How To Invest In A Tax Efficient Trust Or Investment Scheme

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1 Tax Planning Solutions for Professional Connections

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3 Contents Introduction 1 The rising prominence of Business Property Relief 2 Why is BPR useful in IHT planning? 3 IHT solutions combining BPR and trusts 5 An interesting post-death use of BPR 7 What BPR solutions are available now? 8 VCT and EIS Benefits 9 VCT and EIS choices 10 VCT and EIS solutions to complement retirement planning 11 Eliminating income tax 12 Extracting money from a business tax efficiently 13 Next steps 15

4 Introduction Over the following pages we look at how tax efficient investments Trusts, Business Property Relief, Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS) might be beneficial to your clients. Inheritance tax (IHT) is a complex issue with personal, political and economic aspects, making it an area that many people struggle to get to grips with. But IHT can have huge implications for families, making it an essential part of financial and estate planning, particularly for clients in later life. Thanks to IHT, the UK government is able to lay claim to a sizable chunk of the value of an individual s estate when he or she dies. Of course, IHT is one tax that not everyone is required to pay. It s only due if the deceased s estate is valued over the current IHT threshold ( 325,000 for the tax year). The tax is payable at 40 per cent on the estate value over the threshold, known as the Nil Rate Band (NRB). However, the number of people with estates valued above the NRB has increased in recent years. Clients may think that inheritance tax is only for rich people, not realising that the value of their home may push them over the threshold. They may also wrongly assume that they can avoid tax by simply giving away assets. In fact, barring an annual 3,000 allowance and other small gifts, everything a person gives away in the seven years before their death will be taxable. Closing the gap in understanding about IHT involves acknowledging some uncomfortable truths for many people. After all, making financial plans to deal with the circumstances after your death means focusing on painful but inevitable events. But just as with making a will, making investment decisions, before the worst happens, leaves people in greater control of their assets and will undoubtedly give them greater peace of mind that their wealth will go where they intended it to. VCT and EIS can also be important due to increasing government restrictions on pension schemes, affecting higher earners in particular, combined with increasingly heavy tax burdens, affecting almost all tax payers. VCT and EIS solutions represent a compelling investment opportunity for a range of investors, as well as a useful tool to complement more traditional methods of funding retirement, particularly as they have not been affected by the government s austerity measures. As they are not pension contracts, they are not subject to the reduced annual pension allowance. These solutions allow your clients to access a number of tax breaks in a relatively simple structure, helping to reduce the tax burden and potentially generate an attractive return. These will be discussed over the next few pages, and we ll look at ways to use them within an overall financial planning approach. Perhaps the most important thing to remember is that this is not exotic or controversial tax planning, but the use of government-designed schemes that may have their own place in every investor s financial plan. 1

5 The rising prominence of Business Property Relief Business Property Relief (BPR) is a useful inheritance tax planning solution that has steadily grown as a more mainstream option in recent years. Originally designed for entrepreneurs passing on family businesses, BPR delivers full relief from IHT on qualifying companies owned for at least two years. However, it is through portfolios of Alternative Investment Market (AIM) stocks and unquoted company shares that it has become a highly accessible option for a much wider number of clients. While these portfolio solutions are now well established and reasonably well understood within the industry, one misconception is that they represent an alternative strategy to more common IHT mitigation tools, such as trusts. In fact, BPR and trusts should not be seen as mutually exclusive, but complementary solutions that can be combined with some interesting results. Power of Attorney cases Another important point to note is that, under Power of Attorney legislation, setting up new trusts is not permitted, and the Attorney is not completely free to make other gifts, limiting IHT planning. In some cases applications can be made to the courts but this can be a long and expensive process. However, BPR investments are allowed under Power of Attorney legislation as there is no gifting involved. 2

6 Why is BPR useful in IHT planning? BPR solutions have evolved considerably over the last few years and there are a number of options to cater for different client requirements, including varying levels of risk/return on the underlying investments. However, there are a number of benefits common to the vast majority of solutions: Speed of IHT relief BPR portfolios are IHT free once held for two years (provided they are still held at the time of death). Access and control Clients can access part or all of their money at any time providing the ability for them to adjust their investment based upon changing circumstances, including changes in the IHT rules. BPR does not use the Nil Rate Band Meaning clients can utilise this allowance in less liquid assets, such as property, which is otherwise difficult to place outside the estate. Flexibility This includes transfer between spouses without resetting the clock on the two year BPR qualification period. Income options: Many BPR solutions can be used to generate an income, and this can be easily adjusted over time to meet changing requirements. BPR products can be combined with trusts: this approach allows clients to meet specific objectives where one product alone is sub-optimal. Independent Advice As independent advisors we are able to guide you through the benefits of IHT Planning. 3

7 As independent advisors we can formulate a tax efficient plan to protect and enhance your wealth. 4

8 IHT solutions combining BPR and trusts Using a BPR solution as a tax free gateway to discretionary trust investment In 2006, the Government made some fundamental changes to the taxation of trusts, effectively closing what it saw as a loophole. This left discretionary trusts as the last remaining type of flexible IHT efficient trust. Discretionary trusts are subject to a 20% upfront Chargeable Lifetime Transfer tax, if the transfer is above the Nil Rate Band. However, if the investment is held in BPR-qualifying assets for two years prior to being moved into the trust it eliminates the Chargeable Lifetime Transfer. In addition to this 20% tax saving, the investment also receives the BPR benefits outlined on page 3, for this two year period. After this period, the usual (and well known) benefits of the discretionary trust are available: Control of the assets within the trust Avoidance of probate delays Ability to obtain annual income from the trust Increased flexibility and control versus traditional wills Combining a Discounted Gift Trust (DGT) with a BPR investment solution By dividing a client s investment across both a DGT and a BPR product, you are able to combine the benefits of each in a manner appropriate to the client. Whilst the gift into the Discounted Gift Trust is classed as a Chargeable Lifetime Transfer, it does not incur any tax charge on entry because if it is appropriately sized it is deemed to have no value. The DGT carves out the amount required to provide your client with a regular income payment during their lifetime, avoiding the gift with reservations rules. The approach can effectively deliver a 100% discount on the DGT element, providing an income aligned to the client s forecasted lifetime income requirement. Meanwhile, the remaining assets do not need to be held in trust. Instead, they can be held in a BPR solution, making them IHT exempt within two years. These assets are also accessible and under the client s control, allowing them to liquidate and utilise the funds in the event of unforeseen circumstances. This approach can also be set up in a structure whereby the DGT and BPR solution both invest in the same underlying investments, providing greater simplicity. 5

9 BPR for an Interest In Possession trust It is a fairly common scenario where both husband and wife are on their second marriages, both with children from their first marriages, and with separate finances. While they may have agreed that their own money will be passed to their own children upon their death, one partner may have a much higher pension income so want to ensure their spouse receives sufficient financial support in the event of his or her own death. The solution is to leave income from the richer partner s capital to the spouse in the Will. Then, on the second partner s death, the capital is to be distributed to the first partner s children from the first marriage. This is an Interest In Possession Trust, with the second partner having a right to the income from the capital during his or her lifetime. However, the value of the Trust fund will be deemed as an asset of the second partner s estate and be potentially liable to IHT. The answer is to invest the Trust asset into a BPR solution. If it is held in BPR for more than two years and at the time of the second partner s death, it will become an IHT exempt asset. The selection of the correct BPR investment can help balance the demand for income during the lifetime of the second partner, and the beneficiaries desire for capital growth. * Trusts and some forms of tax planning are not regulated by the Financial Conduct Authority. 6

10 An interesting post-death use of BPR The use of BPR for post-death asset replacement If a beneficiary has received a BPR qualifying asset but then sold it and held the proceeds in cash, and the donor has then died, there are some circumstances where IHT relief can still be claimed. Under normal circumstances, there may be a clawback of BPR if the donor dies within seven years of the gift. This is unless the donee still holds the assets gifted at the time of the donor s death and the property concerned is still relevant business property (or would be if the two year ownership condition was satisfied by the donee). Under these conditions only partial clawback would apply. However, the relief can be preserved if the proceeds of sale are invested in a replacement business property relief qualifying asset. For this further relief to apply: the whole of the sale consideration must be applied in acquiring other property *, the acquisition must be an arm s length transaction or on arm s length terms, the replacement property must be acquired within three years of the disposal of the original property, the donee must own either the original property or the replacement property throughout the period between the date of gift and the donor s death (disregarding any period between disposal and acquisition), and, the property must be relevant business property in the hands of the donee (or would be if the donee had held the property for two years). * Importantly, there is no proportional relief if only a part of the proceeds is reinvested. The donee must satisfy the conditions above and must acquire the replacement property within the three year time limit. In this situation the tests are applied as if the donor died at the time of the acquisition of the replacement property. 7

11 What BPR solutions are available now? Since Business Property Relief was introduced in the 1976 Finance Act it has been amended a number of times. Of major significance, the 1996 Finance Act made it more attractive to private investors looking to address IHT liabilities. Under the amendments any qualifying investments held for two years or more at date of death benefit from 100% business property relief. To qualify, investments must be unquoted, however this includes shares quoted on AIM (and PLUS Markets). As a result, many BPR solutions use AIM to deliver a BPR-qualifying portfolio. AIM portfolios AIM solutions offer potential for growth, but also the risk of a fall in value of the underlying companies, and therefore the client s assets. However, these solutions adopt a portfolio approach to provide diversification to reduce this risk. Additionally, it could be argued that recent falls in AIM-listed company values (which have not fully recovered to their previous highs) make this a preferable time to invest in such solutions. Structured investment solutions More recently, providers have begun to offer an alternative approach to BPR investment, aiming to reduce the volatility that comes from AIM investment portfolios. These products look to invest in unquoted companies focused on capital preservation rather than growth. Additionally, investments in these companies use insurance or are structured in a way that reduces exposure to risk. These solutions will therefore only make a modest return, but this can be held as growth in the investment (and remain protected from IHT) or taken as income. However, the solutions that have adopted this approach have demonstrated their resilience to significant economic shocks through the recent market conditions, which would give comfort to clients looking simply to reduce or eliminate IHT rather than turn a large profit. 8

12 VCT and EIS Benefits Changing pension rules and relatively high rates of tax on income and capital gains mean VCT and EIS solutions are gaining traction as more mainstream investment options. They are compelling investments for anyone looking to save for the medium term, or build up a retirement nest egg in a tax-efficient manner. They also offer interesting tax planning opportunities that tackle specific investor situations. Specialist providers in the marketplace have focused their efforts on creating a range of solutions that address different client tax scenarios. These include VCT and EIS solutions that invest in businesses that target capital preservation and use a variety of structures to mitigate risks. Alternatively, solutions may offer growth investments or access to AIM companies in a highly tax efficient manner, that could form part of an overall investment portfolio. Essentially, the VCT and EIS landscape has grown up, and the tax planning opportunities these products provide should mean they deserve serious consideration. Venture Capital Trust VCTs offer the following benefits: 30% income tax relief Tax free capital growth Tax free dividends Portfolio diversification The maximum VCT investment that qualifies for tax relief is 200,000 per tax year, and income tax relief cannot exceed income tax paid in that year. A VCT must be held for five years to retain the income tax relief. Please note: VCT and EIS tax relief depends upon an individuals circumstances and may be subject to change in the future. Enterprise Investment Scheme EIS solutions offer the following benefits: 30% income tax relief CGT deferral Potential IHT relief in two years Tax free capital growth Loss relief The maximum EIS investment is 1,000,000 per tax year for income tax relief, against an income tax bill for this year (or the last tax year, if preferred). Income tax relief cannot exceed income tax paid in that year. An EIS must be invested in BPRqualifying investments for two years and held at time of death to qualify for IHT relief. To retain the income tax relief an EIS must be held for at least three years. Independent Advice As independent advisors we are able to guide you through the new legislation to ensure you end up with the most suitable arrangement to suit your circumstances. 9

13 VCT and EIS choices VCT and EIS providers offer a range of products designed for investors with varying appetites for risk. Capital Preservation Some VCT and EIS solutions look to invest in companies set up specifically for capital preservation. They look for strong recurring cash flows, with investments structured for further protection. These investments look to minimise the risk of loss of capital. Additionally, these VCT and EIS solutions are designed to significantly improve liquidity for investors, aiming to free capital quickly after tax relief has been achieved. Growth There s a strong case for investing in more traditional growth VCT and EIS solutions now. With smaller companies hard hit by recent economic upheavals and lack of bank lending, market conditions have created a mismatch between supply and demand for capital. This in turn has caused company valuations to fall aggressively. This means that VCT and EIS fund managers are able to buy into companies at attractive valuations, picking up bargains that have the potential to provide long-term returns as the market recovers. Also, VCTs are structured so that they can invest gradually over a three year period. This means fund managers are able to take the time to seek out the very best deals. VCTs can invest in smaller UK unquoted companies or companies listed on the Alternative Investment Market (AIM). There are however numerous restrictions on the types of companies into which VCTs can invest, a full list is available on the HMRC website. As well as investing in new VCTs it is sometimes possible to invest into existing VCTs when a top up becomes available. Applying regulated tax planning strategies to your overall investment portfolio can make a significant difference to your current and future wealth. 10

14 VCT and EIS solutions to complement retirement planning Legislation that came into force in April 2011 reduces the amount of money investors can put into their pension which benefits from tax relief. With this increased restriction, investors are looking for complementary or alternative solutions. Tax efficient investments are increasingly being used to complement pensions as part of an overall retirement planning solution. The tax relief provides a reliable return and investors are able to access their money after the tax qualification periods, either to reinvest in tax efficient investments for another round of tax relief, or invest elsewhere. Investors can choose to reinvest the upfront tax relief, either into a VCT or EIS (for further income tax relief ) or directly into a pension. The net effect is a significant boost to an investor s retirement pot based upon tax relief rather than stock market performance. Like pensions, your clients can make an investment into VCTs or EIS solutions over many years, providing diversification and a regular income as each investment period is reached. There are other factors that point to VCT and EIS solutions being useful tools for retirement planning and as part of an overall investment portfolio. Significantly, pension investments are largely subject to income tax as they are drawn down, whereas VCT and EIS solutions are not. Also, whilst VCT and EIS investments have to be held for a fixed period to qualify for tax relief, after the holding period investors have a great deal of flexibility and greater access to the investment compared to pensions. However, it is important not just to consider them in isolation, but as a valid and important part of an overall portfolio. Even compared to ISAs the mainstay of tax efficient investing they offer better tax reliefs because not only is growth tax free but there is a tax rebate on investing. They are often rated higher risk because they invest in smaller unquoted stocks and due to a lack of liquidity indeed they have to be held for a set period to retain the tax reliefs. Therefore it is vital that they are appropriately weighted within your clients portfolios. They offer an investment solution that is largely uncorrelated to the markets, and therefore a complementary asset class to more traditional pension investments. Seen in this context, the risks of what is a relatively long-term investment are put in perspective. VCTs and EIS solutions deliver tax relief both when you invest, and when you access your funds. TAX RELIEF NO TAX RELIEF TAX RELIEF TAX RELIEF PENSION ISA VCT EIS INCOME LIABLE TO TAX TAX FREE INCOME/ GROWTH TAX FREE GROWTH AND DIVIDENDS TAX FREE GROWTH, CGT DEFERRAL AND IHT RELIEF 11

15 Eliminating income tax Consider a retired person with a pension generating an income of 70,000 per annum, of which they pay 30,000 income tax, and who has investable assets of 300,000. Investing 100,000 into a limited life EIS will give the investor income tax relief of 30,000 for that year. They also have the option to carry back the tax relief to the previous tax year. Assuming the investor opts to take the relief on this year s income tax bill, and that this bill is no more than 30,000, he can actually reclaim all of this income tax. He has, in effect, wiped out his entire income tax bill for the year. In Year 2, he could invest another 100,000 with the same results, and again in Year 3 (assuming his income tax bill doesn t change, and assuming current EIS legislation doesn t change). The EIS can return the investor s capital after it has been held for the three year qualifying period. This means the Year 1 investment, having reached the three year qualifying period by Year 4, can, once the fund has been liquidated *, be reinvested in another EIS to eliminate the investor s Year 4 income tax bill. Similarly, the Year 2 EIS investment is reinvested in Year 5, Year 3 in Year 6, and so on... The same process can be followed with VCT investments, however the holding period for VCT qualification is five years. Using EIS investments to eliminate income tax YEAR 1 YEAR 2 YEAR 3 YEAR 4 INVEST 100k IN EIS INVEST 100K IN EIS INVEST 100K IN EIS REINVEST 30K INCOME TAX REBATE 30K INCOME TAX REBATE 30K INCOME TAX RELIEF 30K INCOME TAX REBATE * It should be noted that there is likely to be a short period of time after the three year EIS qualification period while the EIS fund is wound up. Therefore investors following this tax planning idea over an extended period may miss a year as their investment date moves slightly later each tax year. However, under current legislation EIS allows investors to claim income tax relief from the previous year as well as the current year, this could be addressed through taking this option. 12

16 Extracting money from a business tax efficiently Many individuals have a significant amount of their wealth tied up in a business that they may have run for many years. If you have clients in this situation, they may be reluctant to sell as this will incur a capital gains tax liability. Additionally, if their business assets currently qualify for business property relief (BPR), liquidating them would generally mean moving them into non-qualifying assets and exposing them to a potential inheritance tax (IHT) liability. A solution lies in EIS. By selling the business investment and investing the gain into an EIS solution, the capital gain is deferred *. If held until death, it is eliminated entirely. Additionally, as an EIS is BPR-qualifying, the assets will be IHT-free once the funds have been employed in the underlying investments. Assuming the BPR-qualifying business that has just been sold was owned for more than two years, there isn t even a two year wait to achieve this IHT-free status. Plus, of course, the investor also benefits from the 30% income tax relief on investment. A worked example demonstrates the multiple tax benefits very well. A business started from nothing and sold for 1 million will incur a 100,000 capital gains tax liability (under Entrepreneurs Relief). Assuming other assets have used up the investor s 325,000 nil rate band, the remaining 900,000 would then be subject to 40% inheritance tax. The inheritance tax liability would therefore be 360,000. Turning to an experienced guide with specialised wealth management and corporate services expertise makes a good deal of sense. * Investors should be aware that deferring a CGT liability results in the loss of Entrepreneurs Relief. 13

17 Thus, without any planning, the business owner passes only 865,000 of his 1,325,000 assets to his heirs, and pays 460,000 in tax. If, instead, the 1 million from the sale of the business is invested into an EIS, the capital gain tax liability is deferred. The investor also receives 300,000 in income tax relief for the current tax year, (assuming he earned that income over this period). Finally, his EIS investment would be IHT-free once the EIS had employed its funds in the underlying investments (although the income tax relief, which has not been invested in EIS, would be subject to IHT). In this scenario, the business owner will pass 1,505,000 in assets to his heirs. This is 74% more than without this planning approach. NO PLANNING 100,000 CAPITAL GAIN TAX 360,000 INHERITANCE TAX 865,000 TO HEIRS 1 MILLION BUSINESS 325,000 OTHER ASSETS 1,505,000 TO HEIRS 300,000 INCOME TAX RELIEF* 1,000,000 EIS INVESTMENTS 1 MILLION CGT AND IHT FREE * Reduced to 180,000 after IHT on death. 14

18 Next steps These are just a few of the tax planning solutions that utilise Trusts, Business Property Reflief, VCT and EIS. We d be happy to discuss these and other planning ideas, and understand how we could work more closely with you to help meet your clients wealth planning requirements. Please contact us for more information T (Glasgow Office) T (Edinburgh Office) E. info@aglwealth.com W. * These types of investments are not suitable for everyone and an investor may not get back the full amount of their investment 15

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20 Glasgow Office AGL Wealth Management Ltd 69 Buchanan Street Glasgow G1 3HL T: F: E: W: Edinburgh Office AGL Wealth Management Ltd 23 Melville Street Edinburgh EH3 7PE T: F: E: AGL Wealth Management Ltd is authorised and regulated by the Financial Conduct Authority. Registered in England No Registered Office: 1st Floor, 2 Woodberry Grove, North Finchley, London N12 0DR