After seven years from the date of the deed of waiver, the PET becomes exempt from IHT. If the settlor dies within the seven years, the PET becomes chargeable. 

Under a discretionary trust, the amount waived creates a CLT. These rarely attract an entry charge if the value of the waived amount, when added to other CLT’s made in the previous seven years, exceeds the settlor’s current nil rate band. 

Again, CLTs drop out after seven years if no PETs are created after the CLT. If a settlor creates a mixture of PETs and CLTs this can lead to a 14-year timeline. 

If a PET fails and becomes chargeable, it pulls in any CLTs made within seven years of the failed PET thus potentially going back 14 years. 

What happens if the bond falls in value?

If the bond falls in value, the settlor's loan cannot be fully repaid. 

Whether the trustees are liable for the shortfall depends on the precise terms of the trust and the circumstances of each case.

It may be that a clause will be contained within the deed stating that the trustees will not be liable for a loss to the trust fund unless that loss was caused by their own fraud or negligence. 

This ensures the trustees are not liable for any shortfall in adverse market conditions.

Loan trust example 

Paul is 66, widowed and has a potential IHT liability. He also:

• has £150,000 available for an investment; 
• wants to retain some access to the capital, but reduce his IHT liability; 
• would like a tax-efficient income of £6,000 each year for holidays; 
• would like to leave some money to his grandchildren; and 
• has not made any previous gifts or done any IHT planning.

Paul invests £150,000 into a loan trust (on a loan-only basis) through a discretionary trust. 

He names his two adult daughters Natalie and Deborah as additional trustees. The potential beneficiaries include his two daughters and three grandchildren. 

The trustees invest in a single premium bond on the lives of the two youngest grandchildren (it could be on the lives of the children). 

Paul requests a loan repayment each year for £6,000, which he spends. 

The trustees finance this by taking a part-withdrawal from the bond. These are tax free in Paul’s hands. 

He also decides to waive £3,000 of future loan repayments each year by using a deed to waive the loan as part of his annual gifting exemption.  

If, every year, they selected a multi-asset fund and the investment growth was 4.5 per cent and the trustees take a 4 per cent withdrawal of the original investment to repay Paul’s loan, when Paul dies 15 years later:           

• the outstanding loan in his taxable estate would be reduced to £15,000 (£90,000 in loan repayments that Paul has spent and £45,000 waived);
• the value of the bond would be £136,000 meaning that £121,000 is outside his taxable estate; and
• the potential IHT saved on £121,000 is £48,400. 

This example shows:

• loan trusts can provide a tax deferred ‘income’ to the settlor as loan repayments, provided they are kept within limits;
• any growth on the underlying investments accumulates outside the settlor’s taxable estate and is largely free of IHT;
• the settlor can access any of the outstanding loan at any time;
• as the settlor takes and spends loan repayments and/or waives their right to them, their taxable estate reduces; and
• while alive, the settlor will be one of the trustees and so will have some control over who will eventually benefit under the arrangement.

Richard Cooper is a business development manager at the London Institute of Banking and Finance