An adviser s guide to the Discretionary Loan Trust

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1 XIM/DLT/ADGUIDE For advisers only. Not for use with customers. An adviser s guide to the Discretionary Loan Trust

2 Contents Background 3 What is the Discretionary Loan Trust? 4 Who is the Trust suitable for? 4 How the Trust works 5 The benefits of the Discretionary Loan Trust 5 Questions & Answers 6 Why use Friends Provident International Limited? 9 In summary 9 Making life easier for you 9 What to do next 9 Cautionary notes 10 Important Notes This Guide gives basic information about the Friends Provident International Limited (Friends Provident International) Discretionary Loan Trust. Friends Provident International cannot give legal advice in connection with trust arrangements. This document has been drawn up with professional assistance for guidance to our customers and their advisers. Friends Provident International does not accept any legal responsibility for the efficacy or tax consequences of the Trust wordings and whether the Trust will be treated as a settlement for inheritance tax purposes. The following tax treatment applies to any settlement created (after 2006) by a UK domiciled Settlor or that involves a settlement of UK assets: an immediate entry tax charge of 20% on lifetime transfers that exceed the IHT Nil Rate Band (NRB); a periodic tax charge of a maximum of 6% on the value of trust assets over the IHT NRB once every ten years; and an exit charge proportionate to the periodic charge when funds are taken out of a trust between ten-year anniversaries. These rules apply to settlements created on and after 22nd March 2006, additions of new assets to existing trusts and, subject to transitional provisions, to other IHT relevant events in relation to existing trusts. The Trust and statements are based on Friends Provident International s current understanding of UK inheritance tax law and HM Revenue & Customs practice as at January Before proceeding with this Trust we strongly recommend the Trust is referred to your client s own legal advisers to ensure it meets their needs. The Trust is therefore provided on the clear understanding that it is a draft for the consideration of your client s legal advisers. Throughout this Guide, the term spouse also includes a civil partner for UK-domiciled individuals under the UK Civil Partnership Act

3 The Discretionary Loan Trust Background There is little doubt that many individuals underestimate the size of their taxable estate. When you take into account the value of the private residence, contents and personal effects, investments, life assurance policies, bank and building society deposits, cars and second homes, an individual can quickly have an estate worth more than the inheritance tax (IHT) nil rate band which is currently GBP325,000 for tax year On death, assets that exceed this figure passing to a person other than the deceased s UK-domiciled spouse will be subject to inheritance tax at 40%. Just consider how much of an estate would be taken by HM Revenue & Customs (HMRC) if a person should die leaving assets to anyone other than his/her spouse, a situation that will inevitably arise on the death of the survivor of a married couple (see Figure 1). Figure 1: IHT the effect on what you leave behind (based on figures and only one nil rate band available) IHT GBP70,000 Gross Estate GBP500,000 IHT GBP170,000 Gross Estate GBP750,000 IHT GBP270,000 Gross Estate GBP1,000,000 What can be done to mitigate this problem? One effective way of IHT planning is to gift assets direct to individuals. Normally, if the Settlor survives by seven years, the gift will be outside of the estate for IHT purposes. However, not everybody can afford to gift assets away, although they may wish to carry out some IHT planning. The solution It is in order to satisfy the needs of these people that Friends Provident International has introduced the Discretionary Loan Trust a lump sum inheritance tax plan which is designed to provide long-term benefits whilst giving the Settlor the right to receive a stream of tax-efficient cash payments. The purpose of the Trust is therefore to enable your clients, as the investor, to make a lump sum investment which will: provide capital to them as and when they require protect any growth in the investment from UK inheritance tax. 3

4 What is the Discretionary Loan Trust? The Trust is a discretionary trust, i.e. one where the Trustees have full discretion on who will benefit and when. The creation of a loan trust is not a gift for IHT purposes so is not a chargeable lifetime transfer. However, the 10-year periodic charge could apply if the investment growth is in excess of the then Nil Rate Band. Who is the Trust suitable for? The Friends Provident International Discretionary Loan Trust is suitable for investors looking for the following: To reduce their IHT liability To receive regular or one-off repayments of the loan All investment growth to be outside the estate To provide capital for a wide range of potential Beneficiaries on the death of the Lender, potentially free of IHT A wide range of investment funds that offer greater potential for capital growth over the medium to long term The flexibility to release the outstanding loan to Beneficiaries if not required. 4

5 How the Trust works Getting started There are two versions of the discretionary loan trust available, a single settlor and joint settlor deed. Your client (the Settlor) creates a Discretionary Loan Trust, appointing trustees. The Settlor then makes a loan to the trustees of his chosen investment amount. If using the joint settlor version, two individual loans are made to the trustees. The trustees invest this capital into a Friends Provident International investment product. The Trust Deed and an application form for the policy are available on request or from our website The loan and repayments The Settlor can choose to have the loan repaid in regular instalments or by one-off payments. Either way, any capital growth on the policy accumulates outside the Settlor s estate. The loan amount not repaid will form part of the Settlor s estate. The value of an investment is not guaranteed and all trustees assume responsibility for repayment of the loan. For joint cases, trustees must keep accurate records, keeping the two loans separate. Tax-efficiency of policies held in a Discretionary Loan Trust The settlor is able to request loan repayments of up to 5% of the premium amount from the trustees, without an immediate charge to income tax. Each withdrawal is a part-repayment of the loan. If withdrawals of 5% per year are chosen, this would mean the loan would be repaid after 20 years. If more than 5% per year is withdrawn, the excess will be subject to income tax and may reduce any age-related personal allowances or tax credits if the Settlor is resident in the UK. Investment switches within a Friends Provident International Investment product create no liability to Capital Gains Tax, either for the Settlor or the trustees. Life policies are deemed to be non-income producing assets and therefore considerably reduce the administrative duties of the trustees. The combination of these tax benefits make our Investment products the ideal investment choice for a Discretionary Loan Trust. The benefits of the Discretionary Loan Trust The Trust provides your clients with the following: A means of freezing their IHT liability Access to their original capital during their lifetime through regular or one-off loan repayments Protection of any capital growth so that it can pass to their beneficiaries following their death A wide class of discretionary beneficiaries who may finally benefit from the investment A wide range of investment funds to choose from. 5

6 Questions & Answers The following address many typical questions you may have in relation to the Discretionary Loan Trust. The Settlor is the person who creates the Trust. Who is the Discretionary Loan Trust suitable for? What are the main benefits of the Discretionary Loan Trust? How is the Trust set up? Can an existing policy be assigned to the Trust? The Trust is suitable for individuals on whose death a potential IHT liability will arise and who wish to ensure that some IHT mitigation is achieved whilst also retaining access to the invested capital. It enables the Settlor to: retain access to the original invested capital through loan repayments provide long-term benefits in any investment growth to the Settlor s chosen Beneficiaries ensure all growth from the investment is outside of the estate. The Settlor sets up the Trust and the Trustees apply for a Friends Provident International investment product. The Settlor can, if he wishes, pay the premium for the policy direct to Friends Provident International. No. The Discretionary Loan Trust is only suitable for new policy applications. Who is the Settlor? Can spouses set up their own Trust? The person who is lending the money to the Trustees for investment. It is possible as long as the Beneficiary of each Trust is not the other partner. Can spouses set up the Trust jointly? Yes, the joint settlor deed can be used for joint cases. Can spouses set up a Trust for the benefit of each other? When and whom should the Settlor appoint as Trustees? What is the role of the Trustees? Can Beneficiaries be appointed Trustees? Can new Trustees be appointed? Who should be the Beneficiaries? This is not recommended as HMRC could regard it as an Associated Operation and treat both arrangements as one. This could be treated as a gift with reservation and subject to inheritance tax. The Settlor must name the other Trustees when he executes the Trust document. The appointed persons must be aged 18 or over, of sound mind and not bankrupt, and must have the confidence of the Lender these are normally trusted family members or a corporate trustee. It is essential that at least two Trustees are appointed, and a maximum of four. The Trustees are responsible for administering the Trust fund in accordance with the terms of the Trust. The Settlor is automatically a Trustee. Yes, as long as they are aged 18 or over, of sound mind and not bankrupt. However, care should be exercised in advance, as the Beneficiary would then have a say in how the Trust is administered. The Settlor has the power to appoint and retire Trustees, provided at least two remain. Any additional Trustee(s) (up to maximum of four) will assume joint responsibility. The Trust contains a wide class of discretionary Beneficiaries from which the Trustees can choose. 6

7 Can Beneficiaries be changed? On whose lives is the policy written? What is the maximum number of lives assured permitted under the policy? The Trust is a discretionary trust, which means the Trustees have full discretion on who they appoint as Beneficiaries. We recommend the policy is written on the lives of potential Beneficiaries. This has the advantage of enabling the policy to remain in force for as long as possible and thus helps provide both income tax and inheritance tax efficiency. Subject to the limit explained in What is the maximum number of lives assured permitted under the policy? below, clearly the greater the number of potential Beneficiaries who are lives assured the greater the flexibility. Neither the Settlor nor the Settlor s spouse can be a nominated Beneficiary. Friends Provident International will permit up to ten lives assured on a last survivor basis which will enable a number of potential Beneficiaries to be included. Are further investments permitted? Yes. Please refer to our Technical Services Department for further information. What are the inheritance tax benefits of the Trust? How does the Trust provide the Settlor with an income? How are the loan repayments paid to the Settlor? What if the Settlor no longer requires loan repayments? Why is the loan interest-free? Can the Beneficiaries benefit whilst the Settlor is still alive? What if the policy loses value so the Settlor cannot be paid his entitlement? Is the Settlor immediately taxed on the loan repayments? Who is taxed? Is the Trust caught by Pre-owned Assets Tax? The Settlor is able to make a loan to the Trust and receive loan repayments when required. Any investment growth is outside of the Settlor s estate. Income is provided via loan repayments to the Settlor by means of withdrawals from the policy. These can be on a regular or an one-off basis when the Settlor so wishes. Payments in satisfaction of the Settlor s loan entitlement are made from the policy by Friends Provident International direct to the Settlor. The Trustees should keep records of all such payments. The Settlor can release his entitlement. This is likely to be treated as a chargeable transfer, to the extent they are not covered by the annual exemption of GBP3,000. To allow capital growth on the policy to accumulate outside the Lender s estate and for the benefit of the Beneficiaries. The Trustees have a liability to the Settlor for any outstanding loan repayments and must therefore take this into account. The Settlor s entitlement is subject to the Trust fund being sufficient to meet that entitlement. The Trustees have no personal liability to the Settlor in cases where the investment reduces in value. No. Any withdrawals taken are deemed a return of capital by HMRC which means that if 5% per annum is paid to the Lender this can be done for 20 years before there is any immediate tax liability. It is our understanding that if a chargeable event occurs the tax will fall on the Settlor if UK-resident, or if the chargeable event occurs in the same tax year as the death of the Settlor. If the Settlor is non-uk resident or has died in a previous tax year, then the tax will fall on the Trustees if any of the Trustees are UK-resident. If none of the Trustees is UK-resident, the tax will fall on any UK-resident Beneficiaries. No, it is not thought so as HMRC have confirmed in writing to the Association of British Insurers that Pre-owned Assets Tax will not apply to loan trusts. Friends Provident International has also taken legal advice to confirm this. 7

8 Can the arrangement be wound up? Can the policy be surrendered while the Settlor is still alive? What are the IHT implications on the death of the Settlor? The Trust is irrevocable and so cannot simply be wound-up by the Settlor, as he only has the right to recover any outstanding loan amounts. It can be, subject to chargeable event legislation. However, the Trustees still have a liability to the Settlor for any unpaid loan amounts. Any loan repayments not made will form part of the Settlor s estate for IHT purposes. The Beneficiaries will become entitled to the remainder of the Trust fund absolutely. Please note it is important that the Trustees keep accurate records of any loan repayments made to the Settlor. These can be in the form of a receipt sent by the Settlor to the Trustees every time he receives a repayment, which the Trustees retain. A draft receipt is included in the trust documentation pack. For single settlor cases this is form E and for joint settlor cases, form D. 8

9 Why use Friends Provident International? An investment policy is a straightforward and attractive option. Based in the Isle of Man, Friends Provident International investment policies offer: the prospect of long-term capital growth, a comprehensive range of professionally-managed funds, both internally and externally-managed, offering a diverse mix of asset type, geographic location and management style, catering for all attitudes of investment risk, valuable tax benefits of gross roll up, tax-free switches and tax-deferred loan repayments to the Lender via the annual 5% per annum withdrawal allowance, the political stability of assets held in the Isle of Man. In summary The Discretionary Loan Trust allows your clients to reduce the impact of inheritance tax immediately and in the long term. Access to regular withdrawals via loan repayments. All capital growth is immediately outside the estate. On death, capital goes to the appointed Beneficiaries. The valuable tax benefits of a policy from an international life assurance company. Making life easier for you and your clients In addition to the Discretionary Loan Trust, Friends Provident International has a range of trusts to suit other circumstances. With our wide range of products and trust documentation, we can help you develop a realistic strategy for your clients, as well as being flexible enough for any future changes in circumstances. What to do next Our Discretionary Loan Trust Documentation Pack contains all the documentation necessary to put the scheme into operation. 9

10 Cautionary notes The information given in this document is based on Friends Provident International s understanding of UK and Isle of Man tax law and HMRC practice as at January 2013, which may change in the future. Individuals are advised to seek professional independent advice and no liability can be accepted for the personal tax consequences of this Trust or for the effect of future tax and legislative changes. It is important to appreciate that although Friends Provident International has sought the views of leading Tax Counsel on the tax implications of the Trust and he has confirmed that the arrangement does not, in his view, constitute a gift with reservation of benefit within the meaning of the Finance Act 1986, nor does it fall within the definition of a settlement in s43 of IHTA 1984, no guarantee can be given that (albeit unlikely) HMRC will not take a contrary view or that tax legislation will not change in the future. As the value of units can go down as well as up, due regard must be given to the level of possible future growth in the policy when selecting the level of capital repayments required. A high capital repayment may not be thought advisable, at least in the early years following the commencement of the arrangement. Each policy is governed by and shall be construed in accordance with the law of the Isle of Man. If your client effects a policy whilst resident in the United Arab Emirates, all disputes regarding the policy shall be subject to the non-exclusive jurisdiction of the courts of the United Arab Emirates. Some telephone communications with Friends Provident International are recorded and may be randomly monitored or intruded into. All policyholders will receive the protection of the Life Assurance (Compensation of Policyholders) Regulations 1991 of the Isle of Man, wherever their place of residence. Investors should be aware that specific investor protection and compensation schemes that may exist in relation to collective investments and deposits accounts are unlikely to apply in the event of failure of such an investment held within insurance contracts. Complaints we cannot settle can be referred to the Financial Services Ombudsman Scheme for the Isle of Man. A written statement of the policy terms and conditions of the products may be obtained from Friends Provident International on request. Copyright 2013 Friends Provident International. All rights reserved. Friends Provident International Limited Registered & Head Office: Royal Court, Castletown, Isle of Man, British Isles, IM9 1RA Telephone: +44(0) Fax: +44(0) Website: Incorporated company limited by shares Registered in the Isle of Man No Authorised by the Isle of Man Insurance & Pensions Authority Provider of life assurance and investment products Authorised by the Office of the Commissioner of Insurance to conduct long-term insurance business in Hong Kong Registered in the United Arab Emirates as an insurance company (Registration No.76) and as a foreign company (Registration No. 2013) Authorised by the United Arab Emirates Insurance Authority to conduct life insurance and savings business Registered in Singapore No. F06835G Registered by the Monetary Authority of Singapore to conduct life insurance business in Singapore XIM/DLT/ADGUIDE 01.13

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