1. IHT thresholds and why more people are falling into IHT
2. Using business property relief to reduce IHT liability
3. Using AIM stocks and ISAs to reduce IHT liabilities.
Mark Williams, IHT Business Line Manager, Octopus Investments
Why IHT planning is becoming more important
MARK WILLIAMS: Well inheritance tax is charged on the value of somebody’s estate when they die, and everything that’s over and above what’s called the nil rate band, so tax free allowance of £325,000 per individual, or twice that amount, £650,000 for married couples, but everything above that when you die is assessed to inheritance tax at 40%. So there’s obviously a significant problem for a lot of people in the UK.
PRESENTER: But isn’t IHT planning simply a problem for the very well off?
MARK WILLIAMS: Well that may well have been a case once upon a time, but increasingly it’s just not true. So I mean last year, for example, treasury statistics say that one in 20 people were affected by inheritance tax. But by 2018 that’s set to increase to something like one in ten, so one in ten people being affected by this loss of wealth on death, which is obviously quite a mainstream problem therefore.
PRESENTER: So why are more people falling into IHT?
MARK WILLIAMS: Well there’s a combination of factors. One of the primary reasons is of course that that nil rate band that we just talked about has been fixed since 2009 at £325,000. Meanwhile of course house prices have been increasing significantly, the values of people’s stocks and shares have been increasing significantly as the economy’s recovered, so it’s created in effect fiscal creep on a massive scale and people are being more and more impacted by this tax.
PRESENTER: Can you talk us through the limits in a bit more detail?
MARK WILLIAMS: Sure, okay. So that £325,000 nil rate band as it’s called, that’s a tax free amount, when somebody passes away then the value of their estate up to that amount won't be subject to inheritance tax, and as I said for married couples, and civil partners as well, then they get to aggregate the two partners’ allowances, so they can get up to £650,000 tax free. That is impacted by any gifts or transfers that are made in the seven years prior to death though, which erode the value of that tax free allowance when you pass away.
PRESENTER: So if I made a £25,000 gift, died within seven years, I'd only have £300,000 of IHT exemption left.
MARK WILLIAMS: Exactly right.
PRESENTER: You mentioned rises in house prices earlier, could you put some numbers on that?
MARK WILLIAMS: Well, for instance, the average house price in the UK now is £245,000, so a significant part of that nil rate band. But in London and the South East of England it’s almost double that. So it’s very easy for people to run through that nil rate band and start to become susceptible to inheritance tax, especially where other assets, savings, bank account balances, building society balances and investments, take them over and above it.
Gifting and the seven year rule
PRESENTER: So is there anything you can do to sidestep inheritance tax, legitimately of course?
MARK WILLIAMS: Of course, absolutely, so I think inheritance tax has famously been referred to in the past as a voluntary tax, and there are plenty of very established and legitimate ways to avoid it. So for example if you gift your assets before you die, if you survive seven years from the date of the gift, then what you transferred will be completely outside of the inheritance tax. And equally there are statutory reliefs available on certain investments which provide 100% relief from inheritance tax as well.
PRESENTER: But is it unusual for people to want to gift things away?
MARK WILLIAMS: Absolutely. That’s probably one of the biggest objections that people have about doing gifting and trust strategies to avoid inheritance tax. Yes, you can avoid inheritance tax by giving away your assets, but what if you need them back? You can't do anything to reverse a gift. The person you’ve given the assets to might not agree to giving them back to you. So for most people, there’s a concern that in later life, as they perhaps need to move into care for example, they're going to have significantly greater living costs than they have now, and they might not be able to afford to gift away all their assets just to avoid inheritance tax.
Distinguishing between tax planning and tax avoidance
PRESENTER: What’s the difference between tax planning and tax avoidance?
MARK WILLIAMS: Yes, well that’s a line which has become increasingly blurred over recent years. Really for us, it amounts to this, which is that tax planning involves actually using the legislation as it’s been designed to actually achieve the outcomes for you tax-wise that you want to achieve, so being able to arrange your affairs in a way which allows you to utilise the range of tax reliefs and exemptions that are available to you and have been designed to help people reduce tax. Whereas tax avoidance is exploiting loopholes in legislation, legislation that’s been designed to collect tax, but finding ways to snake around that, which the Government’s clearly not supportive of, and which increasingly is coming under fire from HMRC.
PRESENTER: So what are the mainstream tax planning wrappers that are okay in your view?
MARK WILLIAMS: Of course, there are many planning opportunities that people widely consider to be acceptable and mainstream tax planning opportunities such as the use of ISAs and the use of pensions. It’s accepted by everyone that if you make a contribution to a pension, then you'll get income tax relief on your contribution. If you put money in an ISA, then your savings will grow free of income tax and capital gains tax, but those are tax planning strategies in themselves.
PRESENTER: What about the use of trusts?
MARK WILLIAMS: Well trusts for inheritance tax have been a very established way of actually avoiding the tax for a number of years, but of course they do have a number of downsides. So when you give your assets away, or settle them into a trust, then that’s by and large irrevocable; you can't do anything to change that decision. And for inheritance tax purposes, it takes seven years for that gift or transfer into trust to be fully effective. If you were to die within seven years of a gift or a settlement, then there’s still IHT to be paid. And in fact, since 2006, a settlement into a trust, to the extent that it exceeds the nil rate band is charged to an immediate tax at 20%. So for those reasons it’s become quite unattractive.
PRESENTER: But there’s lots of different types of trust out there, are they all as mainstream as an ISA or a pension?
MARK WILLIAMS: Yeah, I think that’s a key point. There’s a plethora of different trust planning strategies out there, no one trust is the same as any other. And increasingly, as I say, since 2006 there’s been a limit on the amount of trust planning that’s been done, just because of the punitive tax charges that are imposed on them.
Business property relief (BPR) and the rules
PRESENTER: Well, in that vein of ISAs and pensions, we want to move onto business property relief, or BPR, what exactly is it?
MARK WILLIAMS: Well BPR’s been around since 1976, so it’s a well-established relief in itself. It’s 100% relief on qualifying business property. So that includes unquoted shares in trading businesses, but also since the AIM market came into play in the ’90s, it includes shares that are quoted on the AIM market, if those companies are trading companies. So it applies to a wide range of assets and has become very attractive, because for all those downsides that we talked about for gift and trust planning, the loss of access and control, the fact that it takes seven years for these to be fully effective for IHT, none of those apply to business property relief. It’s a speedier solution, it allows an investor to retain access and control to their investment, and really importantly it’s using a statutory relief that has been put in place by the Government to incentivise this kind of investment, and is therefore government aligned.
PRESENTER: So when you say property, it doesn’t necessarily mean real estate?
MARK WILLIAMS: No, that’s a key misconception; it’s a bit of a misnomer to call it business property relief. What it’s talking about is just ownership of a business, or a share in a business, and that share in a business will qualify for business property relief.
PRESENTER: What are the rules surrounding BPR?
MARK WILLIAMS: So the rules are that you have to hold the assets for two years before you die, and you have to hold them at the time of death in order to qualify for the relief. But there are certain relaxations of that which make it favourable, for example, if you're selling your own business and transferring into another BPR qualifying asset. In fact, if you sell a business that qualifies for BPR and you reinvest the proceeds into other BPR assets within three years of the disposal, then you don’t for the new assets have to go through that two year clock again; you're immediately requalifying for BPR. So if you were to die the next day then you would be 100% exempt from inheritance tax.
PRESENTER: And how does this work for married couples and civil partners?
MARK WILLIAMS: Yes, so it’s more favourable still for people who are married or in a civil partnership, in that only one, if the couple are investing jointly, only one of them needs to survive for the full two years for BPR to take full effect.
PRESENTER: So, bringing all of this together, what are the key benefits of business property relief?
MARK WILLIAMS: The key benefits are really firstly speed. So the fact that this is a two-year solution rather than a seven-year solution in the case of gifts and trusts for inheritance tax purposes. Access and control is probably the most widely recognised benefit of BPR. An investor doesn’t have to give up control of their capital in order to do this planning. They can have some or all of their capital back at any point in time, if they so need it. Flexibility, so the fact that you can invest now, but perhaps add to your investment over time, withdraw some, do trust planning, off the back of this investment once it’s qualified for BPR without the normal seven-year clock, and also simplicity. So there’s nothing convoluted or contrived about this, or anything that’s difficult for investors to get their head around. It is very simply an investment in a company or in a business, and that business will qualify for 100% relief from inheritance tax if it’s held for two years and held at the time of death, and I think investors value the fact that it’s quite straightforward.
PRESENTER: You mentioned trusts, but what about using insurance products here?
MARK WILLIAMS: Yes, insurance is another way that people seek to deal with inheritance tax. Of course it doesn’t actually end up in reducing the inheritance tax, but it just provides a means for somebody to save up if you like via the premiums that they pay for the inheritance tax liability. The issue is of course that as people become more elderly, then insurance becomes more costly, and for a lot of people it simply is either not available at all, or if it is then it’s very costly. So that has driven people again to solutions which don’t involve medical underwriting assessments, like business property relief.
Government backing for BPR
PRESENTER: How can BPR help with tax and estate planning?
MARK WILLIAMS: Well, the solution, the use of business property relief is becoming much, much more accepted and much more mainstream. People are recognising all those benefits, and using it as a way of transitioning from their assets and their savings and investments which don’t qualify for these reliefs into an environment where business property relief is available up to 100% on the value that they hold. So if they’ve held this investment for two years and at the time of death, they're fully exempt from IHT.
PRESENTER: Why’s the Government so keen to provide such a generous tax break?
MARK WILLIAMS: Well this is all part of the Government’s initiatives to try and get the UK economy back on its feet following the recession. So I think if you take the AIM market, for example, as I mentioned, the shares in trading companies, where those shares are listed on the AIM market, they will qualify for business property relief. And giving business property relief to those companies is just one of a raft of measures that the Government’s introduced in recent times to help investment, encourage investment in AIM companies.
So from 28th April this year, for example, stamp duty will no longer be applicable on AIM shares, and that follows up on legislation that was released last year, introducing the ability for people to hold AIM stocks in an ISA for the first time. So the government are really keen to put in place a range of different tax benefits, reliefs, for smaller companies to try and encourage investment in them, all as a part of reviving the UK economy post the financial crisis.
PRESENTER: What’s the upside of being so generous?
MARK WILLIAMS: Well of course in return for giving this relief away, then the Government is encouraging investment into trading businesses which are actually generating activity in the UK economy, generating employment, generating tax receipts in the form of corporation tax and income tax and national insurance of all the employees that they have, so there are plenty of quid pro quos that the Government gets for giving away this relief.
Using BPR to reduce IHT and maintain control of assets
PRESENTER: Well that’s a lot of the theory, but do you have an example of how someone can retain access and control to their investments in an IHT efficient environment?
MARK WILLIAMS: Definitely. It often helps to bring these things to life when you talk through common examples. Probably the most common thing we see is the client in their late 60s, who wants to do some inheritance tax planning because they’ve identified that their assets exceed the nil rate band, but the solutions they’ve looked at all require them giving up access and control to their assets. So what can they do? Well traditional inheritance tax solutions are restrictive. They don’t offer the flexibility that investing in BPR qualifying assets can, for example.
Plus, as we've said, they can take seven years to come into full effect. By investing in BPR qualifying companies, this client can not only reduce the period to two years, they can also retail full access to their funds, and with some solutions such as the Octopus Inheritance Tax Service, they can even take a regular or ad hoc withdrawals from their investment, which can provide an income for later life, for expenses such as care home fees, which might not be envisaged at the time they make the investment.
PRESENTER: And have you got another example of the way in which somebody can use business property relief to reduce an IHT bill?
MARK WILLIAMS: There are a whole raft of examples of how it can be used, but one of the most common ones is actually with entrepreneurs who have perhaps had a business of their own. So take the example of somebody who’s perhaps got a business which has qualified for BPR for themselves in the past, but is now contemplating selling it, what can they do? Take this client, for example. They're selling a trading business that they’ve perhaps owned for many years, and they're set to realise some fairly significant proceeds, of a million pounds after tax. They receive an income already from other assets, but they are concerned about inheritance tax, now perhaps getting to the stage of life where they're just not sure exactly how long they're going to be around. The nil rate band might cover their other assets, but if they sell that business now and have cash in the bank of a million pounds, then if they were to pass away, then there’s going to be a very significant bill of £400,000 paid in inheritance tax.
So what are the options for them? Well we mentioned a little bit earlier in the session about how business property relief has some relaxations to the normal two-year ownership period, such that if you replace one BPR qualifying asset with another, you can immediately requalify. So if the proceeds from the sale of this business are invested into a BPR solution within three years of the sale, then no IHT bill will be faced in the event of the investor’s immediate death. So they don’t need to do that two-year qualification period over again, they immediately requalify. So this replacement property provision means that their new investment will be immediately exempt.
IHT rules around Isas and Aim stocks
PRESENTER: Well that’s BPR, but I wanted to move on now to AIM stocks and how these can be used in conjunction with ISAs. First of all, how big is the ISA market?
MARK WILLIAMS: Well the ISA market’s huge, so there are over 24 million ISA investors in the UK.
PRESENTER: And what are the demographics of those ISA investors?
MARK WILLIAMS: Well yes, within that set, the most wealth is concentrated among the older investors. There are over six million investors according to HMRC who are over 65 and hold ISAs.
PRESENTER: How well established are ISAs? How much do people have in them?
MARK WILLIAMS: Well ISAs have been around for many years, so the ISA regime was introduced in 1999, but prior to that you had PEPs and TESSAs, personal equity plans, and those were all merged into the ISA regime in 2008. So there are many investors with very sizeable savings in ISAs now, and the average amount that over 65s have in their ISA is £28,000.
PRESENTER: Are ISAs subject to IHT?
MARK WILLIAMS: That’s the big issue. So what many people have enjoyed about ISAs is the fact that they are income tax and capital gains tax free during your lifetime, but what a lot of people just aren’t switched onto is the fact that when they pass away, their assets within their ISA will be subject to the 40% inheritance tax charge along with any other savings. So those tax exemptions that are enjoyed during the lifetime are more than taken away when an investor dies.
PRESENTER: And is there much that advisers and their clients can do about this?
MARK WILLIAMS: Until very recently, it’s been difficult for people to do anything other than to exit the ISA and do some other tax planning; gifts, trusts, business property relief investments, for example. But last year, legislation was changed to allow people for the first time to hold direct holdings of AIM quoted shares in their ISA. As we've already talked about, some AIM shares, specifically shares in companies which are trading companies listed on AIM, they’ll qualify for business property relief. So that means that as a result of this legislative change last year, for the first time people are now able to hold BPR qualifying investments in their ISA, and effectively that means the birth of the IHT free ISA.
Aim stocks that qualify for BPR
PRESENTER: Do all AIM stocks qualify for business property relief?
MARK WILLIAMS: They don’t. So only around half of the companies listed on AIM would ever qualify for BPR, because the rest, the other half are regarded as investment companies by HMRC. So, for example, there are a lot of mining and resource stocks on the AIM market. Those companies, because they tend to build up significant investments within their balance sheets, HMRC don’t regard them as being BPR qualifying companies.
PRESENTER: Well what constitutes the classic trading companies? What sectors do they tend to inhabit?
MARK WILLIAMS: Well AIM is home to a very diverse range of different companies from all sorts of different sectors. So industry, service sectors, hospitality sectors. There’s no one sector that’s more concentrated than the other. And consequently there is ample opportunity for people to build very well diversified portfolios of shareholdings in AIM companies, diversified over a range of different sectors.
PRESENTER: Who keeps a list of what qualifies as a trading company?
MARK WILLIAMS: Unfortunately it’s not as easy as that. So there is no defined list of which companies qualify and which ones don’t, and that’s where really expertise does come in, to be able to assess the accounts of these companies and the activities that they are carrying out on a day-to-day basis which mean that they either do or they don’t qualify for business property relief. So we’re helped in that regard by advice from one of the leading accounting firms, who regularly monitor the companies that we have in our portfolios, to ensure that they remain BPR qualifying. And that can change over time, so it can be very easy for a company to do something which will take them out of the BPR qualification.
So we've had examples where a company has done a sale and lease back on their main office premises, for example, and that one transaction, because it has resulted in them getting investment income, from the sale of the property, has meant that they would no longer qualify for BPR. So you’ve got to monitor this very closely over time, and I reiterate that’s where expertise is really valuable to an investor.
PRESENTER: Well if you're invested in a company that does something like that, how long have you got to get out of it before the Revenue turns up and says that doesn’t qualify for business property relief?
MARK WILLIAMS: Well you want to be out of it by the time you pass away. So a key objective at that stage is for us to look at alternative investments for the portfolio. You do have that replacement property relief to access though, of course, so as soon as we can transition to another qualifying investment, then you don’t need to run that two-year clock again if you’ve already started it with the first investment.
PRESENTER: So is this quite an expensive service to run, given all the ongoing due diligence?
MARK WILLIAMS: It’s certainly more expensive than a typical unit trust or OEIC type investment, of course, because there is considerably more analysis and ongoing engagement by our fund management team to actually make this work as successfully as it does. So one of the things that we are very keen to stress to our investors is just how close we get to these companies. We do over 500 clients, investee company meetings every year, to really get close to the management teams, to understand what their plans are, what the risks are as they see it in their business, to ensure that these investments work from both the tax side, the business property relief for our investors, but also from an investment standpoint, that these are going to be suitable and attractive investments for people going into them.
Risks in Aim stocks, including illiquidity
PRESENTER: How big a risk is illiquidity in a portfolio of AIM stocks?
MARK WILLIAMS: Well shares that are listed on AIM are less liquid in the way that they're traded than shares on the FTSE for sure. But the pools that we’re fishing in, the larger companies on AIM for our portfolios, those shares are very, very well traded, so liquidity is less of a concern. So to give you an example, the average market cap of the 28 stocks that are currently on our buy list for our portfolios is in excess of £250m. So these are pretty sizeable companies, their shares are very regularly traded, and liquidity isn’t something that becomes much of an issue for us.
PRESENTER: And what are the benefits of putting your ISA into the right sort of AIM stocks?
MARK WILLIAMS: Well if course if you are targeting inheritance tax relief through business property relief, you need to be sure that you're actually going to be investing in companies which will be BPR qualifying, which will be regarded as trading companies, not only at the time at which you invest, but until the point at which you actually need the business property relief, when you pass away. So that’s where it pays to have a specialist actually investing on your behalf, a professional discretionary fund manager, actually investing on your behalf and looking exclusively at those companies which will qualify.
PRESENTER: Are AIM stocks high risk, specifically compared to the sort of things you'd invest in in an ISA?
MARK WILLIAMS: Yes, I think that’s probably been the biggest objection that people have had to investing in AIM in the past, the fact that there is volatility; just like any stock exchange investment, there’s going to be highs and lows in the market, and that affects prices and the value of people’s investments. AIM is more volatile because it focuses on smaller companies than the FTSE 100 for example. It is more volatile than the main market. But for long-term investors who can afford to ride out those shorter term volatilities, then it remains an attractive route.
So what is certainly the case is that over the very long term, then the shareholder performance in smaller companies has far exceeded those of investors in much larger companies, and that stands to reason. Shareholder return comes from earnings growth potential, and smaller companies have a much greater earnings growth potential than much larger companies.
PRESENTER: If you're older, can you afford to be taking those longer term risks?
MARK WILLIAMS: Well they absolutely can do, of course any investment, whether it’s appropriate for a particular client depends on their individual circumstances. But for an investor who has the ability to invest over the long term and, as I say, ride out those shorter term volatilities in the market, then the growth potential in AIM, and the fact that many of these stocks are BPR qualifying, makes it an appropriate investment. In fact, one of the key advantages of this means to planning for inheritance tax is these shares don’t need to be sold on death. So the beneficiaries, the estate can inherit these shares and actually continue to hold them for the long term, so they can sell at the right time.
Investment diversification and the Aim market
PRESENTER: Have you got examples of the sort of companies that you invest in on the AIM market?
MARK WILLIAMS: Well, as you said, there is a wide, diverse range of companies listed on AIM. But we tend to focus on the larger companies in AIM, so those with very established balance sheets, those that are perhaps of a certain size. So the average size of our top ten holdings in the AIM market, each of those companies is worth in excess of £250m. These are very sizeable, established companies, they're not start up fledgling companies, and consequently there’s a lot more security in the way that they operate. So to give you an example, of the 28 companies that are currently on our buy list for our AIM portfolios, their average market capitalisation is currently in excess of £250m, so these are sizeable companies.
PRESENTER: What are some of the well-known names that have come through the AIM market?
MARK WILLIAMS: So there are a lot of household names actually listed on AIM. So companies like Majestic Wine, the wine retailer, with outlets up and down the country, Mulberry, the luxury goods manufacturer, Young Breweries, also more recent start-ups, companies like ASOS, the internet retailer, which has grown to a significant size. It’s the largest company on AIM now, with the market cap at current values of over £5bn.
PRESENTER: How many of these stocks do you need in a portfolio to be diversified?
MARK WILLIAMS: This is like any equity portfolio. You want to have a spread of risk over a number of different assets; you don’t want all your eggs in one basket. We build a portfolio of between 25 and 30 stocks for investors, which gives them a really good spread of risk across multiple different sectors and different territorial exposures.
Outsourcing IHT solutions – the pros and cons
PRESENTER: There’s clearly a lot of complexity in this part of the market. What should an adviser and their clients look for in a provider of IHT services?
MARK WILLIAMS: There are quite a few providers who are now in this market, especially off the back of the ISA rule changes last year. Really I think investors and advisers value a firm that has a core specialism in this area. So we for example have a dedicated smaller companies fund management team that has been looking at this market since 2005, has built up considerable expertise and experience along the way, and with that comes a track record of performance that people can actually look at and say well actually they’ve done very well in the way that they’ve managed these portfolios over time. I think another thing, as you rightly say, is clarity of communication. So something that runs through everything we do at Octopus, we make it one of our key objectives to communicate very, very clearly with investors and advisers. So they understand precisely what the opportunities and the benefits of these investments are, but also what the risks attached to them are as well.
PRESENTER: Is there a danger here if you're an adviser that your client could end up being poached by another financial services provider?
MARK WILLIAMS: I think that’s a key concern that advisers have, especially post RDR. It’s something that we are keen to reassure advisers that we want to deal primarily through advisers. So we do the vast majority of our business, greater than 95% of all business that we do for example, is done via financial advisers, because we recognise the value that that can bring to investors who are looking at our solutions, and we have no reason to change from that.
PRESENTER: So why should advisers and their clients start to think very seriously about IHT planning today?
MARK WILLIAMS: It’s a huge concern. As asset prices grow and the nil rate band is fixed, then more and more people are becoming within the IHT net. They also need to realise that this is, although it’s a difficult concept to discuss, it’s not nice to talk about what happens when you pass away, it brings tangible benefits to the people you're leaving your estate to, to say to them well you’ve actually dealt with the potential loss of wealth that IHT could otherwise present. So clients need to overcome those objections, and I think they're doing so increasingly, because they're being presented with solutions, such as business property relief investments, where the downsides of loss of access and control just don’t apply in the way that they did with gifts and trusts, when those were the main ways in which people sought to avoid the tax.
PRESENTER: Mark Williams, thank you very much.
MARK WILLIAMS: Thank you.
This financial promotion has been issued by Octopus Investments Limited which is authorised and regulated by the Financial Conduct Authority. The value of investments, and the income from them, may fall or rise and you may not get back the full amount invested. Tax treatment depends on the individual circumstances of each investor and may be subject to change. The availability of tax reliefs also depends on the investee companies maintaining their qualifying status. Unquoted investments, or those quoted on AIM are likely to have higher volatility and liquidity risk than securities on the London Stock Exchange Official List. The information in this video should not be construed as offering investment or tax advice.”