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R06 Expected Solution Case Study 2

Wizard Learning

April 2012

R06 Expected Solutions – April 2012

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Table of Contents

Introduction ......................................................................................................................... 3 Errors and Inconsistencies ...................................................................................................... 3

Financial Aim 1 – Ensure they have an adequate income in retirement. ........ 5 Fact finding .................................................................................................................................... 5 Analysis ........................................................................................................................................... 6

Maximum Pension Contribution (including carry forward) ................................................ 6 Maximum SIPP Borrowing Calculation ......................................................................................... 7 Suitability of investments ................................................................................................................... 8 Shortfall Calculation .............................................................................................................................. 9

Recommendation & Justification ........................................................................................... 9 Questions that could be asked ..............................................................................................11

Financial Aim 2 – Minimise the impact of Inheritance Tax on their estate 14 Fact finding ..................................................................................................................................14 Analysis .........................................................................................................................................14 Recommendations and Justification ...................................................................................17 Questions that may be asked .....................................................................................................18

Financial Aim 3 – Ensure that their investments are arranged in a tax efficient way. ..................................................................................................................... 23

Fact finding ..................................................................................................................................23 Analysis .........................................................................................................................................23 Recommendations & Justification .......................................................................................25 Questions that could be asked ..............................................................................................26


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Case Study 2 – Peter & Katie

Introduction This case study is about an older couple Peter & Katie. The CII have confirmed that they are in fact married, an important fact that was omitted from the original case study and which has an impact on the planning for these clients. They have two daughters, both married with one child each and there is a suggestion about the financial stability of one of their sons in law. Katie (60) works for a logistics company, and while we are told that she expects £25,000 per annum income from her company defined contribution pension scheme, there is no information about her earnings or the details of the scheme. Peter (62) is in the process of extracting himself from his business and his partners have agreed to buy him out for £700,000. He has a SIPP which includes property and borrowings though little else is known about his pension arrangements. Their main financial objectives are to:

Ensure that they have an adequate income in retirement Minimise the impact of inheritance tax on their estate Ensure their investments are arranged in a tax efficient way

Errors and Inconsistencies A common feature of the earlier papers, these have not really appeared in more recent exams. For this case study however, there are some clear inconsistencies to be taken into account:

Katie has stated that her pension scheme is a defined contribution scheme, which is a money purchase arrangement, however she refers to the benefits in terms of the pension amount that she will receive at retirement rather than the fund value. The expression of benefits as a pension is more closely associated with a defined benefit scheme.

They have said that they are balanced risk investors, however Peter’s pension scheme appears to be invested in a single asset class (commercial property). This apparent lack of diversification would raise the risk profile of the SIPP to one which is not consistent with a balanced risk profile.

Katie is also talking about investing in AIM shares which are highly speculative and also not commensurate with a balanced risk profile.


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They have stated that Peter has agreed £700,000 for the sale of his

business assets. They have not qualified whether this is the net or gross amount he expects to receive or whether they have taken any account of the tax that may be due on the sale or when this would be paid.

They plan to make a joint gift of the sale proceeds of the business to their grandchildren even though the sale proceeds are actually Peter’s (so he would have to assign some of them to Katie first prior to gifting), and more importantly they may have an income shortfall that needs to be addressed.


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Financial Aim 1 – Ensure they have an adequate income in retirement.

Fact finding State the additional information an adviser would need before being able to make any new recommendations relating to providing an adequate income for Peter & Sally in retirement.

We know that Peter is about to retire, what is the proposed timescale? Does Peter intend to stop work entirely or will he continue in a

different/consultancy role for a period of time? When does Katie wish to retire? Will she continue to work or will she stop

working at the same time as Peter? They have stated that they would like an income in retirement of £70,000

per annum gross. How does this relate to their current earnings and expenditure?

How have they arrived at this figure? Have they completed an expenditure analysis, and will their pattern of expenditure change when they retire?

What are their current earnings? There are no details of current earnings for Peter or Katie.

Request full details of Katie’s pension, including current and transfer values, contribution history, investments and charges, plan type and retirement options. Also request projected benefits to NRD and desired retirement age if different.

Katie expects her pension to provide £25,000 per annum of pension at retirement. What is this figure based on? Does this include any element of pension commencement lump sum?

Request details of Peter’s SIPP. Are there any other assets apart from property? When were the two properties last valued? Additional information about the properties and the lease agreements, when are rents due to be reviewed? Also request a contribution history and fee structure to assess the cost of managing the scheme. Does Peter have any unused relief from previous tax years?

Do Peter or Katie have any health problems or adverse family health history? Are they smokers?

Confirm their attitude to investment risk in relation to their retirement planning objectives.

What is their attitude to spouse benefits? What other sources of income do they have including any other pensions

not mentioned? What income is produced by their investments, the dividend yield on the OEIC and the interest rate on the savings account. Are there any penalties or notice periods on the savings accounts?

How much of these assets are they willing to use for income in retirement? What is their entitlement to state pensions and when are these payable

from? Suggest that they visit the www.direct.gov.uk website for pension age checker and to request pension forecast or complete a BR19 form.

http://www.direct.gov.uk/


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Are they prepared to downsize and release capital from their property to help fund a shortfall in retirement income. Would they consider equity release?

Analysis Explain when Katie will become entitled to her state pension.

As Katie is 60 attained she must have had her birthday within 12 months of the date of the fact find/case study.

This means that her date of birth must fall between April 1951 and April 1952.

As such she will not become entitled to her pension on her 60th birthday but sometime between ages 60 and 65.

If her birthday was at the beginning of the year, April 2011, she would be entitled to her state pension at age 61 and 1 month, which would be in May 2012.

If her birthday was recent say April 2012, she would not be entitled to her state pension for another 2 years and 1 month (age 62 and 1 month) in May 2014.

There is plenty of scope for a range of calculations; however there is not sufficient information to provide a proper worked example for Peter and Katie. Listed below are the types of calculation which could be associated with this financial aim and a guide as to how these calculations could be carried out.

Maximum Pension Contribution (including carry forward)

To carry out this calculation you would need the following information:

Total relevant UK earnings for the current tax year The pension input periods for the current and previous tax years Contribution history (pension input amounts) for the current and last

three tax years There are also some eligibility criteria to bear in mind:

In order to carry forward tax relief from an earlier tax year, an individual must have been a member of a registered pension scheme in that tax year.

They do not need to have been a member of the scheme to which they are planning to make the contribution, and the scheme itself could have been any form of registered pension scheme

There is no requirement for the individual to have made any form of pension contribution in the earlier tax year.

The individual must use all of their allowance from the current tax year before being able to carry forward.

When looking at the three previous tax years, any excess contribution over the notional annual allowance (£50,000) in one of those years will


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have no impact on any unused annual allowance being carried forward from an earlier year, or on any unused annual allowance in a later year i.e. each year is looked at in isolation. This only applies specifically to the 2008/09, 2009/10, and 2010/11 tax years.

The maximum amount of personal contributions eligible for tax relief is limited to 100% of the individual’s relevant UK earnings for the current tax year(or £3,600 if greater).

Example Calculation: Assume that Peter has paid £50,000 to his pension in the input period ending in the current tax year (2011/12). In previous tax years he has paid £20,000 in 2008/09, £10,000 in 2009/10 and £20,000 in 2010/11.

Tax Year Pension input amount

Unused Allowance

Cumulative carry forward available

2008/09 £20,000 £30,000 £30,000 2009/10 £10,000 £40,000 £70,000 2010/11 £20,000 £30,000 £100,000

In order to qualify for tax relief on the maximum contribution available of £150,000 (£100,000 carry forward plus £50,000 already paid in current tax year), Peter’s relevant UK earnings would need to be in excess of this amount. Where Peter could not pay the whole amount, the relief from the furthest back tax year is used first, and then the next furthest and so on. In the next tax year the furthest away tax year (2008/09) will have dropped off and any unused relief in that year would be lost.

Maximum SIPP Borrowing Calculation

The case study states that Peter may acquire further assets for the SIPP. You may therefore be required to calculate the maximum additional borrowing available to the SIPP trustees. The value of the two properties held within the SIPP are given as £600,000, but there is no confirmation that this is the full value of the SIPP, and whether or not the SIPP holds cash and/or other assets. The current borrowings are £100,000. For the purposes of this calculation we will assume that the total value of the SIPP is £600,000. The overall maximum borrowing permissible by the SIPP is 50% of the net asset value of the SIPP. The maximum borrowing calculation is therefore as follows: Step 1 – calculate the net asset value of the SIPP

£600,000 - £100,000 = £500,000

Step 2 – Multiply by 50% £500,000 @50% = £250,000 Step 3 –deduct any outstanding borrowing

£250,000 - £100,000 = £150,000

The maximum permissible further borrowing is therefore £150,000.


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Suitability of investments

You may also be asked to comment on the suitability of their current investments in relation to their financial aim. Peter’s Pension – The only details we have are in respect of the property held within the SIPP. While these are providing a good yield, circa 6.67% per annum, which could be used to provide income, if he has no other assets in his SIPP, where would he take his pension commencement lump sum (PCLS) from if required? The maximum PCLS available based on a net value of £500,000 is £125,000 (25%). If Peter wishes to take part or all of this where would it be funded from? Would he be prepared to sell one of the properties to fund the PCLS? Bank Savings Account – They have a large amount of cash on deposit which would appear to be more than they would need for an emergency fund. Interest rates are currently low and inflation is relatively high meaning that the buying power of these funds are being eroded over time. This is not commensurate with their supposed balanced attitude to risk. Any interest paid by this account, whether taken out or accumulated, would be divided equally between Peter and Katie and taxed at their highest marginal rate of income tax. Low interest rates will mean that such a large holding in cash may not be suitable in meeting their income requirements when they both retire. Cash ISAs – In addition to the cash on deposit they also have £40,000 each in cash ISAs. While these have the benefits of tax free returns, the low interest rates applicable to cash mean that they will face the same problem as with their other cash holdings. Open-Ended Investment Company – This investment is all in one fund and while it would be appropriate for a balanced investor the lack of diversification within the portfolio means that the investment risk associated with this investment is higher than if it was part of a balanced portfolio. We have no information about the initial investments so don’t know if there would be any CGT implications on encashment, or whether there are losses that could be used against other gains, such as the sale of Peter’s business assets. The income from this fund would be dividend income, and would be shared equally for income tax purposes between Peter and Katie. The gross dividend income would be added to their other income for the tax year and taxed at their highest marginal rate. The yield on an equity income fund is likely to be much higher than an equity growth fund which you would expect to provide very little in the way of income, therefore is likely to be suitable for their objective for income in retirement. Stocks & Shares ISAs – We are told that Peter and Katie have £50,000 each in stocks and shares ISAs, but we are not given any information about the funds they are invested in so cannot give an opinion on the suitability of the


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investments for their attitude to investment risk. The tax wrapper can be very useful in retirement planning as they provide a source of tax free income. Onshore Investment Bond – this plan is invested in a balanced fund which would suggest that it is suitable for Peter and Katie’s attitude to investment risk. We have no details as to how well the fund has performed or the charges that apply. A tax liability will only arise where they take withdrawals from their investment (see below)

Shortfall Calculation

Without additional information it is impossible to establish whether or not Peter and Katie will be able to achieve their desired retirement income. Without an income and expenditure analysis it is not possible to comment on whether or not £70,000 per annum would be sufficient to maintain their desired lifestyle. While the pension is producing an income of £40,000 per annum from the property investments, this is not necessarily the amount of income that Peter would be able to drawdown. Based on a value of £500,000 (net value of the pension without any further information), the maximum GAD that Peter could drawdown is £26,500 per annum (based on a gilt yield of 2.75%). Added together with Katie’s expected £25,000 per annum this would be well short of their expected retirement income. Alternatively, the income he would receive from an annuity would be circa £28,100 assuming he uses the full £500,000 from his SIPP (which in turn assumes he sells both properties) and purchases a single life annuity with no guarantee paid monthly in arrears. Source: The Money Advice Service comparison tables. Again, this is likely to be well short of their income requirements.

Recommendation & Justification Explain and justify any recommendations you would make relating to providing an adequate income in retirement for Peter & Katie. Under this financial aim, the most suitable course of action would be to recommend that Peter increases his and Katie’s pension contributions using carry forward so as to boost their pension funds prior to taking an income at retirement. Whilst this could still be funded from their cash deposits/ investments, the most obvious source of money is the sale proceeds from the business – which they intend to give away to their grandchildren even though they have a considerable income shortfall.


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Recommendation Benefits Drawbacks Peter to sell one of the properties in the SIPP to fund PCLS

Will provide cash to pay PCLS.

It may be difficult to sell in the current climate. There will be costs involved in selling. Peter may not be able to achieve the full value of the property. It will take time to complete.

Drawdown an income from the fund within min/max HMRC GAD limits

Will provide an income for Peter. Income is flexible and can be changed based on his circumstances. He can still buy an annuity in the future. Properties could be kept as the source of the income withdrawn.

Future benefits dependent on investment returns, gilts rates and annuity rates which may go down reducing the income in the future. Excessive withdrawals will erode the fund.

Consider diversifying Peter’s pension portfolio

This will reduce the overall risk of the pension portfolio by reducing the reliance on a single asset type. Will also provide some liquidity in the portfolio.

At least one of the properties would need to be sold (unless other assets not yet declared) Same problems as above

Peter & Katie could drawdown income from their investments.

OEIC is likely to have a yield of 2- 5% (dividend income) ISAs can provide tax free income and investment bond could provide 5% tax deferred withdrawals.

Any withdrawals will reduce the investment returns on the investments

They could eat into their savings/investments in order to make up the shortfall

They could make their planned gift; the SIPP could remain uncrystallised and continue to grow thereby maximizing death benefits

This would only be a short term solution as they would in all likelihood use up their capital well before they die. The tax consequences of encashing the OEIC and onshore investment bond would need to be carefully managed.


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Questions that could be asked Outline the factors that would make it difficult for Peter & Katie to achieve their retirement aims.

Rates of investment growth assumed in projections are not attained It turns out they need a higher income in retirement than predicted Katie’s pension will not provide as much income as anticipated, or she has

to wait for that pension income for longer/to age 65 Peter is unable to sell one or both of the properties in the SIPP to release

funds for PCLS The rules relating to levels of income tax worsen Plan charges on their pension arrangements increase Pension legislation changes yet again The rules relating to tax relief change e.g. abolishing higher rate relief Long term gilt yields (and therefore annuity and GAD rates) fall even

further Compare the benefits of capped versus flexible drawdown Capped Drawdown Flexible Drawdown Age Limits 55 minimum with no

upper age limit. 55 minimum with no upper age limit.

Minimum Income Nil Nil Maximum Income 100% of GAD No Maximum PCLS Up to 25% of the fund

whenever taken. Up to 25% of the fund whenever taken.

Reviews Three yearly before age 75, and annually thereafter

No reviews required

Contributions in year plan set up

Permitted Not permitted

On-going contributions Permitted Not permitted Taxation of income Paid net of tax under

PAYE Paid net of tax under PAYE

Conditions for access None Member must be in receipt of £20,000 qualifying secure income (Minimum Income Requirement)

Lifetime allowance test at age 75

Yes Yes

Lump sum death benefits

Crystallised fund paid as lump sum subject to 55% tax charge

Crystallised fund paid as lump sum subject to 55% tax charge

Dependants pension Yes Yes Charity Lump sum Yes, but only payable

where there are no other dependants

Yes, but only payable where there are no other dependants


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Capped Drawdown Flexible Drawdown Change to another drawdown type

If eligibility criteria are met could move the flexible drawdown

No, unless spouse inheriting drawdown does not meet MIR in their own right. Reverts automatically to capped

Phasing Income Yes Yes Inheritance Tax Will not typically apply Will not typically apply Purchase of an annuity Yes at any time Yes at any time Transfer to another drawdown plan

Transfers can be made to another capped/flexible drawdown plan which no other sums or assets are held. Partial transfers are not allowed.

Transfers can be made to another capped/flexible drawdown plan which no other sums or assets are held. Partial transfers are not allowed.

Compare the benefits of capped drawdown versus lifetime annuity Capped Drawdown Lifetime Annuity Security of income Income is dependent on

investment returns, future gilts rates and will fluctuate.

Income is fixed at outset and guaranteed for lifetime of annuitant

Flexibility of income Change be changed within min and max HMRC limits

Fixed at outset and cannot be changed

Spouse benefits Spouse can continue drawdown, buy an annuity or tax a lump sum less 55% tax charge

Spouse benefits must be bought at outset and cannot be added/taken away later

Other beneficiaries Lump sum death benefits can be left to no dependent beneficiaries and to a charity

Usually no lump sum death benefits unless capital protection purchased at outset.

Peter is relatively young so annuity rates would be quite low which may incline him to enter into drawdown pension and wait a few years or more until he purchases an annuity if he does so at all. Whilst annuity rates tend to increase with age, and his health will in all likelihood deteriorate as he gets older, there is no guarantee that annuity rates will increase. Even though annuity rates are low at his age (and at this point in time historically speaking), the income he would receive from an annuity would still be circa £28,100 assuming he uses the full £500,000 from his SIPP (which in turn assumes he sells both properties) and purchases a single life annuity with no guarantee paid monthly in arrears. Source: The Money Advice Service comparison tables. This is still higher than max GAD at current long term gilt yield rates of 2.75% -which would provide an upper limit on capped drawdown of £26,500pa


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Phased drawdown or phased retirement would also be options, both of which would help maximise death benefits (as the bulk of the fund would remain uncrystallised), and could tie in with further circumstances revealed on the day of the exam, but as matters stand in the case study their need is to maximise income once Peter retires, and phasing won’t help with that.

List 3 advantages and 3 drawbacks if the SIPP is used to purchase a new property, rather than Peter directly.

Any 3 of the following :

Benefits Separate from Joseph’s assets, if he was ever declared bankrupt No capital gains tax liability on any growth Rental income received is received tax-free Rental income is treated as investment growth and is not counted as a

contribution

Drawbacks Lack of diversification – especially given the existing properties Property may be hard to sell if liquid funds required e.g. to provide

PCLS Only commercial property can be held within the SIPP The SIPP’s ability to borrow will be limited to 50% of its net asset

value including any existing loans


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Financial Aim 2 – Minimise the impact of Inheritance Tax on their estate

Fact finding Identify any additional information you would need before you are able to make any new recommendations relating to minimizing the impact of IHT on their estate.

Have they made wills? If so when and what are the provisions? What is their state of health and therefore their likely life expectancy? Confirm the type of tenancy under which they jointly own their property

and investments. They have not made any significant gifts, but what do they consider

significant? Have they previously used their annual gift exemptions? Are they willing to gift capital assets? Are they willing to gift out of income? How much are they willing to commit to this aim (capital and income

amounts)? Are they prepared to use trusts as part of their IHT planning? If so who would be the trustees? What is their attitude to risk? They have mentioned that they would consider gifting the sale proceeds

from Peter’s partnership share to the grandchildren. Would they be prepared to do this at the expense of their own income and capital needs?

Have they given consideration to the tax implications (CGT would be due, though probably subject to entrepreneur’s relief) on the sale of Peter’s business assets? Where would any tax be funded from?

Does Peter meet the eligibility criteria for entrepreneur’s relief on the sale of his business assets?

Do they wish to leave anything to charities or political parties?

Analysis Calculate the net value of their estates

Asset Peter Katie Main residence £400,000 £400,000 Chattels £50,000 £50,000 Bank savings account £75,000 £75,000 OEIC £81,500 £81,500 Onshore investment bond

£90,000 £90,000

Cash ISA’s £40,000 £40,000 Stocks & Shares ISA’s £50,000 £50,000 Business Assets £700,000 £0 Total £1,486,500 £786,500


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As there is an agreement in place with the other partners to purchase Peter’s share of the partnership, if Peter were to die now it is likely that these business assets would be included in the value of his estate as they would no longer qualify for Business Property Relief (BPR). If he died after his share of the business was sold but before gifting the sale proceeds, the cash received from form part of his estate. If he died after having gifted the sale proceeds to his grandchildren, this would be a chargeable lifetime transfer (he would probably gift them into trust) and take seven years to drop out of his estate fully There is no mention of any wills in the case study, so we have to assume that they are intestate. The distribution of estate if they die intestate – assuming Peter dies first – is as follows:

The main residence would revert to Katie automatically through right of survivorship (assuming joint tenants = joint tenancy);

She would also receive the next £250,000 of the estate and the value of the chattels absolutely;

Katie would also be entitled to a life interest in 50% of the estate remaining;

Olivia and Lynne would inherit 50% of the remainder of the estate absolutely in equal shares;

They would inherit the remainder of the estate on Katie’s death. The case study stated that all the assets are owned as joint tenants, we

assume this refers to joint tenancy rather than tenants in common. All assets are owned as joint tenants, would pass to Katie automatically by

right of survivorship, and the interspousal transfer exemption would apply to these benefits.

The remainder of the estate (including £700,000 business assets, and £90,000 ISAs) would be distributed as outlined above

Katie would inherit £250,000 absolutely and a life interest in £270,000. Olivia and Lynne would inherit £270,000 absolutely in equal shares and

the life interest from Katie when she dies There would be no IHT payable on Peter’s death as the amount inherited

by the children is within the NRB of £325,000, and the interspousal exemption would apply to any assets transferred to Katie.

The same situation in reverse would be true is Katie died first.


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Explain to Peter and Katie the IHT implications if they owned the property as tenants in common and Peter were to die first without having made a will

The investments would revert to Katie automatically through right of survivorship;

She would also receive the next £250,000 of the estate and the value of the chattels absolutely;

Katie would also be entitled to a life interest in 50% of the estate remaining;

Olivia and Lynne would inherit 50% of the remainder of the estate absolutely in equal shares;

They would inherit the remainder of the estate on Katie’s death. Calculate showing all your workings, the IHT impact of Peter dying intestate where they own the property as tenants in common. £ Total Value of Peter’s Estate 1,486,500 Less Personal chattels (to Katie) (50,000) Less investments (to Katie) (246,500) Less £250,000 to Katie absolutely (250,000) Less £470,000Life Interest to Katie (470,000) Less NRB (325,000) Chargeable estate 145,000 IHT due at 40% £58,000 Calculate showing all your workings the IHT payable on Katie’s subsequent death when the benefits are paid to their children/beneficiaries. £ Total Value of Katie’s Estate 786,500 Plus estate inherited from Peter 546,500 Plus Life Interest 470,000 Less NRB (325,000) Chargeable estate 1,478,000 IHT due at 40% £591,200 There is only one NRB on Katie’s death as 100% of the NRB was used up on Peter’s death.


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Consider the situation if Peter and Katie have mutual wills leaving everything to each other and then to Olivia and Lynne. Calculate showing all your workings the potential IHT payable on second death. £ Total Value of combined estate 2,273,000 Less 2 x NRB (650,000)

Chargeable estate 1,623,000

IHT due at 40% £649,200 Explain to Peter and Katie the potential drawbacks of dying without a will.

The deceased would die intestate The estate would be distributed according to strict rules This means that the surviving spouse would not automatically inherit all

of the estate In Peter & Katie’s circumstances a large portion of their estate would be

left absolutely to the children This could impact on the surviving spouse’s ability to maintain their

standard of living Peter and Katie may not want this as they feel that one of their sons-in-

law is careless with money The probate process could be long and drawn out and joint assets would

be frozen during this time Any IHT due must be paid before the estate can be released

Recommendations and Justification Explain how Peter and Katie could re-organise their current arrangements to minimise the impact of IHT on their estate. Recommendation Benefits Drawbacks Peter & Katie should immediately arrange wills.

This will ensure some certainty in the distribution of their assets and avoid intestacy.

They may have difficulty in facing the prospect of their own mortality.

They could consider gifting assets to Olivia & Lynne /grandchildren.

This will start the 7 year clock to remove assets from their estate. Will be no immediate liability to IHT.

They would lose control of the assets and they would no longer have access to the funds for their own capital/income needs.


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Recommendation Benefits Drawbacks They could consider making gifts to trusts.

This would start the countdown to remove assets from their estate. They would retain a degree of control of the assets.

Their own estate would be deprived of the assets for income/capital requirements. There may be an immediate charge to IHT. Trusts are irrevocable; it may be costly and impossible to get assets back if they change their mind.

They could consider gifting out of income and/or using £3,000 annual exemptions.

No liability to IHT and immediate reduction to the estate for IHT purposes.

This must be from surplus income or IHT charges would apply.

They could make provision for the tax by writing a WOL plan under trust for the beneficiaries of their estate. Joint Life second death basis.

This would provide the funds outside of their estate to their beneficiaries to pay for the tax on their estate.

They would need to have the capacity to fund the premiums long term. The premiums would be based on their age and state of health and could be prohibitively expensive.

They could consider investing in assets that attract Business Property Relief such as the AIM shares mentioned by Katie.

After 2 years, the value of the shares would be exempt from IHT, thereby reducing the value of their estate.

Due to the nature of such investments they are deemed to be high risk, and therefore unlikely to be suitable for Peter and Katie’s attitude to investment risk.

Where they make any lifetime gifts, they could put in place gift inter vivos plans.

This would protect the value of the nil rate band during the 7 years after the gift(s) has been made. This could provide a lump sum to pay for the reducing balance of tax due on the PET, and a separate amount to provide for the extra tax payable as a result of the loss of the NRB during the 7 year period

Again affordability and premium cost will be an issue.

Questions that may be asked Describe four methods by which Peter and Katie could immediately reduce the Inheritance Tax value of their estates.


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Make substantial lifetime gifts for the benefit of Olivia and Lynne, or their grandchildren, either directly or into a trust

Make regular gifts from income/£250 using the normal expenditure exemptions/small gifts exemption

Use the annual exemption of £3,000 per annum and any unused exemption from the previous year

Discounted gift trust within the nil rate band could be set up

Recommend and justify a suitable type of insurance policy to cover Peter and Katie’s Inheritance Tax liability on second death and state how the policy should be set up.

A joint life, last survivor/joint life second death whole of life policy with a sum assured

based on the current IHT liability written in trust for the benefit of Peter and Katie’s daughters.

Indexed benefits so that benefits increase with assets in the estate/increasing liability.

Policy written on a guaranteed/non-profit/minimum basis to meet their attitude to risk.

Explain to Peter and Katie the advantages and disadvantages of gifting £700,000 to a discretionary trust rather than gifting assets directly to their grandchildren. Advantages

As Trustees, Peter and Katie can retain some control over when and to whom the assets of the trust are distributed

The beneficiaries of the trust are not named so there they can keep their intentions confidential

There would be some protection of the assets should one or both of thier grandchildren prove to be irresponsible with money in the future

They would be able to make awards of capital and/or income towards the children’s education costs while they are growing up

A discretionary trust can be easily used where more grandchildren are born in the future

Disadvantages

A gift to a discretionary trust is treated as a chargeable lifetime transfer and may be liable to an immediate IHT charge at the lifetime rate of 20%.


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Peter would have to assign/gift half of the assets to Katie first to make a joint gift

The £700,000 is in excess of their joint Nil Rate Bands of £650,000 meaning that a lifetime allowance charge of £10,000 would be incurred if paid by the trustees, or £12,500 if paid by Peter & Katie directly

Where as a gift made directly to the grandchildren would be treated as potential exempt transfer (PET) and there would be no immediate liability to IHT.

Additional IHT may be due where Katie and/or Peter were to die within 7 full years of making the gift

Additional IHT liabilities would arise via periodic and exit charges The capital would no longer be available to meet their own income and

capital needs Outline the basic details of a Discounted Gift Trust and explain how this could help Peter and Katie meet their financial objectives.

A Discounted Gift Trust allows a settlor to make an IHT effective gift whilst retaining a right to future income

The trust establishes two distinct rights The settlor’s right to income for their lifetime, which takes priority The beneficiaries right to the trust fund upon the settlor’s death The amount gifted to the trustees is generally invested in a life assurance

bond or a series of endowment policies The trustees use the regular withdrawal facility or the maturity proceeds

of the endowment plans to pay the settlor’s income To ensure flexibility a discretionary trust or power of appointment trust

is generally used The initial gift into such a trust would therefore be a chargeable lifetime

transfer Any excess over the settlor’s available Nil Rate Band would be subject to

immediate IHT at lifetime rates (which are 50% of death rates) This arrangement can provide an immediate IHT benefit As HMRC will allow a discount on the value of the gift in relation to the

amount of income the settlor is entitled to under the terms of the trust The discount is calculated as the open market value of the right to the

settlor’s retained payments for the remainder of their lifetime The open market option is the amount that some would theoretically be

willing to pay for this right This would meet Peter and Katie’s financial aims by providing additional

income during their lifetime helping to meeting their retirement income shortfall

And an immediate IHT benefit in relation to the discount which will be outside of their estate immediately providing for their objective to minimize the impact of IHT on their estate


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And the remaining gift which will fall outside of their estate should they live 7 complete years

Explain to Peter and Katie the benefits of having a will. The most significant benefits relating to having a will are:

The testator can specify who inherits their property rather than their property being distributed under the rules of intestacy

Helps to avoid any delay in obtaining probate The testator can leave instructions in the will for the care of minor

children Avoids the laws of intestacy applying on death It is an inexpensive way to ensure certainty of the distribution of assets

on death The testator can determine the proportion of their nil rate band used The testator can specify those that they wish to administer the estate The testator can specify burial/funeral instructions The testator can specify protective provisions for individuals e.g. the use

of a home, or access to income from a portfolio, without access to the capital or the ability to sell the property

If the question instead asks what are the consequences of NOT having a will: If a question relates to the consequences of not having made a will then many of the above benefits of having a will simply need to be changed into negative statements. However, remember – do NOT use the word testator because there is no testator if there is no will. Use the name of the individual in the case study instead! What are the requirements for a will to be valid? For a will to be valid there must be:

Witness/writing. The will must be in writing and witnessed Intention. It must have been the testator’s intention to write a will Legal capacity. The testator must have mental capacity and be at least 18 Legalities. A witness should be an adult, of sound mind & independent * Signed and dated. The will must be dated. The will must be signed by the

testator in the presence of two witnesses. Each witness must sign the will in the presence of the testator

*Remember - neither the witness nor their spouse/civil partner can be a beneficiary of the will


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Financial Aim 3 – Ensure that their investments are arranged in a tax efficient way.

Fact finding Identify any additional information you would need before you are able to make any new recommendations relating to ensuring Peter and Katie’s investments are arranged in a tax efficient way.

Request details of Peter and Katie’s current earnings, and the income produced from their existing investments

Establish whether Peter is likely to be a higher rate taxpayer in retirement

Request details of any other income that is not listed on the fact find Find out what allowances and reliefs they have used in the current tax

year. This would include ISA allowances, income and capital gains tax allowances and reliefs

Do Peter and/or Katie have any previous losses to carry forward which could be used to offset future gains

Request additional information in respect of the investment bond, including the original amount and the date invested, any withdrawals made to date, any previous chargeable gains made, details of any surrender penalties that may apply, where the funds are invested including past performance and the charges that apply to the investment

Request additional information about the OEIC including date and amount of original investment, the current yield, any previous withdrawals made and past performance

Are they prepared to transfer ownership of assets to utilise unused tax reliefs and allowances?

How much of an emergency fund do they feel they need?

Analysis This is likely to involve an income tax calculation for both Peter and Katie to establish how much tax they are currently paying and to establish whether there are any unused allowances and relief’s. The case study states that Peter is a higher rate tax payer and Katie is a basic rate tax payer, however there is no income information to substantiate this. If a tax calculation is required in the exam, then substantial additional information would be required in the stem of the question. The layout would be as per case study 1 for Joseph.


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Explain how Peter and Katie will be taxed on their current investments. Bank Savings Account

They own this jointly and therefore the income would be split 50/50 It is likely that the income is paid net of 20% basic rate tax The income received should therefore be grossed up by dividing the net

amount by 0.8 The gross amount would be added to their respective other incomes for

the tax year As Peter is already a higher rate tax payer he would have to pay an

additional 20% income tax on the interest paid As long as the gross amount when added to Katie’s other income does not

exceed the higher rate tax threshold then Katie would have no further tax to pay.

The interest income is taxable whether or not it is paid out or accumulated in the bank account.

OEIC – UK Equity Fund

The income from a UK equity fund will be dividend income As they own this investment jointly the income produced by the fund

would be split between them 50:50 The dividend income is paid net of 10% tax credit So the income must be first grossed up by dividing the net amount by 0.9 Peter will have to pay an additional 22.5% income tax on the gross

dividend as he is already a higher rate tax payer As long as the gross amount when added to Katie’s current income does

not exceed the higher rate tax threshold Katie would have no further tax to pay.

The dividend income is taxable whether or not it is paid out or re-invested back into the fund

Onshore Investment Bond

The Onshore Investment Bond does not create a tax liability until a partial or full surrender of the investment

Any chargeable gains will be shared equally between Peter and Katie 5% tax deferred withdrawals can be made from the bond for 20 years

without any immediate tax liability This is because the payments are treated as a return of the original capital

invested. The 5% is cumulative and if not used can be carried forward for future

use On full or partial surrender of investment bonds any chargeable gains are

subject to income tax For partial withdrawals the gain is determined at the end of the policy

year in which the partial gain occurred and taxed in the tax year in which the end of the policy year falls.


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The chargeable gain is the amount by which the withdrawals exceed the 5% allowance for that year plus any unused allowances carried forward from previous years

The resulting chargeable gain is added to the investor’s other income for the year, after earned income, deposit and dividend income, but with a credit for basic rate tax

As Peter is already a higher rate tax payer he would be liable to pay an additional 20% income tax on his share of the chargeable gain

As Katie is a basic rate tax payer she would be entitled to top slicing relief The chargeable gain is divided by the number of full policy years the plan

has been in force or the number of full policy years since the last chargeable gain

This top sliced amount is then added to Katie’s other income for the relevant tax year and if her total income is below the higher rate tax threshold then no further tax is payable

Where a portion of the top sliced gain is above the higher rate tax threshold additional income tax would be payable by Katie

The tax due would be calculated as 20% of the excess amount multiplied by the number of years of the gain was divided by for the top slice

Where the bond is fully surrendered the top slice multiple is the total number of complete years that the bond has been in force

The gain will be shared equally between Katie and Peter It is taxable in the tax year in which the surrendered rather than the tax

year in which the policy year end falls.

Recommendations & Justification Explain and justify any recommendations you would make relating to improving the tax efficiency of Peter and Katie’s investments Under this financial aim, the most suitable recommendation would be to recommend that Peter and Katie do the following:

Use their cash and/or stocks and shares ISA allowances for the current tax year

Consider transferring some/all of their cash holdings to Katie name to use up her basic rate tax band

Consider transferring some/all of the OEIC holdings to Katie to use up any remaining basic rate tax band

Please note that the benefits and drawbacks are tax-related for this question.


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Recommendation Benefits Drawbacks Use their annual ISA allowances from their cash deposits

• Interest received would be tax-free whereas currently they are taxed at 40% and 20% respectively.

• Any withdrawals made cannot be replenished.

• The annual ISA Cash ISA allowance is limited to £5,340 each in 2011/12.

• The annual stocks and shares ISA allowance is £10,680 less any cash ISA investment for 2011/12

Consider transferring some or all of their cash holdings to Katie

• This will allow any of Katie’s unused basic rate tax band to be set against the deposit income meant that it will be taxed at 20% rather than 40% of Peter’s share

• Peter would lose some control of assets.

• He may not be prepared to give up ownership

Consider transferring some/all of the OEIC holdings to Katie

• This would allow any dividend income to be set against any of Katie’s unused basic rate band and it will be taxed at 10% rather than 32.5%

• Peter would lose some control of assets.

• He may not be prepared to give up ownership

Questions that could be asked Compare the taxation of an onshore bond and OEIC Onshore bond OEIC Taxation of income Up to 5% tax deferred

withdrawals can be taken for a maximum of 20 years as they are regarded as a return of capital. Any excess is taxable.

Any income generated is liable to income tax.

Tax payable on fund switches

Able to switch within the bond without incurring a tax charge.

Fund switches will result in a capital gain arising which may be liable to CGT.

Tax payable on assignment

Ability to assign segments to reduce chargeable events.

Shares in the OEIC can be assigned but could result in a capital gain arising which may be liable to


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Onshore bond OEIC CGT.

Ability to reduce the gain subject to tax

Top slicing relief available for a basic rate taxpayer when the gain pushes them into a higher rate tax band.

Annual CGT exemption can be used to offset any gains.

Taxation of gains on surrender

Gains within the bond are liable to income tax rather than capital gains tax, so after top-slicing, a higher rate taxpayer like Peter would pay 40% tax on surrender less the 20% paid within the bond. There is no further income tax liability for top-sliced gains falling into the basic rate band.

Gains on disposal are subject to capital gains tax after deduction of the annual CGT exemption.

Venture Capital Trusts (VCT) and Enterprise Investment Scheme (EIS) Whilst investments in EISs and VCTs are high risk, nonetheless it is possible that they could form part of an overall balanced portfolio where the other assets were below average risk. It is therefore worth exploring this possibility just in case. The table below briefly summarises the main points:

Venture Capital Trust (VCT) Enterprise Investment

Scheme (EIS)

Maximum £200,000 £500,000

Tax Relief 30% 30%

Min term to qualify for tax benefits

5 years 3 years

Gains Tax free Tax free

Dividends Tax free Taxable

Other Investment can be treated as being paid in the previous tax

year (“carry back” ) for tax relief

CGT deferral relief available IHT free after 2 years with

business property relief Losses can be set off against

income of the same or previous year


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Advantages

Diversification into unlisted investments High growth potential Initial tax relief with the ability to take the fund as cash after a short

qualifying period Disadvantages

EIS - Lack of liquidity in smaller issues VCT – large discounts on share prices will not reflect the true value of the

investment Higher risk investment – a risk of the underlying investments failing

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