CHAPTER 14 ANNUITIES

CHAPTER 14 ANNUITIES In this chapter you will learn about the tax treatment of annuities including: What is an annuity; Income tax on annuities; IHT treatment of annuities; Anti-avoidance rules for IHT. 14.1 What is an Annuity? An annuity normally takes the form of a fixed amount of annual income to be paid out of a trust. For example a discretionary trust could be required, under the terms of the deed, to pay a fixed amount every year to a nominated person (called the annuitant ). 14.2 Income Tax on Annuities If a beneficiary is entitled to receive an annuity from a trust, he will do so net of basic rate tax. ITA 2007, s.449 In most circumstances, the annuity is expressed as a gross amount. The Trustees will withhold 20% tax at source, and pay the net amount to the annuitant. The gross annuity is deducted by the Trustees as a deductible payment in the income tax computation. The deductible payment is deducted from non-savings income in priority to interest and dividends. The basic rate tax withheld from the annual payment is paid by the Trustees to HMRC on the normal self-assessment due date. This has the effect of increasing the trustees' liability in the income tax computation. The Trustees will provide a tax deduction certificate (form R185) to the beneficiary certifying that he or she has received a net payment from which basic rate tax has been withheld. The recipient of the annuity will pay any higher rate tax on the annuity via his selfassessment return. Note that the annuity is always received net of basic rate tax (even in instances where the Trustees have insufficient non-savings income and interest to cover the payment). Reed Elsevier UK Ltd 2015 147 FA 2015

Illustration 1 The Wood Family Trust is a discretionary trust for the descendants of Lawrence Wood. The trust income is payable at the discretion of the Trustees after payment of an annuity of 10,000 (gross) to Danny (Lawrence Wood's godson). The trust income and expenses for 2015/16 are as follows: Income Rental profit 14,000 Gilt interest 12,500 Bank interest (net) 4,400 UK dividends 7,200 Expenses Trust management expenses 900 The income tax payable for 2015/16 is: Non savings Interest Dividends Property income 14,000 Gilt interest 12,500 Bank interest ( 100/80) 5,500 Dividends ( 100/90) 8,000 14,000 18,000 8,000 Less: Annuity (10,000) Taxable income 4,000 18,000 8,000 Less: Expenses (900 100/90) (1,000) Income subject to RAT 4,000 18,000 7,000 Tax 1,000 @ 20% 200 (4,000 1,000) @ 45% 1,350 18,000 @ 45% 8,100 7,000 @ 37½% 2,625 1,000 @ 10% 100 12,375 Add: Tax deducted from annuity (10,000 @ 20%) 2,000 Tax liability 14,375 Less: Credits (1,100 + 800) (1,900) Tax due 12,475 Danny will receive his annuity net of basic rate tax and the Trustees will provide him with a form R185 as follows: Net Tax Annuity 8,000 2,000 Danny will pay any higher rate tax (if appropriate) via his SA return. Reed Elsevier UK Ltd 2015 148 FA 2015

14.3 Free of Tax Annuities In practice, most annuities are expressed as a gross amount from which basic rate tax is paid at source by the trustees (as per the illustration above). However annuities can be expressed as a net amount. Such annuities are called free of tax annuities. The purpose of a free of tax annuity is to guarantee the beneficiary the same net amount each year. This ensures that the annuitant will receive the same amount each year even if the basic rate of tax subsequently changes. The payment received by the annuitant is then grossed up for basic rate tax. At the moment, payments will be grossed up at 100 over 80 to reflect a basic rate of 20%. As with normal annuities, the gross amount of the annuity is deducted from non savings income as a deductible payment. The Trustees are then required to account to HMRC for the basic rate tax deducted. If the annuitant is due a tax repayment for example because his income for the tax year is covered by personal allowances the tax deducted at source by the Trustees (or a proportion of it),must be repaid to the trust. This is because the annuitant is reclaiming tax that was paid by the Trustees. Illustration 2 Wesley is entitled to an annuity of 3,200 from a trust. This is expressed to be free of tax. This means that Wesley will physically receive 3,200, after the deduction of basic rate tax at source. R185 Net Tax Annuity 3,200 800 Wesley has a part-time job paying a salary of 8,000 per year. Calculate Wesley s tax due / (repayable) for 2015/16. Employment income 8,000 Annuity 4,000 12,000 Less: PA (10,600) Taxable 1,400 1,400 @ 20% 280 Less: Credits (800) Tax repayable to Wesley (520) Let us now look at Wesley's tax position for 2015/16. The proportion of the repayment that relates to the annuity is: Total tax repayment Gross annuity/total income i.e. (520) 4,000/12,000 = (173). Reed Elsevier UK Ltd 2015 149 FA 2015

The tax repayment relating to the annuity income is therefore 173. Wesley must therefore repay this 173 to the Trustees. Note that the need to refund tax repayments to the Trustees only applies in the case of free of tax annuities. If an annuitant receives a gross annuity from which tax is withheld at source and the annuitant is in a tax repayment situation, no part of that repayment needs to be returned to the Trustees. 14.4 IHT Treatment of Annuities An annuity normally takes the form of a fixed amount of annual income to be paid out of a trust to a nominated beneficiary. The annuitant has a present right to enjoy some of the income of the trust and therefore has an interest in possession (IIP) in part of the trust fund. The IHT treatment of the interest in possession depends on whether it satisfies the definition of a qualifying IIP. If the right to income arose either before 22 March 2006 or on death, the annuitant has a qualifying IIP. Therefore the part of the trust fund in which he has that IIP will form part of his death estate. In these circumstances the capital value of the annuity needs to be valued. S.50(2) IHTA 1984 says that where a person is entitled to a specified amount of income, his interest in the trust is the taxable amount of capital required to provide the annuity. IHTA 1984, s.50(2) HMRC refer to this taxable amount as the annuity slice. This annuity slice is normally arrived at by an apportionment of trust income arising in the last tax year. Illustration 3 The Wood Family Trust is a discretionary trust for the descendants of Lawrence Wood. It was set up by Lawrence Wood in January 2005 with 1 million in cash. The trust income is payable at the discretion of the Trustees after payment of an annuity of 10,000 (gross) to Danny (Lawrence Wood's godson). The trust income for 2015/16 is as follows: Property income (net of expenses) 14,000 Gilt interest 12,500 Bank interest (net) 4,400 UK dividends 7,200 Danny died on 15 May 2016 at which point the trust assets were valued at 1.8 million. Danny's is entitled to trust income and therefore has an interest in possession in part of the fund. Reed Elsevier UK Ltd 2015 150 FA 2015

His interest arose before 22 March 2006 and is therefore a qualifying IIP. Part of the trust will therefore fall within Danny's death estate. Calculate the "annuity slice". To calculate the annuity slice we multiply the capital value of the trust by the proportion that Danny's income entitlement bears to the total income of the fund in the preceding tax year (here 2015/16). Gross trust income is: Property income (net of expenses) 14,000 Gilt interest 12,500 Bank interest ( 100/80) 5,500 UK dividends ( 100/90) 8,000 Total gross income 40,000 The taxable amount of capital required to provide the annuity is therefore: 1,800,000 10,000/40,000 = 450,000 This is the annuity slice which will fall into Danny's death estate for IHT purposes. 14.5 Annuities Anti-Avoidance The annuity slice can be artificially reduced in order to avoid inheritance tax. Given that the capital value of the annuity slice is determined by the levels of trust income, the Trustees can manipulate the capital value by changing their investment policy so as to deliberately reduce or decrease their income. However there are anti-avoidance provisions which prevent the Trustees obtaining a tax advantage by artificially reducing or increasing income yields. Illustration 4 Danny is the annuitant of a Trust and is entitled to gross income of 10,000 per annum. Annual trust income is typically 40,000 per annum. Therefore the capital value of Danny's annuity slice is ¼ of the value of the trust fund. This is charged to IHT on Danny's death. Assume that Danny had been diagnosed with a terminal illness such that his life expectancy is no more than a couple of years. The Trustees therefore decided to change the asset base of the trust so as to generate high-income yield at the expense of capital growth. This increased the gross income of the trust from a normal annual return of around 40,000, to an income yield of 80,000. When Danny dies, the taxable amount of capital required to provide the annuity is now: Value of trust assets 10,000/80,000 By increasing trust income, the annuity becomes a smaller percentage of total income such that the annuity slice is reduced from ¼ of the fund to ⅛th. Reed Elsevier UK Ltd 2015 151 FA 2015

Illustration 5 Conversely, trust income yields can be artificially decreased in order to reduce annual income for the purpose of valuing the remainder of the trust. Richard is the life tenant of the De Vere Family Settlement which was created on the death of his father in January 2008. Richard is entitled to the annual net income of the trust, after payment of a gross annuity of 20,000 to his cousin Margo. The Trustees have historically invested in a mixture of bank deposits, gilts and UK equities producing annual gross income of around 100,000. The trust fund was valued at 4.5 million in April 2015. Richard has decided to gift his life interest to his daughter Penny. The transfer will take place on Penny's 21 st birthday in June 2016. Penny will become the new life tenant and thereafter entitled to the annual net income of the trust. Richard has an immediate post death interest and therefore has a qualifying IIP for IHT purposes. His gift of his life interest to Penny will therefore be a chargeable lifetime transfer for IHT. Penny will not have a qualifying IIP as her interest in possession arises after March 2006 and will not satisfy the conditions to be either an immediate post death interest or a transitional serial interest. The trust assets will therefore become relevant property. As an IHT liability will arise in June 2016, the transfer must be valued. Using the 2015 value and 2015 income yields, the capital required to provide the life tenant's annual income (ie, the trust fund after the annuity slice ) is: 4.5 million (100,000 20,000)/100,000 = 3.6 million Assuming no changes in asset values or dividend yields, Richard's transfer of value in June 2016 will therefore be 3.6 million. Prior to the transfer taking place, the Trust decided to change the asset base of the trust to invest a significant amount in development land. The land produces no income but the Trustees hope that the investment will generate good capital growth in the short to medium term. Consequently, trust income is reduced to 30,000 in 2015/16. Of this, 20,000 is still required to pay the annuity leaving 10,000 of income to flow though to Richard who is the life tenant. At the date of the gift of Richard's interest to Penny in June 2016, the trust assets are still worth 4.5 million. However, the capital value of the remainder of the fund (after deducting the annuity slice) is now: 4.5 million (30,000 20,000)/30,000 = 1.5 million This will now be Richard's CLT in June 2016. The change in the asset base of the trust has therefore reduced the CLT by 2.1 million. Reed Elsevier UK Ltd 2015 152 FA 2015

14.6 Anti-Avoidance Provisions S.50(3) IHTA 1984 This sort of planning is caught by anti avoidance rules in s.50(3) IHTA 1984. IHTA 1984, s.50(3) Where part of the trust fund is being valued, the Treasury prescribe deemed income yields at the higher rate or the lower rate. These deemed yields are then used to compute notional trust income which is then used to value part of the trust fund. The higher rate is used where the annuity slice is to be valued. The lower rate is used where the remainder of the fund is to be valued. The higher and lower rates are prescribed by Treasury Order (most recently in SI 2000/174). SI 2000/174 Note that deemed income yields at the higher and lower rate will only be used by HMRC to calculate capital values where actual income yields are outside normal ranges. Therefore where the annuity slice is being valued, if the income yield does not exceed the higher rate, we use the actual income to calculate the capital value. Where the remainder of the fund is being valued, if the income yield is above the lower rate, we again use the actual trust income to calculate the capital value. Where the whole of the fund is being valued (for example on a winding up of the trust), the anti avoidance rules do not apply. Illustration 6 Continuing from Illustration 5. The Trustees of the De Vere Family Settlement took steps to reduce trust income which in turn acted to reduce the capital value of the fund in which Richard's life interest subsists. HMRC would apply s.50(3) IHTA and would insist that deemed trust income be computed using prescribed income yields. The current income yield (after the acquisition of the development land) is: 30,000/4,500,000 100 = 0.667% HMRC Shares Valuation division quote a higher rate of 4.5% and a lower rate of 1.75%. The life interest part of the fund is being valued, so we need to refer to the lower rate of 1.75%. Actual income yield is less than the lower rate, so we would calculate the capital value of the life interest part of the fund assuming a deemed income yield of 1.75%. Notional trust income would therefore be: 4.5 million 1.75% = 78,750 Reed Elsevier UK Ltd 2015 153 FA 2015

The capital value of the life tenant's share of the fund (after deducting the annuity slice) is now: 4.5 million (78,750 20,000)/78,750 = 3,357,143 This will be Richard's CLT in 2016. In practice, the higher rate is the yield based on the FTSE Government Securities Index and the lower rate is the dividend yield based on the FTSE Share Index. If necessary, these rates will be given to you in your examination. Reed Elsevier UK Ltd 2015 154 FA 2015

EXAMPLES Example 1 The Orchard Family Settlement is a discretionary trust. The trust income is payable at the discretion of the Trustees after payment of an annuity of 20,000 to Matthew. The annuity is expressed to be free of tax. The trust income and expenses for 2015/16 are as follows: Income Rental profit (after expenses) 18,000 Bank interest (net) 25,600 UK dividends 90,000 Expenses Trust management expenses 2,250 Calculate the income tax payable by the Trustees for 2015/16. Example 2 Mark is the life tenant of the Belvedere Family Trust. The trust was set up by his father in 2002. Mark is entitled to the trust income after payment of an annuity of 10,000 per annum (gross) to his cousin Andrew. The trust fund is invested mainly in FTSE 100 equities. The trust income for 2014/15 was as follows: Bank interest (net) 800 UK dividends 53,100 Andrew died on 16 September 2015 at which point the trust assets were valued at 1.5 million. Mark thereafter became entitled to all of the trust income. Assume a higher rate of 4.5% and a lower rate of 1.75%. Show how much (if any) of the trust fund will fall within Andrew's estate for IHT purposes. Reed Elsevier UK Ltd 2015 155 FA 2015

ANSWERS Answer 1 The annuity to Matthew is free of tax. Therefore the payment needs to be grossed up for basic rate tax (20,000 100/80 = 25,000). The gross income used to pay the annuity is then only taxed at basic rate (not at the rates applicable to trusts). Non savings Interest Dividends Property income 18,000 Bank interest ( 100/80) 32,000 Dividends ( 100/90) 100,000 18,000 32,000 100,000 Less: Annuity (20,000 100/80) (18,000) (7,000) Taxable income Nil 25,000 100,000 Less: Expenses (2,250 100/90) (2,500) Income subject to RAT Nil 25,000 97,500 Tax 1,000 @ 20% 200 (25,000 1,000) @ 45% 10,800 97,500 @ 37½% 36,562 2,500 @ 10% 250 47,812 Add: Tax deducted from annuity (25,000 @ 20%) 5,000 Tax liability 52,812 Less: Credits Tax on interest (32,000 20%) (6,400) Tax on dividends (100,000 10%) (10,000) Tax due 36,412 Reed Elsevier UK Ltd 2015 157 FA 2015

Answer 2 Andrew is the annuitant. Therefore on his death in September 2015 we need to calculate the annuity slice. To calculate the annuity slice we multiply the capital value of the trust by the proportion that Andrew's gross annuity bears to the total income of the fund in the preceding tax year (here 2014/15). Gross trust income is: Bank interest ( 100/80) 1,000 UK dividends ( 100/90) 59,000 Total gross income 60,000 The taxable amount of capital required to provide the annuity is therefore: 1,500,000 10,000/60,000 250,000 The trust income yield is: 60,000/1,500,000 100 4% Where the annuity slice is to be valued, the anti-avoidance rules calculate notional yields at the higher rate. In this case the income yield (4%) does not exceed the higher rate (4.5%). Therefore we use the actual income to calculate the capital value. This amount which will fall into Andrew's death estate for IHT purposes is therefore 250,000. Reed Elsevier UK Ltd 2015 158 FA 2015