1. Where EIS and VCTs are complimentary to pensions
2. What types of clients may benefit from their use
3. Where EIS and VCTs are useful in IHT planning
4. Trusts and the use of BPR
Mark Williams, Head of Strategic Partnerships, Octopus Investments
PRESENTER: Hello and welcome to this Akademia on complementary solutions to a pension for retirement planning. After viewing this session you should be able to discuss with your clients the use of EIS and VCTs; some aspects of BPRs; and the use of the AIM market. I’m Tony Suckling, and in this I’m joined now by Mark Williams. He is the Head of Strategic Partnerships at Octopus Investments. So, Mark, talk us through the use of EIS and VCTs as these complementary solutions in pension planning.
MARK WILLIAMS: Sure. Well we are hearing a lot more about EIS and VCT nowadays, and I think that’s primarily because of the fact that pensions relief is being continually withdrawn by the Government. So we’ve seen reductions in the annual, in the lifetime allowance rather, the amount that people can save during their lifetime tax efficiently into a pension; we’ve seen a continual reduction in the annual allowance, the amount that you can save in any one tax year and get income tax relief on it; and there are going to be future withdrawals that are going to take that to another level. So people are increasingly looking at EIS and VCT as an alternative to pensions planning for their retirement.
PRESENTER: Let’s have a look at it on the slide.
MARK WILLIAMS: So if you look across the range of retirement planning investment wrappers you’ve got. You’ve got pensions, ISAs, VCT and EIS up on the slide here. And we’re comparing the relief that you get upfront, and also the relief that you get, the means to access your investment when you want to take it. So, on a pension, you obviously get upfront tax relief, up to 45% for an additional tax ratepayer; however that’s being withdrawn as we said, and for really high earners the Government tends to claw that back to something like a maximum of £10,000 from next year. You don’t get any upfront relief on an ISA. On EIS and VCT you get 30% income tax reducer. So for every £100,000 that you invest in an EIS or a VCT investment, then you’ll be able to reduce your income tax bill by £30,000.
PRESENTER: That can be quite a surprise to an investor I’ve discovered over the years when talking to financial advisors who say my client didn’t realise they were going to get a substantial sum back almost immediately.
MARK WILLIAMS: Yes, it’s a wonderful relief in that respect. I mean it comes with a number of quid pro quos because it’s important to say that these incentives are in there to drive investment in UK trading companies. So in the case of EIS and VCT there are quite prescriptive rules that we need to adhere to, to invest the money in ways which will ensure that investors will get the reliefs and qualify. But, absolutely, if you can meet those then it’s a fantastic wrapper. And then when you look at the exit side actually on that slide, you can see yes well during the time that your investment’s growing on pensions and ISAs, your investment can grow tax free, income tax and capital gains tax free. The same is true of VCT and EIS. But when you actually come to exit of course on a pension only 25% of your fund value can be accessed tax free, the rest of it at your marginal tax rate. That’s not true of VCT and EIS: those are income tax and capital gains tax free at the point at which you withdraw so really credible tax wrappers.
PRESENTER: Let’s have a look at the effect of these tax treatments on this next slide.
MARK WILLIAMS: And just to highlight the point here, we’ve set some numbers out here, and we’ve talked about somebody who’s investing in effective after upfront tax relief amount of £60,000. And of course pensions, you do get that upfront tax relief. The same is true of VCT and EIS, not true of ISA contributions of course. Your investment value, we’ve assumed a rate of growth here of 100%, and that can be realistic on some pensions as it can for some EIS and VCT. It’s by no means true of all of these investments. But for the sake of example we’ve assumed that we double the amount that you’ve got invested there. Of course again only 25% of your fund value can be accessed tax free in a pension and the rest is accessed at your marginal rate. That’s not true of ISAs, it’s not true of EIS or VCT either, where you can access the full value of your pot tax free when you come out. So again the numbers serve to illustrate there just how attractive EIS and VCT can be.
PRESENTER: Give us an example then of how this might work in practice.
MARK WILLIAMS: So if someone was to come along here, actually if we turn to the next slide perhaps you can see an example here. This client investing round about £157,000, and that’s by no means necessary for every investor. We start with a minimum on the VCT side of £5,000, on the EIS side a little bit higher, £25,000, but this individual investing £157,000. You get a 30% income tax reducer there, which reduces his income tax relief by £47,000. Could be particularly attractive for someone like a landlord who doesn’t have access to pension planning, because of course you’d only get tax relief on a pension investment if you’ve got earned income. And a landlord with rental income, the rental income doesn’t qualify in that way.
PRESENTER: Or dividends in fact. Is that true?
MARK WILLIAMS: Absolutely, yes. So there’s sort of passive incomes you can get from an investment that won’t qualify either for pensions planning. So this individual comes along and thinks well EIS and VCT could be a means of planning for retirement, which would complement whatever they’ve got on the pension side, £47,000 income tax reducer, and we’ve said here well look at this as a way of actually taking that income tax relief and making a pension contribution as well. So in this case £32,000 of the £47,000 goes to make a net pension contribution, which immediately is grossed up to give basic rate tax relief of £8,000, taking you up to £40,000 gross contribution. If they’re an additional rate taxpayer they’ll get an even greater sum by way of relief on their self-assessment form. So this individual takes their £32,000 contribution up to £50,000, and they’ve still got $15,000 left over from the tax relief to actually fund their ISA allowance for the year. So just using EIS and VCT as a way of complementing what they’ve got on the pension side, almost using the relief to actually fund the pension contribution gives them a diversified planning strategy.
PRESENTER: OK, but what about those people who are already in retirement then?
MARK WILLIAMS: Yes absolutely. So VCT and EIS can be useful as a means of planning for retirement, and equally they can be very useful as a way of actually extracting your cash from the pension tax efficiently. So there’s obviously been a huge amount of attention on pensions, recently, because of the new freedoms that people have got for accessing their pensions. We have to remind ourselves of course that doesn’t come at no cost whatsoever, there’s a tax free amount, 25% of your fund, but over and above that of course anything you withdraw from the pension is withdrawn at your marginal rate for the year in which you withdraw from the pension. So if you flick onto the next slide then you can see an example of this perhaps.
So flexi-access drawdown: this is where you can take staged amounts from your pension, and you can do so as we just described, 25% of it being tax free. But using EIS or VCT in conjunction with that withdrawal can have a particularly powerful effect. So let’s talk about a little example now as we turn over. So this individual, they’re a higher rate taxpayer; they’ll pay tax at a 40% marginal income tax rate. They want to crystallise a £50,000 sum from their pension. Now ordinarily only 25% of that would be tax free, £12,500, and the rest of it, £37,500, would be taxed at their marginal rate of 40%, so that gives a total tax bill which takes the net amount withdrawn to £22,500.
Now, the alternative, they could stop there and accept that tax bill, but of course a lot of people have got a range of investments in place already. They’re perhaps not relying on all of this withdrawal from the pension for liquidity; they just perhaps need some of it so they can rely on the tax-free cash. If they were to invest £35,000 in an EIS or a VCT from their withdrawal, they immediately trigger a relief of 30% of that amount, £10,500 in tax relief. So that can be used to go against the tax which is created from the withdrawal of the pension. And that means the net withdrawal, the net cost of withdrawing that full £50,000 is just £4,500 in tax, i.e. just 9% of their total withdrawal.
So it makes it really efficient. Just remember this person is a higher rate taxpayer paying 40% tax ordinarily, but they’ve managed to withdraw this amount from their pension by using EIS and VCT for a net cost of 9% tax.
PRESENTER: That seems very efficient.
MARK WILLIAMS: Absolutely, again there are quid pro quos. They have to invest for a certain amount of time, so an EIS you have to be invested for a minimum of three years to qualify for the reliefs and not have them withdrawn, and in the case of VCT it’s up to five years. But providing you’re happy to do that then those benefits are there to be had for investors.
PRESENTER: OK. What about a business owner then who’s not yet in retirement?
MARK WILLIAMS: Yes a good question. So I mean it’s not just retirees that EIS and VCT are beneficial to, I mean that’s just one example of the sort of person that can use these investment wrappers. A business owner, we’re seeing a lot of attention on this area as well at the moment. Because of course one of the main reasons for people to take income out of a business is via dividends if they have an incorporated business. Now we’ve seen a big announcement in the Budget recently before the summer from the Government that they’re intending to abolish the dividend tax credit from April next year, and that’s led to a bit of a rush for the door from people to look at ways of actually extracting cash from companies tax efficiently in advance of that date.
So, if we have a look at an example here, we see a business owner who again he’s a higher rate taxpayer, he’s paying 40% income tax rate. He’s got profit in the company that he could take by way of a dividend, and he’s got an important date to have in mind here, 5th April, the end of this tax year, because after that the Government’s announced that there’s going to be the withdrawal of the dividend tax credit. And that’s going to lift up the effective rate of income tax for people who are withdrawing dividends from a company.
PRESENTER: 5th April 2016.
MARK WILLIAMS: Absolutely.
PRESENTER: So get to speak to your business owners a long way before that date.
MARK WILLIAMS: That’s the idea. So it requires a tax efficient method of extraction, and if we look onto the next slide, it’ll illustrate this a little bit further. So if a £40,000 dividend was paid to this individual, this middle column here with the red one in the middle, that would create a £10,000 income tax liability at today’s rate, so 25% effectively rate of income tax, leaving him with £30,000 in his pocket after tax. And that’s all very well. That’s going to increase from next year because of the planned evolution of the dividend tax credit. But if it was done this year then that would be the result.
So let’s look at what you could do with EIS and VCT. You could, this individual could for example make a £35,000 EIS or VCT investment, and that produces a 30% income tax reducer in that current year. Or in the case of EIS you can actually carry back that relief and use it against income earned in the previous tax year. But that 30% of £35,000, £10,500 of income tax relief in this example wipes out the £10,000 of income tax you pay from withdrawing a dividend from the company. So it completely eradicates that, and it also leaves you with an extra £500 in your pocket because of the excess there.
So this individual has managed to take a £40,000 dividend without having to trigger any income tax. He has to lock it up in an EIS and VCT for some time, but providing that’s acceptable to him he’s got a tax-free dividend extraction strategy, and he’s also got £5,000 left over there because he’s only invested £35,000 of the £40,000 in EIS and VCT. So tremendous opportunity and one which business owners and their advisers we’re seeing are looking at very carefully at the moment because of this change and increase in the effective rate of dividends from next tax year.
PRESENTER: And all before April 5th 2016.
MARK WILLIAMS: Absolutely.
PRESENTER: Not long to go, needs to be done. What about the growing numbers of people, as we get an ageing population, who are looking to exit their business, looking to sell, so what should happen for them?
MARK WILLIAMS: Well now we start to think about inheritance tax. Because one of the fabulous things of course of owning your own business, if it’s a trading business, it’s going to be exempt from inheritance tax, because it attracts business property relief. So if you look at the next slide here, and we talk about a business owner who’s looking to exit, so this particular chap been very successful. He’s got a business that’s owned by him and it’s worth a million pounds after tax. He’s got diversified income; he’s starting to get concerned about inheritance tax. The nil rate band might cover some of his other assets but it certainly doesn’t cover this particularly sizeable million pound business. And let’s illustrate what he could do then.
So if we look at what’s going to happen here. The problem for this individual, he’s enjoyed an inheritance tax shelter all of his life by owning this business which would have qualified for business property relief. Now as soon as he contracts to sell that business, then he loses that shield from inheritance tax. Those assets, that million pounds will be immediately subject to inheritance tax in the event of his death, so he puts at risk his estate to a 40% inheritance tax charge, £400,000.
OK, well let’s look at the potential solution for this chap. So he’s got a million pounds in his business, and those are the proceeds that he’s going to earn if he sells it. He could make an investment in a BPR qualifying asset, another BPR qualifying asset, and immediately qualify for that 100% inheritance tax shield so that he’s protected from IHT in the event of his death. And that’s under something called the replacement property relief rules, which mean that if you invest within three years of the disposal of one qualifying asset, then you immediately requalify with the one that you replace it with. So you don’t have to go through the normal two-year investment holding period in order to qualify for BPR.
So very straightforwardly this individual had a business, it was protected from IHT, as soon as he sells it, as soon as he contracts to sell it, then it’s going to be liable, those assets are going to be liable to 40% inheritance tax when he dies, and he can do something about that by making another replacement investment in BPR qualifying assets and restore that inheritance tax shield with immediate effect. And of course for some younger entrepreneurs this is just a parking spot for their assets until they find the next business venture which will give them BPR on that. For some people this is the more permanent solution in later life to actually maintain permanently the IHT benefit.
PRESENTER: And just remind me, from the point of sales, there’s three years to create that further BPR, is that right?
MARK WILLIAMS: That’s right, that’s the replacement property rules. So if you reinvest within three years of the original disposal then you’ll immediately requalify for business property relief. You don’t have to go through the normal two-year holding period in order to qualify.
PRESENTER: Are there any other frequent uses of EIS that you see currently?
MARK WILLIAMS: Yes, I mean let’s have a look at this next slide here, and this is where we see a lot of EIS investors focused on, because EIS has a benefit that we haven’t talked about so far. We’ve talked about the fact that you get an income tax reduction upfront, 30% of your investment amount; we’ve talked about the fact that EIS investments can grow free of income tax and capital gains tax; but we haven’t talked about another benefit, and that is that EIS investments allow you to defer capital gains that you’ve realised on the sale of any other asset. And EISs after two years can qualify for business property relief as well, so they’re exempt from IHT. So with all of those tax incentives at your disposal EIS is a really powerful tax planning tool.
So that becomes particularly useful where you’ve got illiquid assets that are pregnant with capital gains, large capital gains. So if you’ve got a property for example, a second property, not your main residence which would be exempt from CGT, but a second property, a holiday home that had a sizeable capital gain within it, or a share portfolio perhaps in this example that’s grown significantly over time, if you just sell that property or sell those shares ordinarily then you trigger capital gains tax at up to 28% for a higher rate taxpayer. So that stops a lot of people from actually doing anything about these assets for inheritance tax. Because of course if you hold these assets and don’t do anything for IHT then you hold until death and all that capital gains tax gets wiped out. But you will be subject to inheritance tax of 40%. So there’s a bit of a dilemma there for a lot of people.
PRESENTER: I can understand that, and people say oh this is just too complicated, it’s just too much to think about, I won’t do it - but you’re encouraging them to do it.
MARK WILLIAMS: I’m encouraging them to take a look at EIS with their advisers to have a look at just how EIS can provide quite a creative solution here. In that it solves a problem. It solves that dilemma where you’ve got illiquid assets that have got large capital gains within them. So you might normally be reluctant to sell them and plan for inheritance tax with the proceeds. With EIS you can have both. So in this example this individual’s got a share portfolio of £350,000. He’s got a sizeable capital gain within it, because it was purchased for £250,000 so £100,000 gain. They’d like to do something for inheritance tax, but then there would be a CGT issue, so £28,000 on, 28% of that £100,000 gain.
Now what they can do by making an EIS investment is defer that gain. So they could sell the assets, sell the share portfolio, and instead of paying capital gains tax, if they reinvest the gain element the £100,000 into an EIS investment, and we’ll see this on the next slide, then they can defer the capital gains. They don’t have to pay the CGT at the point of disposal. And that capital gains tax is deferred within that EIS investment for as long as you hold that EIS investment. And in fact if you hold the EIS investment until death then the CGT is wiped out. But remember of course the EIS is also benefiting from business property relief, so it’s inheritance tax exempt as well.
MARK WILLIAMS: So what does that mean in a nutshell? Well this individual had a £350,000 share portfolio. Upon death there was going to be a significant 40% inheritance tax charge which would leave the beneficiaries with just £210,000 of that £350,000 share portfolio. They could sell the share portfolio, make an EIS investment of £100,000 - that triggers that upfront income tax relief for them, which could be used against their salary or their other income from, rent from properties or from dividends from other shares, so that provides a benefit in itself. But the main benefits, thereafter, is the fact that this EIS investment allows them to defer the capital gains tax they would have paid on the sale of the share portfolio. And after two years their EIS investment will be exempt from inheritance tax because it qualifies for BPR, and when they do pass away then the gains that are deferred in the EIS, if they’re still holding the EIS they’ll fall away and be wiped out for capital gains tax purposes.
So in the example here we’ve said this individual makes £100,000 EIS investment - that’s all they need to do: they only need to invest the gain element from the sale of the share portfolio.
PRESENTER: So it’s not the £350,000.
MARK WILLIAMS: Not the full amount.
PRESENTER: Just the gain.
MARK WILLIAMS: But they might look to invest the rest of the proceeds plus in this case the £30,000 income tax relief that they’ve scooped from the EIS investment, invest that additional £280,000 within another BPR solution that perhaps doesn’t qualify for EIS but is managed on a broader mandate. And then that investment itself will be exempt from IHT as well. So in a nutshell the EIS has provided them with a means of taking these £350,000 worth of assets which would have been worth £210,000 to the beneficiaries and make them exempt from capital gains tax and inheritance tax and so can pass the full value to their beneficiaries of £350,000 plus that additional £30,000 income tax relief they generated from making this EIS investment. So it’s an incredibly efficient use of EIS.
PRESENTER: Many financial advisers I know talk to their clients about onshore bonds; does EIS and IHT solutions come into this area at all?
MARK WILLIAMS: Yes, where you start talking about investment bonds, then we move into something, a similar kind of example but of course we’re into income tax there rather than capital gains tax. And actually if we turn to the next slide we’ve got an example of this. So an individual where they’re a higher rate taxpayer and has in this example £200,000 investment bond with a chargeable gain within it, so these chargeable gains you get with investment bonds, and they’re going to be subject to income tax when you withdraw, not capital gains tax. In this case again of £75,000 which would be, well they’re a higher rate taxpayer so 40% taxpayer, they get some kind of tax paid at source, and then some tax they’d have to pay here at an additional 20%.
So there’s an income tax charge. And again similar to the share portfolio example, this stops most people doing anything with these investment bonds to play for inheritance tax. The investment bond will be within their estate for inheritance tax, but a lot of people don’t want to disturb it because when you exit you create this income tax charge. So what do you do? We’ll flick onto the next slide here, we talk again about EIS and that’s where it can come into play. Because this individual, they’ve got a home, they’ve got cash, all of that adds up to exceeding their nil rate band under current rules for inheritance tax, they’ve got an investment bond which is going to be well within the inheritance tax charge when they pass away.
As I say wouldn’t want normally to disturb it and create an income tax charge, EIS gives them the, or VCT in fact gives them the means of doing that. But of course the great thing about an EIS in particular, which is not true of VCT, the EIS will qualify for business property relief once you’ve held it for two years. So this individual can make an investment in an EIS, in this case £50,000. They’ve surrendered the bond, they’ve triggered an income tax charge, but the £50,000 investment in an EIS will give them a £15,000 tax reduction, the 30% upfront tax reducer you get with EIS, which allows them to offset the tax they’ll pay on the surrendering of the investment bond.
And that investment in EIS after two years qualifies for business property relief, 100% exemption from IHT. And again here they’ve got the option of investing the rest of the proceeds into a business property relief qualifying portfolio which is run on a broader mandate than you need to run an EIS. And that, again a powerful tool for investors who’ve got investment bonds, don’t want to disturb them because of the income tax charges. In order to do something for inheritance tax, they can have both: they can have their cake and they can eat it with EIS.
PRESENTER: And that’s pretty unusual.
MARK WILLIAMS: It is yes.
PRESENTER: I have to ask you as you seem to be at Octopus Investments one of the market leaders in this tax planning area, is there any potential that this might fall foul of the Government’s recent move towards tax avoidance?
MARK WILLIAMS: Yes, this is a question that we’re frequently asked, because people understandably want to make sure that they’re absolutely the right side of the line on this, and we’ve seen increasing attacks from the Government in recent years on what they perceive to be aggressive tax planning. I think it’s an important distinction to make. What we’re talking about today in all of these reliefs are government tax wrappers that have been put in place using statutory reliefs, like EIS, VCT, business property relief. There are prescriptive rules in place which investment managers need to adhere to, to invest the money in ways which will then qualify for the reliefs. And there’s a quid pro quo for the Government here, because of course all of this investment into smaller companies, smaller trading companies in the UK, generates a lot of activity for the economy, a lot of tax receipts from all of that activity, and that’s why the Government are happy to provide these reliefs.
Now of course that doesn’t mean that these rules can never change at any time in the future. But we certainly wouldn’t expect any kind of retrospective changes on this. In fact in the case of EIS and VCT what we do on every investment we make is we go out to the revenue, to HMRC, under something called the Advanced Assurance mechanism, where we write to the Revenue and say will this investment qualify for these reliefs once we’ve made it, does it meet all the rules in your view? And it’s not until HMRC write back to us and say absolutely, if you make an investment like that then it will qualify for the relief under these rules, that we would make it.
So investors are on a lot stronger ground with these tax wrappers than they are with some of the much more aggressive tax planning which HMRC has turned against that’s been done in the past.
PRESENTER: So we’ve done EIS, we’ve done VCTs; talk a little bit now about BPR and where that come in.
MARK WILLIAMS: Of course, we’ve talked about it already in some of these examples, but, as well as running EIS investments, which as we’ve said will qualify for inheritance tax relief, business property relief, at Octopus we’re a market leader in inheritance tax solutions which use business property relief. So in order for a company, for shares in a company to qualify for business property relief, they need to either be unquoted shares or shares which are quoted on the junior stick exchange, the AIM market, and they can’t be full market listed shares such as FTSE shares for example. And the company that you’re investing in, the company which you’re holding shares in needs to be a trading business very broadly.
So that allows us to build portfolios for people which qualify for BPR. Either portfolios of shares which are listed on the AIM market, we have a team that focuses specifically on the AIM market to do that, or actually in companies which we’ve set up for the purposes of trading in a way which will qualify for business property relief, but which perhaps focuses a little bit more on capital preservations rather than the growth that you can achieve invested in the AIM market.
PRESENTER: Let’s look at an example then.
MARK WILLIAMS: Well the first one that springs to mind, Tony, of course is individuals who are perhaps in poor health or they’re perhaps very elderly, and they don’t have access to some of the solutions that advisers would look to for inheritance tax as a first port of call ordinarily or traditionally certainly, so life insurance for example. Individuals who are elderly, very elderly or in poor health, they don’t often have access to life insurance, or if they do then it’s not on particularly cost efficient terms. So it’s when they can start to look at other ways of planning for inheritance tax, like using business property relief, again individuals who want to gift away their assets to plan for inheritance tax relief, it’s a very well-known fact that if you gift away your assets and survive for seven years then those assets will fall out of your estate for inheritance tax purposes, and you can avoid inheritance tax perfectly legitimately in that way.
But again individuals who are very elderly or in poor health, often if you talk to them they’ll say well I don’t think I’m going to live for seven years, I’m not confident that’s going to happen. BPR provides a really effective tool in that case, because we’re talking about a two-year holding period requirement rather than seven years. And if you ask a lot of people in that situation, will they live for two years? Then they’ll think I’ve got a very good chance of doing that.
PRESENTER: Right, so that’s BPR in those circumstances. Powers of attorney seem to be coming more and more to the fore for both executors, potential executors, sons, daughters and solicitors. Where does this sort of planning come in where powers of attorney are concerned?
MARK WILLIAMS: It’s quite an important one, because there are more and more powers of attorney being issued now because people are living longer and longer, but not necessarily in good mental health. Although people are living for longer people are often losing mental capacity in their very later life. So power of attorney comes into play there. But once you’ve got a power of attorney in place then the inheritance tax planning that you can do again becomes quite limited. Because the Court of Protection which governs how these powers of attorney will operate and doesn’t permit the recipient or the attorney to actually make significant gifts out of the donor’s estate. That’s a deprivation of capital and that doesn’t meet the requirements of the Court of Protection.
So, what can you do as an alternative, again assuming that perhaps life insurance or some of the traditional planning tools that investors might turn to aren’t available? Again business property relief provides a means of planning for inheritance tax relief where there’s a power of attorney in place. Because very straightforwardly you’re making an investment which qualifies for a statutory relief, business property relief, after two years it becomes 100% exempt from IHT, and it doesn’t require any of the capital in the donor’s estate actually leaving their estate. It’s theirs if they need it in the future, perhaps for some costs, unforeseen costs like going into care, which many people have to consider. So that’s why using business property relief doesn’t require Court of Protection approval.
So that’s why business property relief investments, they don’t require the Court of Protection approval, and it’s probably the key driver for why we see about one in five, 20% of all the cases we see in inheritance tax planning coming to us for business property relief qualifying investments being where there’s a power of attorney in place.
PRESENTER: Mark, briefly explain the IHT situation where ISAs are concerned, because I believe there has been a change recently.
MARK WILLIAMS: Yes, a good question. Well very straightforwardly in an ordinary course of events then an ISA portfolio will be within your estate for inheritance tax purposes. And people who hold ISAs, they’re very tax efficient during your lifetime, as we all know income tax and capital gains tax-free during your lifetime, but the one thing that a lot of people seem to overlook in our experience is the fact that ISA investments will be subject to inheritance tax relief when you die. So the same 40% tax that applies to normal portfolios or shares that are outside of an ISA. And a very important change came about in 2013 when for the first time the Government ran a consultation and then changed the legislation to allow people to hold direct holdings, shareholdings in AIM-quoted companies within their ISA for the first time. And as we’ve just talked about of course shares in trading companies that are listed on the AIM market can qualify for business property relief.
So, for the first time, very exciting, back in September 2013 the situation where we could for the first time create an inheritance tax-free ISA by using investments in AIM trading companies within the ISA to build something which qualified for business property relief.
PRESENTER: Let’s have a look at an example of this.
MARK WILLIAMS: So, again, one of the beauties of all of this planning with business property relief is it’s very straightforward, and actually this is no different here when you’re talking about ISAs. So this individual with an ISA portfolio of £150,000 so quite sizeable - we’re certainly seeing a lot of investors who’ve been saving for many years who’ve built up significant ISA savings. That’s going to be within their estate for inheritance tax purposes and subject to 40% IHT when they die. The solution or the potential solution lies in the AIM inheritance tax ISA, which as I say has become possible since September 2013. We’d been running portfolios of AIM shares for a long time before that, so doing it within an ISA was nothing particularly new for us, but for investors it’s opened up a really exciting opportunity.
If they transfer their ISA portfolio to Octopus for us to manage within the ISA, within AIM trading companies, we’ll build a portfolio of 25 to 30 business property relief qualifying companies within that portfolio. Then after two years those ISA savings will be exempt from IHT. So we’ve got the means of turning an ISA portfolio which would be subject to inheritance tax into one which wouldn’t be within just two years, and of course all the usual ISA benefits that you get, no income tax on your dividends, no capital gains tax on any sales of shares, any disposals of shares, they still apply.
So inheritance tax-free ISAs are here as a result of those changes, and it’s very welcome news and has been certainly for thousands of investors who we’ve seen accessing this opportunity since the rules have changed.
PRESENTER: OK, Mark, let’s now turn to trust planning, we haven’t mentioned that so far today.
MARK WILLIAMS: We haven’t: another angle where business property relief can be used quite effectively. Because of course lots of people like using trusts, they’re a mainstay of inheritance tax planning and estate planning for people, and have been for hundreds of years. Since 2006 a particular change occurred to the rules, which meant that lifetime transfers into a discretionary trust, to the extent that they see the nil rate band, well they’ll be subject to an immediate lifetime tax charge of 20%, something called a Chargeable Lifetime Transfer and subject to an upfront tax charge of 20%. And that’s put the brakes on trust planning for especially very wealthy individuals who like all the benefits that you get from having a trust wrapper around their assets, like all that certainty that it can provide, but certainly don’t want to incur significant lifetime tax charges in doing so, in setting up the trust. Business property relief provides a means of investing assets, transferring assets into a discretionary trust up to unlimited amounts without triggering a 20% lifetime tax charge.
PRESENTER: Well let’s have a look at an example then, because these things always become a little clearer with an example.
MARK WILLIAMS: Well let’s look at this gentleman here. A grandfather with a million pounds to put into trust for his grandchildren, a significant amount - if the nil rate band had been used on other gifts perhaps that he’d made, then all of that million pounds would be subject to this 20% tax charge when it goes into the trust, so £200,000. And for a lot of people that’s quite prohibitive. It stops them from contemplating trust planning with significant amounts. And the amount of trust planning that’s been done since these rules were introduced in 2006 has been curtailed as a result of that.
Using business property relief provides you with a means of transferring assets into discretionary trusts up to unlimited amounts without incurring the 20% chargeable lifetime transfer charge. So this individual could, instead of putting cash into the trust, could invest in a BPR qualifying asset. So shares in AIM portfolios or shares in some of the companies that we run, which try to target capital preservation in the way that they trade, will quality for business property relief. Once those have been held for two years then they’ll qualify for the relief and they can be transferred into the trust without any chargeable lifetime transfer charge. And in fact it’s even better than that for business owners who’ve sold their business in the last three years, because as we discussed earlier their investment in a replacement BPR qualifying asset will immediately qualify, so if it was transferred at that point into a trust, there’s no need to wait for two years, it can be transferred immediately without the chargeable lifetime transfer charge of 20%.
So, if we turn onto the next slide, we can perhaps have a look at that in a bit more detail. So, if this gentleman was to, in the first example, not using BPR, if he’d transferred cash into the trust and then died within seven years of settlement, then there would be further inheritance tax to pay on top of the 20% he’d paid initially. Of course if he survived for more than three years from the settlement then there would be some taper relief to reduce the amount that would be payable, but there would still be tax to pay. However, if he’d done the planning using the BPR shares, which he settled into trust without that upfront charge, providing the trust is still holding those shares at the point in which the gentleman dies, if he does die within that seven years of the settlement there’s no further IHT to pay.
So that trust transfer has been fully effective for inheritance tax planning. And as I just said replacement property relief can mean that the benefits can be even more powerful than that, or certainly speedier than that initial two years that most people would have to wait.
PRESENTER: Now let’s then turn onto something called the relevant property regime, what is it and what’s happened since 2006?
MARK WILLIAMS: Well, that’s what we’re talking about here, and if we turn to the next slide we can have a look at this. We’re talking about this relevant property regime that where assets are inside the discretionary trust then they’re not within any real person’s, any human being’s estate for inheritance tax. And that’s one of the really powerful features of discretionary trust planning. But it brings me into this whole new different tax regime, the 20% upfront; also a 6% charge, periodic charge every 10 years for the trust.
Now with these rules having first been introduced in 2006 we’re starting to see some of the first trusts to have been around under these rules for 10 years coming towards their first periodic charge. But business property relief is not only of a benefit to settlors, as we just discussed, who can transfer assets into trusts without the 20% upfront charge, it can also be of benefit to trustees who are looking at ways of planning around the periodic charge of 6%.
So if a trustee was to take assets within discretionary trust and invest into BPR qualifying shares, providing they held them for two years by the time of the 10-year periodic charge, then they get 100% relief from that charge, and then your normal 6% charge wouldn’t apply. And what’s more actually an appointment out of the trust to the beneficiaries following the 10-year charge, if those assets were still BPR qualifying, would be without the normal exit charges that you get when you’re appointing assets out of a discretionary charge.
So BPR provides trustees with a means of planning around periodic and exit charges, as well as it does at settlors planning around chargeable lifetime transfer charges on setting up a trust.
PRESENTER: So we’ve talked about these trusts. We hear sometimes financial advisers talking about loan trusts; what do you mean by that and where do they come into play?
MARK WILLIAMS: Right OK, good question. So loan trusts are a particular inheritance tax planning tool that people use relatively widely. What a loan trust involves is rather than making an actual transfer of assets to a discretionary trust, the individual will make a loan to a discretionary trust. So that doesn’t do anything for the amount that you’ve actually lent to the trust from inheritance tax purposes, that’s still a debt in your estate that will be subject to 40% charge, but any growth on the assets in the trust that the loan has been used to invest in will be outside of your estate going forward.
So, if I loan £100,000 to a discretionary trust, and then the trust invests and makes particularly successful investment and turns that £100,000 into £200,000, then…
PRESENTER: A second £100,000 doesn’t fall into the estate.
MARK WILLIAMS: Absolutely right. But of course things don’t often and don’t always pan out like that. And what we see increasingly is advisers coming to us and looking for a solution because they’ve set up a loan trust in the past perhaps, or perhaps their client set it up themselves or with a previous adviser, and the investments in the loan trust, they might have grown and they might have given some growth that’s outside of the estate for inheritance tax purposes, but the capital is still very much inside the estate for IHT purposes. And in some instances where the investments haven’t grown at all, then the loan trust planning hasn’t achieved anything for inheritance tax at all.
PRESENTER: OK, all right, so do you want to talk through this example?
MARK WILLIAMS: Yes good idea. So if we look at this next slide here, we’ll see that this lady had a loan trust in place. She put it in place with a £300,000 loan to trust which was invested and is now worth £350,000. So all that’s done is take £50,000 out of the estate; the £300,000 original loan amount is still very much within her estate for IHT purposes. So it’s been partially effective but it certainly hasn’t dealt with the main problem, this £300,000. So her action in this case could be to have the loan repaid back to her. So the £300,000 comes back to her in her hands, and then she can use that liquidity, use that cash to make a BPR qualifying investment, which after two years would be outside of her estate for IHT, 100% exempt from inheritance tax.
It’s a much faster IHT planning tool than most loan trusts will provide. It deals with the capital not just the growth in the value of the asset. And she’s still got access to her investment because she hasn’t gifted it away, and it’s not locked up in a trust.
PRESENTER: That’s going to be very comforting to an awful lot of people.
MARK WILLIAMS: Yes absolutely. So when you’re talking about this kind of planning, two of the main attractions are access to your investment, the fact that you’ve got an investment, you can hold those shares personally, and request to sell those shares if you want to get some or all of your money back. And also having control over your investment, to be able to do things with it, perhaps transfer into trusts. But loan trust planning is a key one for advisers to look at where those are in place as a more effective way of dealing with inheritance tax.
PRESENTER: Finally then generational planning. I saw what George Osborne did in his famous Budget, as providing an opportunity for people to I think he said to pass wealth down through the generations. How is that working in practice?
MARK WILLIAMS: Well the Government understandably is very keen on that, and we’ve seen that as you say with the steps they’ve taken with the property nil rate band that’s due to come in from, or going to be phased in from 2017. If we look at this next slide we’ll just perhaps draw this to a close. And really what we’re saying here is, well this lady here passed away holding a significant amount of BPR qualifying shares, they were left to her children in the will. And one of the particular features that we’ve got with our inheritance tax services is that investors can use the portfolios that we’ve got to actually pay an inheritance tax bill on other assets.
So where there’s an IHT bill on the home or on a share portfolio or elsewhere, then there’s no need to wait for probate to have passed for us to appoint some of those assets out to the beneficiaries. We can actually use some of the assets to pay an inheritance tax bill straight to HMRC with immediate effect. And that solves this chicken and egg problem that advisers will be familiar with where you’ve got probate to process, which can drag on for a long period of time, and you need to raise the capital to pay inheritance tax but you perhaps don’t want to sell some of the assets, like a home. So BPR can be quite an attractive tool.
PRESENTER: Briefly then where can advisers find out more about this; presumably the Octopus Investment website?
MARK WILLIAMS: Absolutely, advisers to go to our website or call one of our team, then they can be introduced to this subject area. And beyond what we’ve said today, we can talk through the range of portfolios that we run for investors. We can invite advisers to go on and log on to our adviser academy to actually use our self-learning tools to help them navigate this area, and we’ve got a team on hand to help them with that.
PRESENTER: On that note, Mark Williams, thank you very much indeed.
MARK WILLIAMS: Thank you.
PRESENTER: In order to consider the viewing of this video as structured CPD, you must complete the reflective statement to demonstrate what you’ve learned and its relevance to you.
After this session you will understand where EIS and VCTs are complementary to pensions; what types of clients may benefit from their use; where EIS and VCTs are useful in IHT planning; trusts and the use of BPR. Please now complete your reflective statement in order to validate your CPD.