Tax & Trusts

058 | Inheritance tax planning

In order to consider the viewing of Akademia videos as structured learning, you must complete the reflective statement to demonstrate what you have learned and its relevance to you.


  • Paul Latham, Managing Director, Octopus Investments

Learning outcomes:

  1. The latest IHT rules
  2. How Business Property Relief is used in IHT planning
  3. The tax implications of BPR
  4. BPR in later life planning and for use with Powers of Attorney

PDF of IHT guide by Octopus


Tax & Trusts
Learning outcomes: 1. The latest IHT rules 2. How Business Property Relief is used in IHT planning 3. The tax implications of BPR 4. BPR in later life planning and for use with Powers of Attorney Tutor: Paul Latham, Managing Director, Octopus Investments PRESENTER: Hello and welcome to this Akademia on inheritance tax planning. I’m Tony Suckling and after viewing this session you will be able to help clients through the recent rule changes to IHT planning and in particular business property relief. So, let’s begin with IHT, which has been in the news a lot recently. It was one of those headline grabbers for most of the political parties in the run up to the election. Since when we’ve seen the Conservative Party enact their manifesto pledge in full. To talk about this, we’re joined by Paul Latham, Managing Director of Octopus Investments. Paul, what does this actually mean? PAUL LATHAM: Well for a while people have been thinking that they didn’t have to worry too much about it, the state inheritance tax funding, because this million pound allowance was going to be introduced. But as we’ve seen in the legislation that’s come forth it’s not really a million pounds and it’s not yet either. PRESENTER: So what actually is it then, just give us that basic element? PAUL LATHAM: OK. So the basic normal rate band for an individual is £325,000, and what they are going to do from 2020 is to add another £175,000 and so it would be a £500,000 allowance in total. But it’s a bit more complicated than that. PRESENTER: And it’s called the phased main residence allowance is it? PAUL LATHAM: Yes, the sort of industry term people are using now is the residential nil rate band but you’re right. It’s phased in so it starts in 2017. PRESENTER: Let’s have a look on the slide, yes. PAUL LATHAM: So in 2017 it will go up to £100,000 for that in addition to the normal nil rate band, and then will grow over the next three years, so by 2020 it’ll be the full amount of £175,000. PRESENTER: And this is for both individuals and spouses; how does that work? PAUL LATHAM: So just like the nil rate band at the moment if you’re married or in a civil partnership one spouse can pass on any unused nil rate band to the other spouse, the surviving spouse, and that will be the same for this residential nil rate band as well. PRESENTER: OK. Quite complicated but in practice most estates will benefit will they? PAUL LATHAM: Most will have some benefit but there are a few restrictions. It has to relate just to the main residents. So it’s not an addition to the normal nil rate band. So if you haven’t got a home, then, at time of death it’s not going to help you. There’s also some constraints if you have died before this starts to be introduced in 2017, there’s no benefit for you, or if you sold your house pre the announcement in July of this year, 2015. There’s also a limit so that if you’re estate is above £2m then they start to claw back this additional amount, and so there’s no benefits once you’ve got beyond £2.35m. PRESENTER: Right OK. So in fact the banner headline for a million pound inheritance without any tax, it’s not quite what it seems is it? PAUL LATHAM: No, indeed, and so many people were hoping that that would be the £325,000 would jump to a million, and so a couple would have £2m - nowhere near that and some constraints around this. You also have to have children or grandchildren to leave this to. So you can’t just leave the house to a carer or a friend or, and benefit from this additional allowance; it has to be a house that’s going to offspring. PRESENTER: As ever the devil is in the detail. People really do need to consider getting proper advice about this and for what might be seen as quite low levels of estate values. PAUL LATHAM: Yes, indeed, so we’re not talking about the high worth here, this is people in relatively modest amounts of money. Most houses are growing in value over time. Particularly as this isn’t going to be fully introduced for another five years, the house values will have outstripped that additional benefit, more than likely. In fact the Treasury’s own estimates are, they say that this isn’t going to reduce the amount of inheritance tax that’s being paid. So getting good advice on how does one plan around this is essential. PRESENTER: OK. Now let’s talk about this seven years. For somebody of my age, you begin to start thinking about this, the seven year rule about the idea of making a gift or settling assets into trust for that gift to be exempt from inheritance tax. So do investors normally need to plan at least seven years in advance? PAUL LATHAM: Yes, traditional planning, as you say gifting or putting into a trust would be seven years. So, in order to ensure that you’re going to not have to pay inheritance tax on an asset, you need to have given it away at least seven years before you die - which introduced all sorts of complications. No one knows precisely when they’re going to die and they may need access to those assets in later life as they continue to survive in care or whatever. So the seven years is there as a rule but it’s quite difficult for most people to use that as a way of reducing inheritance tax. Most people don’t want to give away their assets at least seven years before they think they might die. Most people can’t get their head around that and therefore don’t do that sort of planning. But that’s not the only opportunity. So there’s another piece of legislation, another allowance that’s been introduced by the government many decades ago that is called business property relief, and that allows people to do planning that has got a two year horizon to it. PRESENTER: Let’s make it quite clear that business property relief doesn’t necessarily refer to bricks and mortar, because there is quite a misunderstanding about that isn’t there? PAUL LATHAM: Yes, there is. So it’s an allowance that’s been around for decades, as I say, but one that’s not particularly well understood in the market. Particularly investors themselves, clients are not aware of them, although most advisers will be. And most people think this is a pretty niche area for to be thinking around because they haven’t heard about it. But if you look at the statistics issued by the Government, this is the third largest allowance at time of death from inheritance tax. So transferring to the spouse, which doesn’t really save inheritance tax just defers it, is the largest; gift to charity in a will will be the second largest; business property relief comes after that. So this is a mainstream part of the tax regime and very commonly used. But could be much more widely used, people don’t quite understand. PRESENTER: So how does it work and what does it involve? PAUL LATHAM: OK. So you’re right to point out that business property relief isn’t anything to do with property; in fact there’s rules to stop you using property for this allowance. The way the most people access this would be through shareholdings in unquoted trading companies. So by holding a share in a company, certain sort of company, there’s the ability for that investment to be outside of the estate for inheritance tax purposes. So if someone was to put £100,000 into the right sorts of unquoted trading company by buying shares in that company then they would save £40,000, assuming they’d held it at least two years before they died. PRESENTER: When you say the right sort of company, there are obviously rules involved in what sorts of companies you can invest this in; talk us through those rules. PAUL LATHAM: So first thing it needs to be unquoted. So it needs to be not on the main market. It can be an AIM company. So it can be listed on the AIM market, but not on the main market, not on the London Stock Exchange; so it’s either AIM listed or it’s an unquoted company so a private company. It also needs to be a trading company, which means that not all of the companies on AIM will qualify, because not all are trading companies. So it needs to be carrying on a real trade of doing real things; it can’t itself be making investments because that would be against the rules. So it’s quite a complicated set of rules which… PRESENTER: And it has to be active in its trading; it can’t just simply be there potentially waiting for something to happen. PAUL LATHAM: Absolutely, so the activity within the business is key to make sure that it does continue to qualify. And so for example a hotel is deemed by the HMRC, the Revenue, not to be a qualifying trade because it’s not active enough; it’s just letting out of rooms. Similarly a storage supplier so people with big yellow boxes where you, yes, that doesn’t qualify either; there’s not enough activity there. It needs to be a real trading company - which means that it’s quite complicated to assess and therefore I would say this wouldn’t I you need a fund manager to help you do that. PRESENTER: And generally do fund managers tend to invest in one company or do they like multimanagers group a set of companies together? PAUL LATHAM: So there’s two different products in the market; we offer these two different flavours. So one would be a portfolio so spread across a basket of investments that would be in AIM. And so for people who are happy to take market risk and see the volatility that markets bring, then that would be a solution. The other solution is one where companies have been created specifically with this relief in mind. And so they are trading companies, they are large companies but unquoted, and in that case you’d be looking for diversification within that company. So it may be an investment into one company, but you’d look to see a spread of activity by that company across a number of different trades to make sure that it’s got a balanced portfolio. PRESENTER: OK. Now does the seven year rule apply to this sort of investment? PAUL LATHAM: No, this is focussed on the two year rule, and so what you’ve got is the opportunity to plan just two years in advance of your expected time of death. But, as importantly, unlike gifting in to a trust or to an individual, you still maintain control. It’s just an investment, it’s no different to any other investment, and so the individual themselves has control over and access to that money right until death, and therefore if they need extra money for health care, an operation or foreign holiday, they’ve got access to their money and can withdraw it; it’s still in their own name. PRESENTER: That’s really quite interesting because one of the things that worries people in putting things into trust is that once it’s there, that’s it, it’s gone forever; it has nothing to do with you. You hear stories about people having to pay rent to the trust if they’ve put a house in trust and all those sorts of things, and this is completely different to that; you retain hundred percent control. PAUL LATHAM: Hundred percent control, and in fact that’s essential in order for it to work. So you need to maintain control, you’ve got access to it, you need money back out then you can withdraw from it. It’s yours just like any other investment. PRESENTER: OK. Now you said it’s been going for many decades since the ‘70s, I believe; have the rules changed about who is a qualifying investor since then? PAUL LATHAM: Yes, they have. So when this was first introduced it was for majority holders, the majority shareholders in companies. So if an individual owned more than 50% of the shares then they would be able to benefit from this relief. What happened relatively soon after it was introduced was that they changed that to allow minority shareholders. So individuals can hold a small part of the appropriate unquoted trading company and still benefit from the same relief. So that was the key change that’s happened in over the time. The other change that’s happened is that it wasn’t it, before the AIM market existed, there was no carve out to allow AIM shares, so it was unquoted. For the main market those were the only two options and so it was restricted to the unquoted market. When AIM was introduced almost 20 years ago, they added a piece of legislation so that business property relief legislation allowed investments in AIM companies. PRESENTER: So it is quite a wide scope for somebody to… PAUL LATHAM: And has been widened over the years yes through every flavour of government so it isn’t something that’s fickle. PRESENTER: Tell me again how popular this is, because I have at the back of my mind the Government’s current tax avoidance issue as such, so are you finding that quite a lot of people, are there a large number of people using BPR? PAUL LATHAM: So I think that you’re identifying a key differentiator here. This isn’t about a loophole in legislation that’s designed to collect tax; this is all about a relief that’s been given explicitly by the government to save tax. And so with the increasing pressure on those avoidance opportunities, there’s been a flight to the safer sort of government approved, government stamped allowances, and so we’ve seen more people interested in this rather than what would have been more esoteric schemes in the past that have been closed down or people feel they might be closed down. So this is very public, it’s very open, the government understands what’s going on. PRESENTER: But at the same time you have to abide by the rules. PAUL LATHAM: Absolutely so. PRESENTER: So I imagine there is quite a lot of administrative detail that needs to be collected and presented to HMRC, is that accurate? PAUL LATHAM: So it’s not onerous on the investor. So the onus is on the HMRC to get comfortable that the companies that an individual has invested in qualify or don’t. And so they will see for the AIM companies, for example they will see regular deaths, therefore they will see people with that holding in the probate, it’s the Revenue that will look at the company and say is it qualifying or not. Similarly with the unquoted companies, they will have seen that happen. Our own company we’ve had 400 people have died holding this and they will have seen that in the probate as one of the lines, one of the investments and will have seen how that’s been taken into account. PRESENTER: Right OK, but this viewing of the investment takes place after death; they don’t publish a list of qualifying companies beforehand. PAUL LATHAM: Absolutely so you can’t get that sort of advance assurance from HMRC that this will qualify - which is why looking at the track record of the fund manager, have they managed to get this right year in, year out, for 10, 15 years is clearly important. Because even AIM companies that qualify today may not qualify tomorrow. They may do some restructuring; they may do a takeover of something that no longer qualifies; they may build up too much cash on their balance sheet. There’s a whole lot of things that we would be monitoring through regular contact with the company, as well as getting external validation from PwC to the qualification of the companies that were investing in both the unquoted companies and the AIM companies. PRESENTER: In practice for an IFA is that a feasible activity or do they have to, do they require help one step further up as it were? PAUL LATHAM: Yes. So I think the fund manager, having a fund manager that focuses on this area is key for advisers. They could theoretically do this themselves, they could pick a portfolio of AIM stocks, work out whether they think it qualifies or not, carry on maintaining that qualification by continually reviewing, very onerous on the adviser. So you don’t hear of advisers doing that and in fact some of the larger broker firms that used to offer this sort of service have backed off and, you know, their clients have… PRESENTER: And left it to the specialist. PAUL LATHAM: Absolutely. PRESENTER: OK and there is help out there from the specialists. PAUL LATHAM: Absolutely, yes. PRESENTER: OK. Now, to qualify for business property relief, the share either needs to be unlisted or listed on the AIM exchange, you said, but that sounds to me as if it’s slightly higher risk than most as it were, I’m going to put it in quotation marks, ‘normal investors’ would think about. Is that true, is there a slightly riskier feel to the investments would you say and have you found that that’s put some people off? PAUL LATHAM: It’s definitely is a consideration for the investor and their adviser to look at and see whether they’re comfortable with it. But if we take the two separately, the AIM portfolio, it’s a large portfolio, we run typically 20/25 stocks in that portfolio, sometimes more, so it’s diversified portfolio across the AIM market. Most investors would already have had exposure to the markets. They may not have been AIM shares but would have been main market shares. So they will be used to the idea that markets move up and down, they need to get comfortable with that, but the prize here is clearly significant: 40% is a significant benefit if they qualify for business property relief. If you look at the unquoted companies, those are typically set up and indeed we kicked this part of the market off 10 years ago, set up with capital preservation in mind. So these are companies that are specifically set up for the product. So for people coming with that in mind, in our case the only shareholders in that company are people who have come into us looking for business property relief. So it’s designed around the need of the shareholder, i.e. the investor, with them specifically in mind so you could set that up to be a high risk company or you could set that up to be one that’s looking at capital preservation, in our case it’s the latter. So it definitely is horses for courses. This won’t be suitable for every investor. If their risk capital appetite means that they only want ever to hold cash and nothing more, then this is not appropriate. These are unquoted trading companies. But for most investors that’s not an issue as I say the prize is significant. PRESENTER: Talk us through the slide which helps advisers decide who to consider for the proper type of investor in this, yes? PAUL LATHAM: OK. So there’s a number of different sorts of people that would be looking for this sort of investment. So if they’re elderly and living beyond seven years seems unlikely then that is clearly something that the seven year planning is not an option for them. But it’s not just about the people in that position; it could be that someone is looking to mitigate inheritance tax that’s already for assets that are already in the trust, so an interest in possession trusts for example. PRESENTER: Say it again slowly? An interest in possession trust, OK. PAUL LATHAM: So, with those and there’s lots of different names for them. Sometimes they’re referred to as IPDI trusts. The life tenant, so this would typically be a husband, dies, in his will he puts the house and other assets that the wife can use in her name through her lifetime. But once she dies then it may go to his children from a previous marriage. So that wife will have the inheritance tax bill to settle for those assets when she dies, even though the assets are going to pass to the children. So this is an opportunity again for business property relief investments because if the trusts, or the IPDI trust puts those assets into BPR qualifying and they’re there for at least two years before the wife dies then she has saved tax, more money goes back to the children so. PRESENTER: So in your experience sometimes higher risk unlisted investments may be suitable for a part of somebody’s estate, whereas their tolerance for risk in other parts of their estate is somewhat lesser, is that right, yes? PAUL LATHAM: Yes. So the adviser and their client need to look at it in the round. It’s part of an overall portfolio, no one’s going to have all of their assets in something they qualify for business property relief is very unlikely. But as part of what they’re doing, it would make sense for many clients. It’s also important to understand that you’ve got to balance the benefits for that client along with the risk. So you can’t just look at risk as one dimension; it’s what are the benefits they’re getting out of this particular investment as well. PRESENTER: OK. Due diligence, there, I’ve used that very important word, set of words, due diligence. It’s really crucial that due diligence is done properly in this. What are the things that advisers need to think about, know about to ensure that this due diligence process is carried out correctly? PAUL LATHAM: OK so the starting point for most advisers would be to pick up one of the reports that have been done by independent commentators. There are a number of people now are active in this field and that will give them a sense of what happens behind the scenes from someone who’s spent time with us, spent time looking at what we’re doing and how we’re doing it. That’s the sort of first stage of due diligence. But I think that the way to get comfortable is to spend time with the manager, yourself as an adviser, maybe with your client as well, because this is a relatively big decision that the client will be making, and giving the client access to the fund manager I think is important as well. But the things that you’ll need to be having in mind there is what’s the track record, has this manager been going for a good number of years? Have they delivered in terms of performance what they said they would deliver? Have they delivered liquidity in the way that they said they would deliver? We’ve not talked about liquidity yet but that’s as important because typically after death the next generation, the beneficiaries of the will, will want to liquidate and get the money back out. PRESENTER: And sometimes before death, if the unexpected happens. PAUL LATHAM: Indeed. And so the ability to get money back out quickly within a few weeks is really important someone who needs access to money but is told that they need to give six months’ notice, it’s not going to be suitable. So liquidity’s important. And perhaps the largest one is business property relief itself. So has this manager had a track record of being able to tell about these investments over a long period so there have been enough holders of that investment that have been through the probate process and have got business property relief. So those are I think the key things. And a number of those come with size. Now Octopus is the largest provider of this so I would say wouldn’t I? But actually size brings a number of benefits. First of all there’s the diversification I talked about. So we can within our products not be concentrated in one particular trade but a large team that can be active in a number of different trades which helps for that diversification. But it also helps in terms of liquidity. So if a large investor’s coming in with a million pounds that’s a small amount for us, big for them. PRESENTER: That will skew the fund. PAUL LATHAM: Isn’t pushing it, isn’t a problem for us to deploy, and when they want their million pounds back out again, again it’s easy enough, it’s part of a much much bigger pot of money. So size is something that also should be a consideration for the investors. PRESENTER: How important is it for the investor and the financial adviser to understand the valuation process? I presume that you do have a process? PAUL LATHAM: Yes. So again talking about the two sorts of products, we’ve got the AIM products which are clearly quoted and it’s easy as an instant valuation on those. For the unquoted products then that is it’s important - which raises the sort of governance and overall structure of how the manager runs that pot of money, that investment, so independent reviews, independent non-executive directors on the company rather than just the manager managing that company, the valuation process itself being reviewed by external parties. There’s the audit of the company as well, so a number of things that give some comfort around the valuation. But it is an unquoted company, you can’t go to the FT and look and see what its value. So again track record over a short period, the fund manager who wanted to could sort of distort the valuation, you can’t carry on doing that over time, so something that’s been running for years and years really helps in giving comfort that they must, that the valuation is a robust process that’s worked for people coming in and buying, and as well as people going out selling. PRESENTER: You talked about capital preservation. Presumably there are figures that are available that are publishable so that people can see that track record of capital preservation? PAUL LATHAM: Absolutely. So yes the adviser would need to look at that track record and show that it’s happened year in year out that the capital’s been preserved and the returns, typically modest return, so nobody’s going into these products hoping to double their money in a year. That would be high risk and not capital preservation, so the modest returns we target at 3% after all costs, but that is delivered year in year out; it’s another part of that track record. PRESENTER: OK. You’re beginning to sound a bit like the pension companies where due diligence has to be carried out in a major way, but also the strength of a manager’s relationships with his trading counterparties. What are counterparties and why are they important in this situation? PAUL LATHAM: OK so I think that it’s imperative that the underlying trades of the unquoted companies are integrated with a manager themselves so that it’s in-house, that it’s being done clearly for the benefit for the company and the shareholders rather than being subcontracted out to some third party. So at Octopus we have that managed in-house rather than just evolved to others. So you could as a fund manager just be sourcing the funds and letting others effectively manage that company. That’s not the way that we operate. We think it’s important to have that integration to make sure that we understand exactly what’s going on, that we’re aligning the trades with the desires of those shareholders. PRESENTER: Fine, and keeping on the side of the regulator. PAUL LATHAM: Yes, so the key regulation part here is the BPR legislation and the qualification for that. The product itself is just an investment. So it’s as simple as that. So we’re regulated fund managers, there’s the overarching requirement for us though to perform our fiduciary duties as every other fund manager should. PRESENTER: OK. So just move us a little bit into the future now, are you seeing any trends that are likely to be developing over the next 12 months, or few years even? PAUL LATHAM: Yes, so I think the change that has been happening and is continuing to happen is that there’s less opportunity for people to use other sorts of products for inheritance tax. We’ve talked already about the real clamping down on avoidance schemes, closing of loopholes. That is pushing more people towards us. As far as business property relief itself is concerned, I think it survived for decades through numerous flavours of government. It seems that there’s a continuing desire to stimulate the economy by encouraging money into that part of the sector. That seems to be sound, but who knows. A government tomorrow could change the rules one way or the other. PRESENTER: OK. You hear, or one hears quite a lot about powers of attorney. Are you finding that that’s a useful activity in terms of BPR? PAUL LATHAM: Definitely, so about 20% of our investors have powers of attorney. So let me just explain a bit of background to that and why it’s important. So typically if you took that a son is looking the mother’s money. She’s no longer capable of doing it herself and so the power of attorney has been evoked and the son is now in charge. If he’s thinking about the inheritance tax bill that will be paid by his mother’s estate, he hasn’t got very many options to him. So even if she’s going to live more than seven years, gifting’s not available because the power of attorney has to under the Court of Protection rules act in the best interests of the individual, the mother. And it can’t be in the mother’s best interest that her assets are given away, probably to the son. Yes, there’s a conflict there as well to be managed. So typical inheritance tax mitigation plans are not available for powers of attorney in those situations. Business property relief is as I’ve just said an investment. It’s simply deciding that instead of her money being invested in portfolio of shares on the stockmarket, that they’re invested in a BPR qualifying share. So that has been endorsed by the Court of Protection for powers of attorney cases time and time again. It’s standard practice now for people to think about this as the solution because he’s not taking anything out of the mother’s estate; it’s just reducing the inheritance tax bill through this relief. PRESENTER: But not just members of the family you are finding that solicitors are beginning to come on to the scene now or have been on the scene? PAUL LATHAM: So I sort of painted the simplest picture of the son looking after the mother. In many cases the attorney is a professional, is a solicitor or an accountant, and they are now becoming more and more aware of this as an opportunity. And I think it’s something for advisers to work with their professional connections there, their solicitor and accountant connections in powers of attorney cases. PRESENTER: Another good reason for financial adviser to go and see a solicitor. PAUL LATHAM: Yes, indeed, and there’s always a two-way benefit from those conversations. They’ll be clients that adviser doesn’t know of that the solicitor can point in that direction. PRESENTER: So Paul wrap it up for me then, what are the sorts of issues that a financial adviser ought to be thinking about where BPR is concerned? PAUL LATHAM: So they should be looking through their client book for individuals who have got an inheritance tax problem. That’s often difficult to assess easily so they’ll be some work to make sure they understand the full assets of the individual. Working out if there is a problem and then working out what the potential solutions are. So particularly if the client’s got a life expectation of less than seven years then BPR should be one of the things they’re considering. But more importantly is the client someone who’s got the right attitude to risk. We talked about the needs to be accepting at that. But also would like to keep access to the money and needs the simplicity of something that is just an investment and can benefit from what is either exposure to the market through the AIM stocks or something that’s more boring and predictable from the capital preservation products that are on offer. PRESENTER: On that note, Paul Latham, Managing Director of Octopus, thank you very much indeed. PAUL LATHAM: 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 the latest IHT rules; how business property relief is used in IHT planning; the tax implications of BPR; BPR in later life planning and for use with powers of attorney. Please complete a reflective statement in order to validate your CPD.