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Estate Planning - Normal Expenditure out of Income

Wednesday, 18 November 2009

By far the most common method of varying a will or the provision on intestacy is the execution of an instrument of variation - particularly when tax efficiency is a consideration. However, in some circumstances a simpler and equally efficient method may be available. This article looks at two such methods - disclaimers by beneficiaries, and elections by a spouse to capitalise a life interest to which s/he would otherwise be entitled under intestacy.


There is a fundamental difference between a disclaimer and an instrument of variation. A disclaimer is a refusal to take an interest in the first place, rather than the transfer of an interest. As a result, a beneficiary is precluded from disclaiming once s/he has accepted the interest - for example, by allowing the asset in question to be transferred to them or accepting the payment to them of interest earned by the asset.

The other big difference is that the disclaiming beneficiary has no control over who will become entitled to their disclaimed gift. Disclaimers therefore cannot be used to redirect gifts. Subject to a contrary intention appearing in the will, the disclaimer of a specific or pecuniary legacy will automatically result in the property forming part of the deceased's residuary estate, and it will be distributed accordingly. If a gift of residuary estate is disclaimed then the property will fall to be dealt with under the intestacy rules, while disclaimer of an interest under intestacy simply results in a further application of the intestacy rules to the exclusion of the disclaiming beneficiary. Each route is capable of producing an increase in IHT, and it is therefore always essential to consider the impact of the disclaimer on the rest of the estate.

There are other limitations on the use of disclaimers, including the fact that a beneficiary cannot disclaim only part of their gift, unless the gift is a pecuniary legacy or the will makes clear that it is severable. Furthermore, disclaimer cannot be used to sever the deceased's share in a beneficial joint tenancy. Such a severance can only be effected by variation.

For these reasons a variation is generally considered to be safer and more flexible than a disclaimer. Nevertheless, disclaimers can still be tax efficient for Inheritance Tax and CGT purposes - section 142 of Inheritance Tax Act 1984 and section 62(6) of Inheritance Tax Act 1984 ensure that if made in writing within two years of death, the disclaimer will be retrospective to the date of death. As a result Inheritance Tax and CGT due in relation to the estate will be charged as if the beneficiary had never been entitled to the interest in question.

In addition, in certain circumstances disclaimers can have distinct advantages - and where a beneficiary has a choice as to whether they make a variation or disclaimer it is worth considering the merits of both before reaching a conclusion. For example :

a) unlike the position in relation to variations, there is no requirement that the personal representatives join in a disclaimer if its effect is to increase the Inheritance Tax payable by the estate;

b) there is no need to make an election or give notice to the Revenue following a disclaimer which complies with sections 142 of Inheritance Tax Act 1984 and section 62(6) of Inheritance Tax Act 1984. Its retrospective effect is automatic. Of course, there may be circumstances in which this is not in the interests of the beneficiaries concerned - in which case, the disclaimer must be oral, or made outside the two year period, so as to ensure that neither section 142 nor section 62(6) can apply;

c) in contrast, if an instrument of variation is to have the benefit of section 142 of Inheritance Tax Act 1984 and section 62(6) of Inheritance Tax Act 1984 it must be followed within 6 months by an election to the Revenue, whereupon it becomes irrevocable. A disclaimer, on the other hand, can be retracted at any time provided nobody has acted upon it or changed their position in reliance upon it;

d) since the decision in Russell v IRC [1988] STC 195 it has been clear that the Revenue do not accept that a second variation falls within section 142 of Inheritance Tax Act 1984 (and presumably section 62(6) of Inheritance Tax Act 1984) if it further directs any part of the estate that has already been redirected under an earlier variation. As a result, and to avoid any uncertainty, the Revenue recommend that variations covering a number of items in the estate should be made in one instrument. Save for the ability to retract mentioned above, the position is the same in relation to disclaimers - but there is perhaps less scope for confusion as the disclaimers are made by different beneficiaries in relation to distinct interests in the estate. There is nothing to preclude the beneficiaries from making their disclaimers independently of each other and on different dates, and the same beneficiary can disclaim their several interests under the estate in separate documents. Nevertheless, it is generally preferable for the rearrangement of provision of the entire estate to be organised and take place at the same time;

e) as a result of section 93 of Inheritance Tax Act 1984, and provided the disclaimer is not made for a consideration of money or money's worth, it is possible to disclaim a beneficial interest in possession in settled property. There is no time limit (because the section does not just relate to interests passing on death) and no requirement for writing. In contrast it is generally not possible to vary such an interest, unless the deceased exercised by will a general power of appointment over the asset in question;

f) despite section 142 of Inheritance Tax Act 1984 a person making a variation will still be treated as the "settlor" for the purposes of other tax legislation. For example, if a variation is in favour of the "settlor's" minor child, sections 663 and 664 of TA 1988 provide that any income arising from the relevant assets will, if applied rather than accumulated, be treated as the income of the "settlor" and not of their child. Although the position is not entirely without doubt, it seems likely that a person disclaiming is not a "settlor" for these purposes.

g) needless to say, there are no difficulties in dealing with income tax after a disclaimer, since if the beneficiary has received any income from the gift they will not be entitled to disclaim in any event. Nor are they treated as having received the undistributed income between the date of death and disclaimer.

Despite these advantages, disclaimers are rarely considered when planning post-death rearrangements. To this extent, they have fallen into the same category as the often ignored statutory power to capitalise a spouse's interest under the intestacy rules.

Capitalisation under intestacy

Where the deceased dies intestate and leaves a spouse and issue, section 46 of the Administration of Estates Act 1925 provides that the spouse will receive :

a) the deceased's personal chattels;

b) a statutory legacy (currently £250,000); and

c) a life interest in half of the remainder of the estate.

The spouse's life interest under c) above will therefore only arise if the deceased has died intestate, leaving a spouse and children and their net estate (excluding personal chattels) exceeds £250,000. The other half of the remainder of the estate goes to the children on the statutory trusts, that is, when they reach 18.

Of course, if the children are all adults they can together agree with the spouse to break the trust and distribute the capital between them. Apart from this, however, the trustees have no power to advance capital to the spouse.

Section 47A of the 1925 Act provides a (limited) solution to the problem. A surviving spouse who is entitled to a life interest in part of the deceased's residuary estate may elect to have it redeemed, capitalising their life interest. Surprisingly, the election can be made by minor spouses and, unlike the position in relation to disclaimers, there is nothing to preclude an election in circumstances where the spouse has already received payments of income - although there may be grounds for claiming that they are estopped from exercising their right under the section if they had previously indicated that they did not intend to do so and the representatives have taken steps in reliance upon that representation.

In respect of deaths on or after the 1st of January 1996 the power can only be exercised if the spouse has survived the intestate for 28 days. Furthermore, no election will be possible until a grant has been taken out in relation to the estate. The election is made by the spouse notifying the personal representatives in writing, or, if they are the sole representative, by giving written notice to the senior registrar of the Family Division of the High Court. Once made the election is irrevocable, save with the consent of the personal representatives.

Sections 17(c) and 145 of Inheritance Tax Act 1984 provide that following an election by the spouse Inheritance Tax will be charged as if the spouse was never entitled to the life interest but had from the outset been entitled to the capital sum. As a result, the election is not a transfer of value for Inheritance Tax purposes. The sections operate without any need to make a further election to the Revenue, and regardless of whether the spouse makes their election to the representatives within 2 years of the deceased's death. Instead, the time limit is 12 months from the date when representation is first taken out, and (unlike the position in relation to variations) this can be extended by the court if it is satisfied that the limitation period will operate unfairly because :

a) the representation first taken out was probate of a will and has now been revoked on the ground that the will was invalid; or

b) at the time when first representation was first taken out, questions remained about whether a person had an interest in the estate, or what that interest might be; or

c) of other circumstances affecting the administration or distribution of the estate.

In consequence, section 47A may prove a useful tool in circumstances where there has been some delay in, for example, taking out representation or ascertaining those entitled to the estate, and it is no longer possible to make a retrospective instrument of variation or disclaimer within sections 142 of Inheritance Tax Act 1984 and section 62(6) of Inheritance Tax Act 1984.

Rules made under subsections 47A (3A) and (3B) of the 1925 Act set out the way in which the capitalisation is to be calculated, based upon the age of the surviving spouse and the prevailing yield on medium-term Government securities. It is essential to calculate this sum before considering whether capitalisation is appropriate - if the adult children wish to agree on a different sum, any increase may amount to a PET. Another relevant consideration must be the fact that the costs of the capitalisation are borne by the residuary estate.

Finally, it is important to note that there are no specific provisions dealing with the effect of an election by the spouse on either income tax or, more importantly, CGT. With regard to the latter, unless there is a valid instrument of variation within the meaning of section 62(6) Inheritance Tax Act 1984 there will be a disposal by the personal representatives to the spouse and children, who have become absolutely entitled to the trust fund as a result of the capitalisation. Any gain would be calculated by reference to the value of the estate at the date of death, and the representatives will be taxed at a uniform rate of 18%.
For further assistance please contact Head of our Private Client Department by telephone on 020 7611 4848.