Tolley's Practical Tax by Matthew Hutton MA, CTA (fellow), AIIT, TEP
Matthew Hutton continues his series of articles on trusts by dealing with their inheritance tax implications.The first in our three part series considered the income tax and capital gains tax (CGT) treatment of different types of trust. This article moves on to inheritance tax (IHT). These articles assume both that the settlor is domiciled in the UK and that the trustees are resident in the UK for tax purposes.Starting a trust
gift of property to the trustees of a settlement is a transfer of value by the settlor (measured on the basis of the loss to his estate) for IHT purposes. The implications of that transfer of value will depend upon the type of trust concerned.Chargeable transfers
A lifetime gift to a discretionary trust or, after 21 March 2006, a life interest trust (other than a disabled person’s trust) is an immediately chargeable transfer. Subject to the £3,000 annual exemption, the value of the chargeable transfer will be taxed at nil %, provided that its value combined with the amount of any other chargeable transfers made by the settlor in the preceding seven years does not exceed the nil-rate band threshold for the tax year in question (£285,000 for 2006/07). To the extent that it does exceed that threshold, IHT is charged at 20%. If the settlor dies within seven years of the gift, a further 20% (to make a total of 40%) will be payable. Any IHT should generally be paid by the trustees, to avoid the need to ‘gross up’ the value of the gift.‘Potentially exempt transfers’ (PET’s) before 22 March 2006
By contrast, a gift to the trustees of a qualifying accumulation and maintenance settlement or a life interest settlement was a PET which, whatever its amount, is taken to be exempt unless the settlor dies within seven years (in which case it is treated as a chargeable transfer).Reporting
Remember that, with a chargeable transfer (even at the nil-rate), notice should be given to HMRC Capital Taxes within twelve months after the end of the month in which the gift was made (subject to a de minimis provision of no more than £10,000 chargeable transfers made in the relevant tax year plus no more than £40,000 in the preceding ten years). Because a PET is assumed to be exempt, no notice of a PET need be given for IHT purposes except in the event that it becomes chargeable by reason of the transferor’s death within seven years.‘Relevant property’ trusts
The current regime was introduced for discretionary trusts with the advent of capital transfer tax in 1975. Because, since 22 March 2006 it applies also to practically every lifetime trust, it is referred to as the ‘relevant property’ regime. The rules treat a discretionary trust as a separate taxpayer for IHT purposes, although one which (in family terms) is treated as the ‘child’ of its ‘parent’ settlor. That is, the chargeable gifts history of the settlor in the seven years preceding the date of the settlement is always taken into account in fixing the tax charge on the settlement. The trust is subjected to two forms of taxation: on each ten-year anniversary of the making of the trust and in addition whenever any capital leaves the discretionary regime (the ‘exit charge’).The ten-year anniversary charge
The thinking behind the legislation is to subject a relevant property trust to IHT as if the property in the settlement had been the subject of a lifetime gift made every generation. The rate of IHT on death is 40%, whereas the rate on chargeable lifetime gifts (which the donor survives by more than seven years) is 20%. A generation is assumed to be 33 1/3 years. HMRC want to collect the money rather more regularly than three times every 100 years, so the charge on property in the settlement is collected every ten years at a maximum rate of 6%, which equates to 20% every 33 1/3 years. However, 6% is a maximum rate and in most cases the effective rate will be much less than this, given the effect of the nil-rate band. There is of course no guarantee that this basis of calculation will not be changed in the future, eg. to apply the death rates of IHT.There are two elements in calculating the charge:
the chargeable amount. This is the value of all ‘relevant property’ in the settlement immediately before the ten-year anniversary. Reliefs for business and agricultural property are available to reduce the amount chargeable to tax; and
the rate of tax, which is 30% of the ‘effective rate’ applicable to a lifetime charge made by a hypothetical transferor with a gifts history equal to that of the settlor in the seven years before he made the settlement (excluding the date of settlement, though see below for ‘related settlements’). The hypothetical transfer is subjected to the lifetime rate of 20% to find the appropriate tax rate, having made any adjustments required in the circumstances as summarised under ‘other matters’ below. This rate divided by the deemed chargeable transfer produces the ‘effective rate’, which is multiplied by 30% to discover the actual rate payable on the ten year anniversary; this is then applied to the chargeable property to find the tax payable.
The exit charge
This charge arises when property leaves the relevant property regime, by way of gift. There is no exit charge if the event happens in the first quarter (three months) following either creation of the settlement or the last ten-year anniversary. If the trust was established by Will, there is no exit charge if the event happens within two years, but at least three months, after the death (IHTA 1984, s 144).There is a distinction between calculation of the exit charge in (a) the first ten years of the life of the settlement and (b) the ten year period following the first or subsequent ten-year anniversaries. The exit charge in the first ten years is related back to the circumstances at the date of settlement (subject to scaling down to reflect the number of three month periods – or quarters – which have elapsed since then). If there was no positive charge to IHT at outset, there will generally be no charge on an exit within the first ten years, whatever the then value of the property. However, in calculating the rate of tax on an exit within the first ten years in a case where business or agricultural property went into the settlement, note that the initial deemed chargeable transfer is the gross and not the net value. The exit charge following the first ten year anniversary adopts the rate charged on the last anniversary, again scaled down by reference to the number of completed quarters which have elapsed since then.
Other matters affecting the calculation of charge
In order to create equity both for the taxpayer trust and for HMRC, adjustments are made to the calculation of both charges for: related settlements, that is other settlements made by the settlor on the same day as the discretionary (or other ‘relevant property’) settlement commenced;
property within the trust at any time which is not ‘relevant property’ (ie subject to the relevant property regime);
additions of property to the settlement at any time thereafter;
property changing character within the settlement; and
property moving between settlements.
Accumulation and Maintenance (A&M) trusts (created before 22 March 2006)
These are a ‘privileged’ type of discretionary trust introduced in 1975. While the qualifying conditions (defined in IHTA 1984, s 71) are satisfied, the privilege consists in a freedom from the exit and ten-yearly charges imposed on discretionary trusts. The A&M trust is a type of discretionary trust primarily designed to benefit children or grandchildren under the age of 25. For CGT and income tax purposes, an A&M trust is treated exactly like any other discretionary trust (as was described in article one of this series).The s 71 conditions
The conditions are strict. They fall into two parts, which are broadly as follows: There is no interest in possession, the income is to be accumulated insofar as not paid out for maintenance, education or benefit of the beneficiaries and one or more beneficiaries will become entitled to income or capital at a specified age not exceeding 25.
Either no more than 25 years have passed since the settlement was created or, more commonly, all those who are or have been beneficiaries are or were grandchildren of a common grandparent.
If there is any possibility of either set of conditions being breached, the settlement will not have A&M status and will therefore be treated as an ordinary discretionary trust with its exit and ten-yearly charges.
Ending the A&M regime
An A&M settlement will typically have prospective shares in capital owned by one of a number of qualifying beneficiaries. As and when each beneficiary reaches the specified age, or otherwise has a right to income, the capital underlying that share will fall outside the A&M regime.That said, there will typically be in the trust deed power for the trustees to vary the shares, so that a particular beneficiary may be deprived of his share before attaining the specified age (in which case that capital will continue within the A&M regime for the benefit of the other beneficiaries). Subject to that point, on or before attaining the specified age, the capital will either become subject to an interest in possession or will vest outright. On outright vesting there will be CGT implications to consider. If the assets have grown in value in the trustees’ ownership there will be a deemed disposal as described in article one of the series. It may be possible to hold over the gain either under TCGA 1992, s 260 if capital vests with no prior right to income or under s 165 if the assets are defined business assets.
FA 2006 transitional rules
No new A&M trust can be created on or after 22 March 2006. For trusts already in being at that date, there will be no IHT penalty if capital is advanced outright on or before the beneficiaries attain age 18 – or the trusts are changed before 6 April 2008 to provide that. Failing this, the trust will on 6 April 2008 enter the ‘relevant property’ regime, with the effects described above. If, before 6 April 2008, the trusts are changed (if necessary) to provide that capital vests at 25 (and income at 18), the trust will not enter the ‘relevant property’ regime in relation to a presumptive share before the beneficiary attains age 18 and the relevant property regime will apply up to a maximum of seven years between those ages (that is, there will be an exit charge when capital is advanced outright).Interest in possession (or life interest) trusts
For IHT purposes, someone entitled to an interest in possession arising (generally) before 22 March 2006 is treated by IHTA 1984, s 49(1) as beneficially entitled to the underlying property in the trust fund. This means that, so long as the beneficiary is alive and the interest continues, there is no chargeable event for IHT purposes. When the beneficiary dies, there will be a chargeable transfer. The value in the life interest trust is aggregated with the free estate and the combined total is subjected to IHT at the appropriate rate, known as the ‘estate rate’. The trustees are liable for the IHT in respect of the trust fund and the executors for IHT on the free estate.If the interest comes to an end during the beneficiary’s lifetime (other than by outright advance to him), he will be treated as having made a transfer of value. This will be either:
a PET if the capital is advanced to an individual or passes on life interest or A&M trusts before 22 March 2005 (and will become exempt if the life tenant survives for seven years); or
a chargeable transfer by the life tenant if the capital becomes subject to discretionary trusts or (after 21 March 2005) on life interest trusts.
There is a further exemption on the termination of an interest in possession if the capital reverts to the settlor (or in certain circumstances his spouse or widow), whether absolutely or on a further life interest trust. Any planning opportunities presented by this are of course gone for trusts created on or after 22 March 2006. For trusts in being at that day, the exemption will still apply, so as to remove the IHT charge on death of the life tenant. However if the capital does not then vest outright, the trust fund will otherwise enter the ‘relevant property’ regime.
FA 2006 transitional rules
A life interest trust made on or after 22 March 2006 triggers the ‘relevant property’ regime, even if the primary beneficiary is the settlor or the settlor’s spouse. Interests in possession in being at 22 March 2006 continue to fall within IHTA 1984, s 49(1). There will be a chargeable transfer when that interest comes to an end, whether during life or on death, unless the capital is appointed to the life tenant or his spouse absolutely. Any continuing settlement falls within the ‘relevant property’ regime. The benefit of this transitional rule is extended to ‘transitional serial interests’ (TSIs): where an interest in being is created before 6 April 2008 which replaces an interest in possession in existence at 22 March 2006, that replacement interest is treated as if it were itself in existence at 22 March 2006. A life interest ending after 5 April 2008 will also be a TSI if it ends on the death of the life tenant’s spouse who was entitled to a life interest in the same property on 22 March 2006.Will trusts
An interest in possession trust for a surviving spouse will generally be spouse exempt as an ‘immediate post-death interest’ (IPDI). In broad terms, the four conditions set out in IHTA 1984, s 49A require the income to be paid to the spouse until death or earlier termination, typically by capital payment whether to the spouse or to eg. one of the children (which would be a PET by the spouse). Similarly, there can be an IPDI for a non-spouse beneficiary. Any continuing trust would fall within the ‘relevant property’ regime, unless it is either a ‘disabled person’s trust’ or a ‘bereaved minors trust’.Bereaved minors trusts
These are trusts defined by IHTA 1984, s 71A under which, broadly, under the Will or intestacy, a parent, step-parent or person with parental responsibility for the minor leaves assets which he or she inherits at the age of 18. Separately, there is a regime under s 71D called an ‘age 18-to-25 trust’ under which income arises at 18 and capital at 25, when the ‘relevant property’ regime applies to the share in the capital at, but not before, the time the minor attains 18.Anti-avoidance
Gifts with reservation of benefit (GWR)
Unless the settlor is irrevocably excluded from benefit under the settlement, he will be treated by FA 1986, s 102 (as amended) as continuing to be beneficially entitled to the trust property. While both settlor and spouse will usually be irrevocably excluded from benefit, settlements from which the settlor but not his spouse is excluded are not caught for IHT purposes (although the anti-avoidance CGT and income tax rules will apply to such a ‘settlor-interested’ trust, as described in article one of this series).Effects
If the reservation of benefit continues until death, the settlor is treated as if the trust property were comprised in his estate at its then market value. If the benefit was released within the seven years before his death, the settlor is treated as having made a PET at that time at its then value.
If the benefit was released more than seven years before the settlor’s death, the notional PET will become exempt, with no IHT implications.
There is the possibility of double taxation insofar as a gift to discretionary trustees from which the settlor is not excluded from benefit will be both the chargeable transfer and a gift with reservation of benefit. This problem is addressed by the IHT (Double Charges Relief) Regulations 1987 which generally ensure that there is no double taxation.
The pre-owned assets regime
These rules, found in FA 2004, Sch 15 applying from 2005/06, affect trustees indirectly rather than directly. They impose a charge to income tax on a person who in broad terms and in certain circumstances has disposed of land and chattels (or other property with which land or chattels are purchased) and he now occupies that land or enjoys possession of those chattels without their forming part of his estate for IHT purposes. A third charge applies where a person is or would be subject to income tax on any income arising under a settler-interested trust to the extent that the trust fund includes ‘intangibles’ (ie, property other than land or chattels) following such a disposal or contribution by him. These rules are aimed at various arrangements adopted since 18 March 1986 designed to avoid the GWR regime. While such arrangements typically involve trusts, the pre-owned assets charge is primarily a problem for the settlor, though of course the trustees will typically need to be involved in deciding how to respond to them.Planning
The third article in this series, to appear in the next issue of TPT, will consider planning opportunities, pitfalls and suggestions of circumstances in which trusts of one type or another might sensibly be used in practice.Matthew Hutton
August 2006
Matthew Hutton is author of ‘Tottel’s Trusts and Estates Annual 2006-07’, from which the above article is extracted. The book is one of ‘Tottel’s Core Tax Annuals 2006-07’. The series is due to be launched in September 2006. Each of the new Core Tax Annuals costs just £19.95, or all six cost just £99.50! The Core Set comprises:
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