It may surprise you to know that as a Tax Adviser, I too do a bit of shearing from time to time! Let me explain.
Inheritance Tax (IHT) is charged when you die, on your estate at death plus any gifts made in the previous seven years. The first £312,000 (for 2008/09) is charged at 0% (the “nil rate band”), and the rest at 40%.
IHT is also charged on gifts made at any time if the gift was a “gift with reservation of benefit” (a GWROB). The classic GWROB is where you give your house away, perhaps to your children, but continue to live there, but the GWROB rules apply in any case where you are still able to “enjoy” (a legal term which broadly means “benefit from”) an asset you have given away. This will be a GWROB and when you die, the asset will still be included in your estate.
Tax advisers have been very ingenious in trying to find ways around the GWROB rules, because many people cannot afford simply to give assets away and cease to enjoy any benefit from them.
The principal technique used is known as “shearing”. This means splitting an asset up so that most of its value can be given away, but it can still be “enjoyed” in some form by the giver.
A popular example of “shearing” used to be the lease scheme for your home. Say you own the freehold of your family home. You arrange to grant yourself a lease for your best estimate of your remaining lifespan (plus a few years for good luck!) at a peppercorn rent, and then you give the freehold away to your children.
The lease has little value in your estate, and as the lease gets shorter and shorter as the years go by, the value of the freehold (which is now owned by your children, not you) goes up. By “shearing” the lease out of the freehold, you have passed on most of the value in your home to your children, and you have not made a GWROB because you have given all the freehold away, and the lease is a separate asset “sheared” from the freehold.
Unfortunately, this no longer works, because anti-avoidance legislation was introduced in the 1990s to prevent it, and even those who had “sheared” their leases before the new legislation came in are now likely to be caught for an income tax charge on the rental value of the property. This is the “previously owned asset tax” or POAT.
Some forms of “shearing” still work, however. A popular one is the “discounted gift” scheme. This comes in many forms, mostly marketed by insurance companies. The bare bones of the scheme are as follows:
You give a cash sum to a trust, which is held in favour of whoever you wish to benefit, but you reserve the right to a repayment from the trust of 5% of the sum given each year. The value of the gift is therefore not the actual sum you have given away, because it is burdened by the obligation to pay you back 5% per year.
The extent to which such a gift is “discounted” depends on your age and your state of health. Brutally put, the sooner you are likely to die, the smaller the discount because the fewer the years you will be around to collect your 5%.
You might think that this is a clear example of a GWROB, but HMRC accept that it works, and even have a helpful article on their website on how to calculate the discount!
This scheme has three advantages from an IHT point of view:
· You can carry on enjoying an “income” of 5% from the money gifted (and because this is a repayment of capital it is tax free, so for a 40% taxpayer the yield is equivalent to 8.33% of taxable interest).
· If you survive for seven years, the cash gifted is out of your estate for IHT purposes.
· Even if you do not survive for seven years, the discount on the value of the gift means that for IHT purposes you have given away less than if you simply handed the cash directly to your children.
There are other “shearing” schemes, some of them more sophisticated than this, which enable you to have your cake (or rather give away your cake) and continue to eat it. How about a scheme whereby you can enjoy the income from a buy to let property whilst its capital value is outside your estate once seven years have passed since the structure was set up? It can be done, by a skilled “shearer”, but as those New Zealanders told me when I asked how they could work so quickly:
“That’s a trade secret, mate!”