On 19th March the Chancellor announced a review of Deeds of Variation to crackdown on tax avoidance. Carolyn Bagley, Partner at law firm Hewitsons, examines the usage of Variations and the case against abolition.

What is a Variation?

Deeds of Variation (or Deeds of Family Arrangement) are a binding method for a family to rearrange, after a death, who inherits.

A beneficial interest, inherited following a death, is redirected by the beneficiary to someone else, so essentially a Variation is a gift, from the original beneficiary to the new beneficiary, made within two years of death.

What is special about these gifts? S.142 IHT Act (IHTA) 1984 provides an election to avoid the normal Inheritance Tax (IHT) and Capital Gains Tax (CGT) rules which otherwise apply to gifts. The gift is effectively treated as if made under the Will/Intestacy.

Surprisingly often, advisors forget a Variation is just a gift without tax consequences. Mistakes are made when it is misconceived as changing the Will: it cannot change purely administrative powers, or executors, or give something away which has ceased to exist. It cannot correct a defective Will, but is a useful tool for IHT planning, for flexible family protection, and sometimes for righting wrongs. Variations are notorious sources of litigation and negligence claims – but that calls for an article in itself.

Is it fair to allow post-death re-arrangements without suffering CGT on the gift disposal, nor IHT if the donor died within seven years?

Intestacy

Jo dies without a Will, leaving a widow, son, and £1.5 million, including the family home worth £1million. Under intestacy rules, his widow inherits £975,000 (£450,000 and half of the rest), so she does not inherit the whole of the family home. The son inherits the rest, but that exceeds the Nil Rate Band (NRB) of £325,000 and so IHT would be payable.

The son has no wish to pay IHT earlier than necessary and wants to provide for his mother. He executes a Variation to redirect (gift) his inheritance to his mother. Using s.142 he elects for his gift to be taxed as if his father had made a Will leaving all to his widow. Consequently, even if the son does not outlive his gift by seven years, it will not form part of his taxable estate on death, and he makes no disposal, so no CGT, even if assets have increased in value between death and variation.

Generation Skipping

Widow dies, leaving everything to son. He is wealthy and concerned the inheritance will remain unused until he dies, at which time it will suffer 40 per cent IHT before passing to his daughter. He executes a Variation to gift the inheritance to his daughter. The son makes the gift, but for tax purposes it’s treated as if made by his mother’s Will. No IHT or CGT.

Gift With Reservation (GWR)

S.142 Variations are the only General Anti-Abuse Rule (GAAR)-free situation allowing us to ‘have our cake and eat it’ when gifting. The original beneficiary redirects his inheritance into a Discretionary (Relevant Property) Trust under which both he and others, such as the family, are potential beneficiaries. He successfully removes the inheritance from his own taxable estate, potentially saving 40 per cent IHT on his future death, yet at the same time he can still access the inheritance. If the sum varied is under the NRB, there may never be any future IHT on that inheritance. It is also useful for beneficiaries who cannot make their decision within the relevant two year time period, who effectively buy more time by varying into a Trust. The cost implications mean it is generally not recommended for sums under £100,000.

Appointments from a Relevant Property Trust

IHTA 1984 s 144 provides a similar benefit to s 142. Where an appointment from a discretionary will trust is made within two years of death, the asset will be treated, for IHT purposes, as if it had always been left in the Will directly to the new beneficiary. CGT is also avoided, provided the appointment is made before any assent to the trustees, and before the administration has been completed. The flexibility of a discretionary trust will can thereby be combined with tax efficiency, making this type of Will very effective and cost-efficient for those with complex family or financial situations.

Discretionary trust wills, using a s 144 appointment, help:

• balance foreign forced heirship, or lifetime gifts;
• protect disabled, or vulnerable, beneficiaries by enabling the trust wording to be the most advantageous available at the date of death; and
• enable tax-efficient distribution of complex business and farm assets, using the benefit of hindsight about values, relief eligibility and family circumstances.

Section 144 is also used to unwind NRB discretionary trusts in wills made before the availability of transferable NRBs. Currently, many choose to leave their will unaltered, knowing their heirs have the option to unwind the trust within two years of their death. If s 144 is abolished, what of those who are unaware or have lost mental capacity to update their will?

What can be varied?

• Absolute entitlements: a simple legacy, or outright share in the residuary estate.
• Life interests. This avoids Trust property being aggregated with the free estate of the life tenant. This cannot be done after the death of the life tenant, because by then the interest has ceased to exist. However, if the life tenant dies before taking any benefit from the life interest, then her Executors can “disclaim” (reject the inheritance) on her behalf. The disadvantage of a Disclaimer is that you cannot choose who inherits the disclaimed asset.
• Reversionary interests. For example: life interest to widow with reversionary interest to son, the son knows he will not need his interest and so varies (gifts) it to his daughter. Reversionary interests are excluded assets for IHT, so this does not need a Variation for IHT purposes, but the Variation election prevents CGT complications.
• Assets owned as beneficial joint tenants. These pass by survivorship, not by the Will, which emphasises that it isn’t the Will which is varied, but ownership of an inherited asset, irrespective of whether that inheritance is by Will, intestacy or survivorship.
• Assets already sold. This is because it is the original beneficiary’s entitlement to an asset which is redirected, rather than the asset itself. Ideally the Variation recites the sale and the proceeds, which are effectively being redirected. The sale is retrospectively treated as made by the executor/beneficiary only as a nominee for the new beneficiary.
• Assets where the original beneficiary has subsequently died: re-direction of the first estate can be made by the executors and beneficiaries of the second estate.

Double Dipping

Don’t rush into a Variation: if you get it wrong the first time, that same asset cannot be varied a second time. The original beneficiary does not get two bites of the cherry. There can however be a double reading-back, through combining s.142 (Variations) with s.144 (Appointments out of Discretionary Trust). A Discretionary Trust might limit the beneficiaries to the widow and issue, but s.144 can be used to appoint an asset from the Discretionary Trust to the son, who then uses s142 to redirect the asset to his partner.

Abolition?

The 1989 budget announced Variations would be outlawed. Public outcry highlighted that Variations are often used to correct situations by the less well off, or unsophisticated, who have not taken advice from a solicitor beforehand. The (Labour) government backed down: Variations remained available, to level the playing field. Is the current political climate different?

Multiple ‘tax avoidances scandals’ include Ed Miliband’s legitimate use of Variations. Presumably his father left everything to his mother, which, pre 2007, wasted his father’s NRB resulting in ‘unnecessary’ IHT being likely on his mother’s subsequent death. His father’s estate was varied, so that Miliband received a share in the family home. Did this backfire? The 2007 Transferable NRB meant his father’s NRB would have been available for use anyway, whereas CGT was paid on the subsequent sale of his share. However, as property values increase faster than the NRB allowance, perhaps Miliband did well out of the Variation after all.

Gifts by Variation are made in that format purely for tax benefits and so it can be argued Variations are used for ‘tax avoidance’. However, the use of Discretionary Trust Wills, intended to be varied using s.144, are also, even primarily, for family protection purposes. In the HMRC manual, Variations are a separate sub-section to Disclaimers, or to s.144 distributions from Relevant Property Will Trusts, or to Precatory Trusts. However, will the review differentiate? Until we know, solicitors can only continue to advise that in many cases the best solution is a Discretionary Trust Will, with a view to “varying” it after death.

For more information please contact Carolyn Bagley on 01908 247010 or click here to email Carolyn.