Polly is a fortunate 25-year-old who has bought an apartment in London with cash gifted by her parents and a mortgage of GBP150,000. She has life assurance to pay off her mortgage if she dies. The apartment is worth around GBP300,000.
Polly’s parents, Joe and Jan, are happy for her to keep the GBP150,000 of capital advanced to her, but, if she were to die prematurely, they want to make sure the capital would come back to them, to supplement their income in their old age. They also have an adult daughter, Sally, who still lives with them.
Polly has not yet made a will and she has asked a friend, Tillie, who is a lawyer, what will happen to the flat if she dies in an accident. Tillie, who has just completed her STEP exams, explains that Polly’s estate will pass under the intestacy rules. As Polly is unmarried and has no children, her parents will take the whole of her estate. Her sister Sally will get nothing.
Polly is happy with this because she knows her parents will look after Sally. As Polly has no other assets, the value of the flat – GBP300,000 – will be within the current GBP325,000 nil rate band for inheritance tax (IHT), so in the short term no IHT would be payable if Polly were to die prematurely.
Tillie explains that the main drawback of Joe and Jan inheriting the flat outright on Polly’s death is that this will increase their estates with a potential IHT liability on the second death at 40 per cent.
If Polly were to die, her parents could improve the position by making a deed of variation,1 within two years, to pass the flat to a discretionary trust, with a wide class of beneficiaries including themselves, Sally and wider family members. Although Joe and Jan would be beneficiaries, this would not be caught by the gift with reservation2 of benefit anti-avoidance provisions, as a deed of variation is effective ‘for all purposes’ under the Inheritance Tax Act 1984. However, the position is not the same for income tax and capital gains tax (CGT): a deed of variation has no effect for income tax and a limited effect for CGT. This means (in contrast to the position for IHT) Joe and Jan will be treated as settlors3 for income tax and would be taxed on all the income as it arises. If Sally had been a minor, Joe and Jan might also have been caught by the parental settlement rule under s629 of the Income Tax (Trading and Other Income) Act 2005, which taxes a parent on a settlement for a minor child, if income is actually paid to the child and exceeds GBP100 a year.
For CGT, Joe and Jan can elect in the deed of variation for the trust to receive the flat at the market value at death. This may be useful to avoid a CGT charge if the flat has risen in value by the time of the variation. For all other CGT purposes, they will be treated as settlors. This would be relevant on a future appointment out of trust, which is a deemed disposal for CGT, as hold-over relief4 is precluded where a trust is settlor interested. Hold-over relief, if available, defers the CGT liability arising at the time of an appointment out of trust, effectively passing the trustees’ gain on to the beneficiary, to be charged at a later date on a future disposal.
To avoid all these complications, the better route would be for Polly to make a will leaving her estate on discretionary trust for a wide class of family members including her parents and Sally, coupled with a letter of wishes to guide the trustees. The result would be:
- Joe and Jan would not be settlors for IHT purposes (as for a deed of variation).
- Neither Joe nor Jan would be settlors for income tax purposes. Joe and Jan would only be taxed to the extent of actual income distributions to them.
- Neither Joe nor Jan would be the settlor for CGT purposes.
A disclaimer by Joe and Jan of any entitlement to Polly’s assets would not be appropriate here. Though a disclaimer would avoid the gift with reservation and settlor-interested issues, the default beneficiary, Sally, would take outright and, in any case, Polly wants Joe and Jan to be able to benefit from the income.
- 1Under s142 of the Inheritance Tax Act 1984.
- 2Under s102 of the Finance Act 1986.
- 3Under ss620–624 of the Income Tax (Trading and Other Income) Act 2005.
- 4Under s260 of the Taxation of Chargeable Gains Act 1992 (TCGA), or, alternatively, under s165 TCGA, for business assets where s260 does not apply.