Debt and charge scheme - income tax on the increase

Hi all,

I am dealing with a matter where the husband died leaving the usual nil rate band discretionary trust in his will. The nil rate band amounted to £184,000 and this was loaned to the wife in 2005 on the usual RPI linked basis. The property is due to be sold and the RPI repayment is likely to lead to an increase of just short of £100,000. The trustees intend to repay the debt as the wife has moved into care, hence the sale of the property. They are currently trying to decide how much of the increase to waive.

An important factor for them in their decision is how much income tax will be payable on the increased amount. I had always understood that the increase would be taxed at the basic rate of 20% but given that the repayment is to a discretionary trust I am now doubting myself and wondering if it would be taxed at 45%.

I would appreciate any guidance.

Thank you in advance.

Claire Cutts
Hartley & Worstenholme

Hi Claire

As you say, as the interest on the loan is being repaid to the trustees of a discretionary trust, the trustees will be liable to pay income tax on the interest at the rate applicable to trusts. Assuming that there are no other trusts set up by the same settlor, then the income tax rates will be 20% on the first £1,000 and 45% on the remainder above £1,000.

One saving grace is that if the trustees then distribute the income to one or more beneficiaries, then the income payments will be franked with a 45% tax credit, so any surplus tax over and above the beneficiary’s personal income tax rate can be reclaimed. So for example if the beneficiary had pension or salary income of £20,000 and you paid £20,000 of gross trust income to them, they could reclaim 25% income tax (45% - 20%). I hope this helps.

Philip Evans
Graham & Rosen Solicitors

There is a very informative discussion of this topic in James Kessler’s book on drafting trusts and will trusts. There is an argument that the indexation uplift is not subject to income tax, but it is not an argument, apparently, that HMRC are happy to accept.

Paul Davies
Clarke Willmott LLP

So for future reference when drawing up a loan document of this nature would it be best not to require the re-payment of the loan subject to RPI? Instead just the initial sum?

Sharon Edelstyn
Phoenix Legal Group

The need to set up this sort of arrangement has become much less common since the TNRB, although it will still be useful from time to time (mainly where either spouse had been widowed previously and there is an extra NRB floating around needing to be captured).

The indexation and interest will increase the amount of the loan/charge, which in turn will reduce the surviving spouse’s net estate and, thereby, save IHT. However, I would ensure that there is a mechanism/power for waiving any indexation/interest.

It may be that one can waive the indexation/interest without it affecting the amount of IHT. For example, suppose the taxable estate after deducting all NRBs but before deducting the debt/charge amounts to £300k and the debt/charge amount is a total of £425k, comprising £325k plus £100k indexation/interest: there is no IHT to pay; even if the £100k indexation/interest is waived, there is still no IHT because the debt/charge of £325k covers the whole of the taxable element of the estate.

However, if the estate is larger, then all of the indexation and interest will serve to save IHT @ 40%; if only one of indexation/interest is charged, then HMRC will seek to tax that as income; if that “income” is distributed to a taxpayer (or divided amongst a number of beneficiaries, possibly even split over two tax years) who is not going to pay 45% income tax, then either the net effect is likely to be the same (eg although the estate saves 40% IHT while the beneficiary is taxed at 40%, or there will be some tax saving if the beneficiary is a 0%/20% taxpayer).

I did read it discussed that if both indexation and interest were charged (according to the documentation), then only the interest would be subject to income tax, whilst the indexation would not be chargeable. The consequence of that was that if the interest were waived, the indexation would not be subject to income tax, as it was only the interest that was going to be chargeable. I would not like to rely on that view without the client appreciating that HMRC might take a different view.

As I say, if the indexation/interest is needed to save IHT, then the income tax can often be mitigated to an extent by judicious distribution to beneficiaries, so I would look to see whether it is possible to achieve that in the first instance.

Paul Davidoff
New Quadrant Partners

That’s very informative thank you. A few years ago I dealt with an estate where the deceased had (following her spouse’s death) entered into a NRB loan arrangement which was RPI linked (but no interest was charged - I assume because the Trustees thought that the indexing would not be taxable to income tax) and although her estate was well below the NRB because of the RPI element the executors had to pay income tax of approximately £20,000.00. The beneficiaries were not higher rate tax payers and they reclaimed the additional income tax through their accountant. As you say such schemes are not so common but you do find a few clients who want to retain the NRB to try and protect a portion of their estate being used for care home fees.

Sharon Edelstyn
Phoenix Legal Group