How contractors will fare under contentious IHT reforms

Contractors who aren’t parents or grandparents may be unfazed by scary headlines about an incoming ‘clampdown on the use of multiple trusts to avoid inheritance tax,’ but three potential areas of their financial plans could be hit, writes Gerry Brown, manager of tax and trusts at Prudential.

Before getting to this trio, some background on inheritance tax (IHT) – perhaps the most emotive of the UK taxes – needs consideration, not least because it is normally IR35, and not IHT, that dominates contractors’ tax thoughts.

IHT

Individuals are upset by the notion that having paid taxes throughout their working lifetime, their families effectively suffer a stinging charge on death. Worse still is the realisation that IHT is calculated on the value of assets owned by an individual on death; including that most cherished of assets -- the family home.

But is this an accurate picture? In 2014-15 it is estimated that 35,611 deaths will result in an IHT charge, up from 26,337 in 2013-14. So this appears to be a tax that impacts only a tiny minority of UK families, albeit an increasing one.

How does IHT work?

Inheritance tax is levied on:

• the assets (less deductible liabilities) transferred on death (known as “the estate”);
• gifts made in the 7 years before death;
• gifts made at any time, when the individual who made the gift continues to benefit from the gifted asset;
• gifts by individuals to most trusts.

For property in trusts, there is a charge on the tenth anniversary of the creation of the trust and every subsequent tenth anniversary. Assets transferred out to trust beneficiaries are also subject to a charge.

The current IHT code has a panoply of exemptions and reliefs which offer opportunities to the tax planner.

Currently the first £325,000 of net wealth (known as the nil rate band) is taxed at 0% and the balance at 40%. (A rate of 36% may be available where at least 10% of the estate passes to charity.) The unused proportion of a nil rate band can be transferred to a spouse thus meaning that a family can avail of a combined nil rate band of £650,000.

Impact on contractors

From a contractor’s viewpoint, the IHT code offers a very generous relief for business owners; sole traders, partners and most importantly shareholders in a trading company. The current rate of relief is 100% This means that in effect shares in trading contracting companies don’t attract IHT.

However at some point the contractor will retire, his or her company will cease trading and business relief will be “lost”. The value of the company – perhaps extracted via dividends; perhaps the proceeds of a voluntary liquidation, will be in the owner’s estate and liable to IHT.

Where trusts come in

One of the principal strategies in IHT planning is to reduce the estate – the amount on which the tax is charged.

The ‘easy’ way to achieve this is to make gifts to “desired beneficiaries” – children, grandchildren, financial dependents. While this is fine from a tax viewpoint (the gifts will be fully exempt after seven years) it may have unwanted consequences. The recipient might waste the money; might become bankrupt; might make an unsuitable marriage (very Jane Austen!); might have dependency issues.

Outright gifts can solve tax problems but might create or exacerbate non-tax issues.

Trusts can come to the rescue in such situations. A gift to trustees reduces the estate for inheritance tax purposes. The trustees become the legal owners of the gifted assets and can distribute them in such a way, in such an amount and at such a time as they see fit. The beneficiaries can only benefit at the trustees’ discretion.

Governments have always been concerned that trusts offering this degree of flexibility were being used for tax avoidance purposes, and legislation provides that transfers to such trusts are immediately chargeable to IHT (subject to available exemptions, reliefs and the settlor’s available nil rate band). To prevent avoidance of the IHT, the trusts themselves are taxed; there is a charge on every tenth anniversary of the creation of the trust. The value of assets transferred from the trust is also subject to a charge. The calculation of the tax charges on trusts is notoriously complex.

Where the taxman is coming in

HM Revenue & Customs (HMRC) has issued a consultation aimed at simplifying the calculation of IHT charges. As the mainstream media’s headline-writers have picked up, the proposals also counter perceived tax avoidance strategies involving setting up multiple trusts.

The basic proposal is that trustees of all trusts established by the same individual will share a single IHT nil rate band – the settlement nil rate band (SNRB). Transfers in excess of the proportion of the SNRB allocated to a specific trust will be taxed at 6%.

The consultation proposes that the individual can decide how to allocate the SNRB between each of the trusts. 

It is intended that the new method of calculating the IHT charge will apply to ten year anniversaries and distributions by the trustees after April 5th 2015, and only to trusts created after June 6th 2014. It’s because of the latter that campaigners against retrospective taxation are unhappy.

Meanwhile, the current complex system will apply to existing trusts. As far as it’s concerned, HMRC suggests that the additional tax “take” in respect of these changes will be negligible. However, the reforms will certainly make IHT planning using trusts more difficult.

The trust trio contractors must review

If you’re a contractor, you might so far think that these proposals are unlikely to impact you to any great degree. But as mentioned at this piece’s outset, there are three areas of financial planning that contractors often partake in that could be significantly affected. Firstly, you may well have life assurance policies held in trust – policies providing a benefit on death. Secondly, you may well have shareholder protection arrangements in force – and, thirdly, you may well have pension arrangements in trust. If any of these three apply to you, then it will be necessary for you to check the financial position of your arrangement(s) with a professional adviser.