Deeds of variation: the gift of hindsight

So what is a Deed of Variation? It is simply a deed whereby you gift, or vary, your inheritance to someone else, and which must be completed within two years of death. The advantage is that, when appropriately drafted, the deed is written back into the Will of the deceased for inheritance tax purposes, so it is as though the assets always passed directly to the new beneficiary under the Will. This gives the ability to consider the circumstances prevailing after the death and then effectively re-write the deceased’s Will in the most tax efficient way.

Example

Fred’s mother Dorothy, who was in her 90s, has just died leaving her estate of £500,000 to Fred. There was no inheritance tax payable on Dorothy’s death because her estate had the benefit of her nil-rate band allowance and of her late husband’s nil rate band allowance, totalling £650,000. Fred is wealthy in his own right so he doesn’t particularly want these assets, and is aware that keeping them only increases his own inheritance tax liability - if the assets are still owned by him at his death, he will suffer a 40per cent inheritance tax charge of £200,000.

Fred could simply accept the inheritance and then make some gifts himself, but if he dies within seven years of the date of those gifts, the value will be taken into account when calculating the inheritance tax on his own death.

He would also have an immediate inheritance tax charge if he settled the full value of his inheritance into a trust. Alternatively, Fred might be able to “disclaim” – effectively to refuse to accept his inheritance. However, the downside of this is that he cannot choose where the assets go, as this would be dictated by the terms of his mother’s Will.

The best option for Fred in these circumstances is therefore to enter into a deed of variation, in effect re-writing his mother’s Will, so that his inheritance instead passes either to his children outright or perhaps into a discretionary trust. That will keep those funds outside his estate, thus avoiding the £200,000 inheritance tax charge on his death even if Fred dies the next day. The trustees (of whom Fred could be one) can use the funds in the trust for the benefit of Fred’s family as and when appropriate.

So if a person has failed to include inheritance tax planning provisions within their Will, or if circumstances have changed, it may be possible, using a deed of variation, to improve things after death. However, it needs to be understood that this is not as good as getting it right in the first place. For example, although a deed of variation treats the gift as being made by the deceased for inheritance tax purposes, for all other purposes the original beneficiary is the one making the gift to the new beneficiary. This can have adverse tax consequences: for example, if Fred wished to be a potential beneficiary of the variation discretionary trust, all the trust’s income would be taxable on Fred even if he does not receive it. As Fred is wealthy, he is likely to be a higher rate tax payer.

By contrast, if Dorothy had put in place a more sophisticated Will under which her estate passed into a discretionary trust, the income from that trust could have been used to pay her grandchildren’s (or maybe greatgrandchildren’s!) school fees. Any income paid out of this trust would be treated as belonging to the grandchildren; and with appropriate documentation in place their personal allowances and/or lower rates of tax could be used to minimise or eliminate any income tax liability, resulting in an overall more tax efficient structure.

Therefore although deeds of variation can be very useful and important tools in inheritance tax planning, they are not a substitute for getting it right in the first place, and having a well drafted, flexible Will.