Life interest trust holding insurance bond

Pre 2006 a UK resident and domiciled father settles an offshore bond on a UK life interest trust equally for his four children. Bond matures on the last of the children to die. Father died last year predeceasing his children.

One child (UK resident and domiciled) dies and one quarter of the value of the unmatured bond is subject to IHT, payable by the trustees.

Without any other assets, the trustees need to encash part of the bond to pay the IHT. Ordinarily the bond encashment would give rise to a chargeable event, taxable to income tax on the trustees at 45%. So overall a tax charge of up to 85%.

Do members consider if there is any form of relief here? Either a:

  1. valuation discount for IHT because of the inherent income tax charge, or
  2. perhaps a reduction in the chargeable event gain under section 507A ITTOIA 2005 (post Lobler case), on the grounds that the gain is wholly disproportionate so that a tax “officer may take into account (as well as the gain) any factor which the officer considers appropriate including …” (my emphasis added).

Has anyone successfully reduced the tax charge in this sort of situation.

Thank you in advance.

Maxine Higgins
Citroen Wells

The answer may perhaps be found in IHTM28160. Where the policy is wholly chargeable in the death estate HMRC seem to agree to a deduction for the chargeable event income tax, although they seem to be conceding this only if the death itself triggers the gain. So they are then prepared to accept that the liability may be treated as arising before the death. If you read other sections in this part of the Manual the common theme is that HMRC seem to accept that if the income is chargeable to IHT it is just and reasonable to allow a deduction for the matching prospective liability even if at the moment of death it is strictly only contingent,

Leaving aside the complication of multiple beneficiaries and the identity of the life assured, a charge to IHT on a policy in the estate of a single beneficiary who predeceases the life assured is a far from unusual occurrence. Indeed any settlor who settles a policy on their own life for a sole or joint absolute interests (if only in default as subject to defeasance via a power of appointment) needs to be warned of the possibility. Because such a policy when it matures will be invariably not give rise to a charge to income tax or CGT the problem of a contingent liability to such tax will not be relevant. But if it did it would surely be deductible. The quantification might be an issue because the payment would be deferred until maturity.

In your case HMRC might object that the liability arises because you have chosen to cash in part of the bond. But that is beside the point. The IHT charge is based on the fiction that the deceased’s share of the policy could be sold in the open market and the hypothetical willing purchaser would surely make a price adjustment for any tax liability inherent in the asset. So the acid test is: would he have no choice when the policy matured but to suffer a deduction for the tax payable by the trustee? Would the trustee get a good discharge by paying an assignee of the policy only the net amount? The assignment of a part interest in a policy could only be equitable but that does not matter; the analogy is with an assignment of an interest in settled property which may result in CGT not only on a future disposal of it but which also may suffer the underlying cost of CGT on an absolute entitlement gain taxable on the trustees and which they can properly recover from the settled property.

So in my view, if your client is only entitled to a share of the net of tax proceeds on maturity or earlier surrender of the entire policy, and not of the gross (which seems right as the income tax is not his liability), the tax is deductible. It seems HMRC only disallow a deduction to a deceased settlor because of his right to recover the tax. But you have accelerated the tax payable (due to the trustees’ illiquidity) so you may be met with the argument that what is deductible is not the actual tax payable but rather the NPV of the tax payable on maturity, which probably involves an estimate of the life expectancy of the life assured and an agreement on the interest rate for discounting.

Jack Harper

On reflection I may have missed the wood by focusing on the tree of the tax liability. Surely what is in the death estate is a chose in action, the deceased’s interest in the trust, which just happens to hold an insurance policy as the trust property. IHT is chargeable on the open market value of that asset which will be its net of tax value if the tax is deductible from the trust property. The entire value of the chose in action must be discounted by reference to the future date when it can be turned into cash. The owner of it could presumably not himself turn it into cash, the trustees alone had that right, so there is no justification for HMRC arguing that it was readily realisable. (They do have some funny ideas at times, such as that unbilled work in progress is “really” an account receivable; if only it were so!).

Jack Harper