A client recently raised an intriguing proposition based on a suggestion from his IFA; could he put his inheritance due from his mother’s estate into a Discretionary Trust, and then borrow it back?
The intention was that, with his children/grandchildren also named as beneficiaries, the client could exercise considerable discretion over the application of the funds, including gifting funds to his children which would amount to a potentially exempt transfer (PET), providing he survived 7 years from the date of the gift. On his death, the Trust would recover the debt which would in turn reduce the inheritance tax (IHT) liability on his free estate.
The intended benefit would be that the client could enjoy his inheritance without having to suffer the IHT consequences of increasing the value of his own estate which would interfere with his own IHT planning.
My immediate thought was a resounding NO; if it was that straightforward, it would likely be more common practice. However, on further consideration, I couldn’t find any concrete guidance to categorically state that this wouldn’t work.
Below, I’ve listed a number of compelling arguments suggesting that this approach may not hold up in practice:
The Trust model scenario noted above would likely amount to a ‘sham’. That is to say that whilst it is a proper Trust on paper, in practice the Trust lacks substance and genuine purpose. Particularly because the client’s intention is to always retain the full benefit of the assets.
Although it doesn’t meet the criteria, it is possible that HMRC would treat this as an ‘Associated Operation’ under Section 268 of the Inheritance Tax Act 1984; on the basis that the client would not have entered into a Deed of Variation on these terms had he not been able to loan the money back to himself. An ‘Associated Operation’ refers to a situation whereby connected transactions attempt to avoid inheritance tax; in this example, by using the Trust as an intermediary. There is, therefore, a high probability that HMRC will disregard the ‘debt’ on this basis.
The structure proposed does raise a question over the proper exercise of the Trustee’s fiduciary duties. If the client and his spouse are to be the Trustees and they lend the whole Trust Fund back to themselves, this may be construed as a conflict of interest and breach of duty. Receiving the entire Trust Fund as a loan creates a direct financial benefit to the Trustees and puts them in a position where their personal gain (receiving the loan) directly conflicts with their duty to manage the Trust assets prudently for the beneficiaries. As they are also the beneficiaries, the client/spouse would not take issue with this. Fundamentally, this dual role creates inherent problems that undermine the very purpose of a Trust.
As the Trust’s only assets will essentially be a debt, it is unlikely that regular reporting to HMRC will be necessary. However, this is predicated on the assumption that the total value of the Trust Fund does not exceed the Nil Rate Band (currently £325,000). Of course, if the Nil Rate Band is lowered in the future, there will be taxation consequences and reporting requirements. However, on a technical note, the loan will be redeemable at any point; again, in practice this is unlikely to matter as the client’s will not choose/need to redeem it at any point. The chance of HMRC allowing this is slim at best.
The notion that the client’s estate will benefit from a debt of the value of the loan in addition to the tax-free allowances available at the time of death can prove problematic to their estate. The principle on paper is sound, however in practice, there is a high expectation that this will be heavily scrutinised by HMRC on the client’s death. In this event, the legal fees and time dedicated to address this with HMRC will likely be substantial.
Realistically, no one can know whether this model will work until it is tried. The law governing Trusts/Inheritance is subject to change and whilst it is somewhat plausible that this proposal may work as things stand at the present, this may not be the case at a later date. In conclusion, if something sounds too good to be true, it usually is.
Related Expertise
Disclaimer: This publication is provided by Laytons LLP for informational purposes only. The information contained in this publication should not be construed as legal advice. Any questions or further information regarding the matters discussed in this publication can be directed to your regular contact at Laytons LLP or Laytons’ Private Wealth & Philanthropy team.