping returns

The pursuit of an ethical investment policy can limit portfolio choice and potentially exert a material effect on performance and risk. Despite this, there is a growing view that companies which act in a socially responsible way are more likely to flourish and deliver the best long-term balance between risk and return.

However, one of the most commonlyasked questions about ethical investment is whether there’s a trade-off in terms of financial risk and return. The answer is not straightforward, and this seems to be one reason why there is still much apathy towards SRI. Each ethical investor will have different criteria and approaches will vary accordingly, so it is not advisable to assume that all ethical policies will have the same effect on portfolio performance.

If you want more information about socially responsible investments, please speak to your usual Smith & Williamson contact, or our specialist adviser Neal Bailey.


Where Does Pension Reform Leave Families Or Like-Minded Individuals Who Want To Invest In Grouped Pension Funds?

Over the last three years, pension planning has seen radical reform aimed at simplification. But the Government appears to be somewhat torn in its pensions strategy. On the one hand, it wants to encourage us to save for old age, and, on the other, it views pension funds as a source of extra revenue – which is unsurprising when you consider their underlying value is equivalent to the combined economies of Greece and Portugal.

So, are pensions still a good thing? Of course they are. Where else can you build up a personal fund of £1.6m with tax relief, held in investments largely tax free, from which you can eventually withdraw up to 25% tax free? In this sense, the drive to simplicity has worked because these are straightforward benefits we can all grasp.

So how do grouped family pension arrangements fit in? A good deal of emphasis was placed on them in the early days of pension simplification – the idea being that they could generate funds which could pass between generations. Has this now been thwarted? Well, possibly not, as we explain below.

A family affair

Recent legislative change has driven pension provision towards individual contracts. However, a successful businessperson can help his/her family accumulate a pension fund of up to £1.6m.

Groups of investors

The family concept can be extended to groups of like-minded individuals who want to join together to purchase a property or maximise their investment potential. Individual contracts can give rise to problems when one or more of the members want to retire or withdraw from the investment. Ownership by a common fund can alleviate these issues and allow the administrator to reorganise the fund sensibly, avoiding possible sale and restructure.


Directors of family companies have long been able to purchase commercial property and let it back to the business on ‘armslength’ terms using small self-administered pension schemes (SSASs) which were introduced in the early 1970s. Under this type of arrangement, the company gets a tax deduction for the rents paid and they are not taxed in the pension scheme

Before the recent changes, companies needed to consult an actuary regarding the level of contribution to such schemes. These contributions were linked to earnings and could only be made in respect of the directors or employees of the sponsoring company drawing a salary. The new rules are less restrictive and allow wider membership which can extend to children and grandchildren.


Partners were not previously able to establish SSASs as they were not a corporate entity. Now partners can invest together in a partnership self-invested personal pension (SIPP). This brings the benefits of control, ownership, cost capping succession planning and exit facilitation to retiring partners, while engaging new and younger partners in the overall business plan.

Choosing an arrangement

So what type of arrangement is best – an individual SIPP, a family group SSAS or a family group SIPP?

Apart from the grouping concept, all the arrangements are similar. However, SSASs can grant arms-length secured loans to the business, which is a valuable feature for many businesses not available under a family group SIPP.

Group SIPP arrangements are relatively new to the market and represent a very viable proposition either for families or for groups of like-minded individuals (whether they are connected or not) to join together as a more powerful investment unit. The concept of a group SIPP or SSAS has much to offer, particularly as they provide alternatives to either annuity purchase or alternatively secured pensions at age 75.


We Look At Changes To The Rules Affecting Life Policy Trusts In The Run Up To The Tax Year-End And Suggest Some Courses Of Action.

All life policy trusts executed after 22 March 2006 are subject to the same IHT rules. In simple terms, this means that transfers into the trusts are treated as chargeable and are also subject to periodic or ten-year charges and exit charges. However, trusts created prior to 22 March 2006, which are not altered or added to after this date, are still subject to the old rules until 5 April 2008. This means that action must be taken before then to avoid future periodic and exit charges (depending upon the type of trust).

Take action

So, how does this affect you if you have an existing life policy trust and what action should you consider before 5 April 2008?

The following guidance might be helpful, but does not substitute a proper review of your existing policy trusts. Trusts should be reviewed to ensure that they continue to meet the criteria expected, and also that any obligation to pay ten-year anniversary and/or exit charges can be fulfilled.

Accumulation and maintenance trusts

Existing trusts must change the entitlement of the beneficiaries by 5 April 2008, so that they become absolutely entitled by age 18. Otherwise, they will become subject to periodic and exit charges. It is also possible to amend the age of absolute entitlement to between 18 and 25, in which case a special charge will apply for each year that has elapsed between 18 and 25. In the event that you have settled life policies on such trusts, be sure to review them and take action by 5 April 2008.

Interest in possession trusts

When the rule changes were first proposed, it was believed that additions to existing life policy trusts could cause their pre-change status to alter, so that they would become liable under the new regime. This caused concern among advisers over the payment of continuing life policy premiums.

HMRC quickly announced that existing policy trusts would not be affected as the right to pay premiums is contractual and not a further settlement. This was confirmed in the Finance Act 2006.

Changes to policies

The revised rules assume that the policies and premiums are only varied in line with policy conditions that applied as at 22 March 2006, and policy variations will include:

  • increases in premiums in line with the Retail Price Index (RPI) or a flat annual percentage
  • increases in premiums on five or tenyearly reviews to maintain the same level of cover
  • renewable term policies where the policy term is increased
  • convertible term policies which become whole-of-life policies.

Finally, many existing policy trusts give trustees the power to change the default beneficiaries or life tenants. Initially, it was anticipated that default beneficiaries or life tenants could be changed by 5 April 2008, but should not be changed thereafter. HMRC has clarified this, and these trusts are now allowed to continue even if changes to the life tenants are made after 5 April 2008. This is provided that these only occur on the death of the person originally entitled.

New interest in possession trusts

Under the new rules, premiums payable might be normal gifts out of income or covered by the annual exemption. Otherwise (subject to the nil-rate band), they could be exposed to IHT.

Where single premium investments that exceed the nil-rate band are paid into insurance policies that are held in trust, there will be a lifetime charge to pay.

Furthermore, normal reporting requirements will apply such that chargeable transfers in excess of £10,000 in a tax year, or £40,000 over a ten-year period, will be reportable on Form IHT 100. An increase in the threshold to £200,000 (based on the gross value transferred to the trustee) is thought to be imminent, although no change has yet been made.

HMRC has clarified the position on the reporting of premiums and confirmed that Form D34 is not required where the settlor provides the trustees with a cheque payable to the life office to buy a policy. It will be required if the settlor transferred the policy to the trustees after issue, although it is still unclear what the position is where the policy is placed under trust at the point of issue.

Problems with term assurance policies

Periodic and exit charges will now apply to all trusts in the same way as they currently apply to discretionary trusts, so it will be necessary to value policies held by them every ten years.

Most whole-of-life policies are valued at the greater of their surrender value and premiums paid, while term assurance policies are valued under the normal IHT open market value principles.

Most term assurance policies will have no value. However, problems will arise where the life assured has a reduced life expectancy on the trust’s tenth anniversary or, in the event of a claim, if the proceeds are in the trust on its tenth anniversary.

Furthermore, any variations to life policies held in trusts before 22 March 2006 will need to be contractual at that date, otherwise the trust will fall into the new regime when changes to the policy are made.

Who is liable?

Finally, who is liable for the tax where the life policy trust holds no assets and the underlying policy has no value? The legislation lists the following individuals as liable to IHT: trustees, beneficiaries with interest in possession, a beneficiary to whom settled property has been applied after the time of the transfer, and also the settlor.

HMRC has accepted that for discretionary trusts there may be no-one in a position to pay the tax and would not hold the trustees personally liable. However, interest will be charged on the tax liability until it is paid.

If you think you may need to review existing policy trusts, please contact your usual Smith & Williamson adviser or one of our specialists listed on the back page.


World Markets – Volatile And Increasingly Risky

Over the past month, investor sentiment has been pulled in contrary directions by further evidence of deterioration in the US sub-prime market, and mounting losses amongst the companies that originated, guaranteed and invested in these assets, offset by hopes that the cavalry would ride to the rescue in the form of cuts in prime rates. It was hardly surprising that markets have been volatile, but the fall in asset-backed securities and bank shares turned into a rout, before three major US investment banks announced the formation of a superfund to hold mortgage backed assets. The trillion-Euro European covered bond market actually shut down for a few days because it was impossible to make proper prices.

As if to illustrate the marked difference between the health of the real economy and that of the financial system, BHP launched a bid for Rio, clearly signalling faith in the growth of ongoing demand for commodities in Asia. With the oil price close to $100 per barrel, it seems clear that the global economic slowdown is not serious… yet. However, the failure of leading equity indices to break through their July highs, which in many cases are also their 2000 highs, during a period of the year that normally favours equity outperformance, is a danger sign. Many are close to important support levels that, if breached, could point to declines of the order of 10%. We remain strategically bearish of the dollar, and believe the gold price has further upside, although in the short term, the one is oversold and the other overbought.

USA – canaries in the mine?

Throughout the current credit crisis, we have been looking for signs of contagion in the real economy. So far there has been little evidence from the official data that this is taking place, since this will only appear after a lag, but we may be getting some advance warning from the latest quarterly corporate profit statements. Taken together, they suggest marked weakness spreading from housebuilders to transport and to the providers of internet equipment, with large corporations cutting back their expenditure. Exporters have been upbeat, thanks to a weak dollar, and this should provide some cushion to GDP growth, although durable goods orders fell for the third successive month and commentators have been increasingly using the ‘R’ word. The October National Activity Index, which has reliably predicted recessions since 1971, has fallen close to the danger level, and the November Conference Board Index of consumer confidence tumbled, with components for business conditions, employment and income particularly weak. There is no doubt that the credit crisis will claim many more victims and the bill will continue to rise. According to the OECD, total losses could hit $300bn, forcing many banks to recapitalise in a difficult market, while preventing them from lending to even the most creditworthy of companies for a considerable time. Meanwhile, home prices continued to fall in Q3, with the 4.5% year-on-year decline equalling that of the previous quarter. It will need governments to break the log-jam, and California is leading the way by securing an agreement with the state’s four leading mortgage lenders to extend the period of low introductory rates on adjustable rate mortgages. We doubt that this will be sufficient to prevent spiralling foreclosures and further capital losses, however, and while there is pressure on the Fed to cut rates, inflationary pressures, from soaring oil and soft commodity prices, and from consumer goods imported from China, may stay their hand for longer than the bulls would like. We remain cautious, although the major Indices are oversold, and would confine US investments to selected multinationals.

UK – housing headwinds

The economy is losing steam. Q3 GDP growth has been revised down from 0.8% to 0.7% quarter-on-quarter, with utilities, manufacturing and services all weaker than the initial estimates. On an expenditure basis, however, growth in household spending was running at the highest annualised rate since Q2 2004. This dichotomy cannot last, and we suspect the consumers will have to trim their spending, especially as gas, train and food costs continue to rise in the new year. The number of loans approved for house purchase fell to a record low in October. Clearly banks are tightening their lending criteria, and few are keen to occupy the space vacated by the collapse of Northern Rock. Hometrack estimates that house prices were rising at a mere 3.6% year-onyear in November, and the time properties are staying on the market has risen to eight weeks, close to the five-year high of 8.1 weeks. Things could get worse. Derivative contracts are pricing in a 7% fall in prices over 2008. Even without the cost of supporting Northern Rock, government finances are also deteriorating. Corporate balance sheets are strong, overall, but the cash is largely concentrated in the mining and oil sectors. The fall in bond yields in theory underpins equity valuations, but any bullishness must be tempered with the recognition that analysts have been slow to downgrade their earnings forecasts, while the ongoing credit crisis undermines M&A activity. FTSE is close to the critical 6,000 level. Let us hope it holds.

Europe – becoming less bullish

The slowdown continues, with business expectations in the service sector down to their lowest levels since November 2002, although there was a recovery in the manufacturing PMI. The French and German business confidence surveys both showed a surprise rebound in November, but closer examination of the latter shows that business expectations declined. The credit crunch and soaring sub-prime losses in the German landesbanks are clearly having an impact on consumer sentiment. The strength of the Euro is now beginning to seriously hurt exporters such as Airbus, and even members of the European Central Bank believe that the currency is overvalued, although the trade-weighted Euro has shown only a 7% appreciation over the past year. Despite currency strength, domestic inflation is becoming a problem in Germany, making it hard for the European Central Bank to cut rates to support growth. German investors have been worried by the subprime problems, while the French have been upset by the strikes and sabotage by workers seeking to preserve privileges the state can no longer afford. We are less confident of further upside for European equities in the short term, especially as our favourite market, the German DAX, has fallen below its four-year uptrend on a semi-log basis – a danger sign.

Far East – sitting on the sidelines

While some corporate reports in the West highlight signs of domestic slowdown, others suggest Asia is in rude health. Thus, Cisco’s emerging market sales growth was 35% in Q3, with Indian sales up by 50%. At long last, at both state and national level, India is beginning to invest in infrastructure, and this will provide additional support for the economy in 2008. Western investors continue to see a divergence between the economic prospects of Asia and the developed economies, but with the risk of weakening consumer demand spilling over into falling Asian exports, and growing trade friction with the EU, they are becoming less inclined to add to their holdings. We are also becoming more cautious. As much as 30% of the profits of domestic Chinese companies derives from share trading, so the recent fall in the A-share market could lead to losses and an erosion in confidence. The Japanese economy continues to disappoint, although the Bank of Japan persists in seeing a recovery that is invisible to most other observers. M&A activity is increasing, however, and this provides support to the market.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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