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Tolley's Practical Tax by Matthew Hutton MA, CTA (fellow), AIIT, TEP

Matthew Hutton concludes his series of articles on the taxation of trusts following Finance Act 2006 by considering the circumstances in which trusts of one type or another might be used tax efficiently.This is the final article in our three part series. The first part considered the income tax and capital gains tax (CGT) treatment of different types of trust. Part two reviewed the inheritance tax (IHT) implications of the three main types of trust. This final part aims to pull the threads together by suggesting various circumstances in the office in which trusts might usefully be used – and highlights certain pitfalls.

The FA 2006 IHT regime for trusts, described in article two of this series, constitutes a sea change in the way that trusts are taxed and therefore in the way that one might regard them in the context of estate planning. The Government’s intention is that for trusts created on or after 22 March 2006 there will be an IHT cost if capital vests absolutely at an age greater than 18. This is subject to the transitional rules for interest in possession trusts in existence at 22 March 2006. Generally, this article looks to the future rather than the past.

General considerations

The overriding advantage of any gift into trust, especially if the beneficiaries are minors or are for some reason not considered able to manage their own finances, is that the capital is protected and that its management can be put in the hands of the trustees (whether or not one or more of these is a ‘professional’). If the settlor has in mind the benefit of one of or a few specified children, grandchildren, nephews or nieces, certainly if they are generally over the age of 18, he may well plump for a life interest trust, for reasons of income tax efficiency. The beneficiaries would under such a trust have the right to income, though the trustees should always have power to advance capital to them (subject to tax and other implications).

Where the settlor has a wider class of beneficiaries in mind (and especially if he might wish further beneficiaries to be added in future), the flexibility offered by a discretionary trust may well suit his purposes.

The two previous articles have proceeded on a tax by tax basis. This last article looks at each type of trust in turn, starting with the life interest trust.

Life interest trusts

Income tax

Where capital of the trust was settled before 9 March 1999, a life interest trust on the settlor’s minor children could be used to overcome the disadvantage of the parental settlement rules in ITTOIA 2005, s 629. So long as the income belongs absolutely to each child and is not paid out or applied for his or her benefit, and is retained by the trustees pending attainment of the age of 18, the income is not assessed on the parent for tax purposes and is treated as that of the child, in other words carrying the benefit of the child’s personal allowance, starting, lower and basic rates of tax. That treatment continues for such settlements (though not for income
from capital added to them since 9 March 1999). For settlements made since that date, however, income from such settlements will be taxed on the parent whether or not it is paid out (given that the income from that parent for that child exceeds £100 per tax year).

Dividend income

The FA 1999 changes to dividend taxation can produce an adverse effect on discretionary settlements. That is, where there is no brought forward tax pool and the income of the trust comprises dividend income all of which is effectively distributed to one or more higher rate beneficiaries, their effective rate of tax is 46% rather than 40%. With a life interest settlement, on the other hand, the beneficiaries are in the same net position as if they had owned the shares beneficially, ie a maximum rate of 40%.

Estate planning

The settlor may wish to ensure that his assets go to his children even if his wife remarries following his death. This result could be achieved though an interest in possession in his Will for his surviving spouse (now known as an ‘IPDI’ as defined in IHTA 1984, s 49A) and, following her death, capital for the children. If by contrast he were to make an outright gift to his wife, there is no guarantee that she would not leave her property away from the children.

Inheritance tax: questions of valuation

Where an interest in possession comes to an end during the beneficiary’s life rather than on his death, a special rule applies which displaces the general ‘estate before less estate after’ principle (under which the amount of the transfer of value is the difference between the value of the taxpayer’s estate before the transfer and again after the transfer – not necessarily the same as the value of what is received by the donee). Since 1990 HMRC Capital Taxes accept that, to measure the transfer of value, the settled property is valued in isolation. This may bring advantages. However, the principle is subject to the application of the anti-avoidance ‘associated operations’ rules in IHTA 1984, s 268.

This is a point which continues to apply to those interests in possession which continue to be treated under IHTA 1984 s 49(1), that is, not within the ‘relevant property’ regime.

Reverter to settlor trusts

Advantage cannot be taken of the IHT exemption for new trusts created on or after 22 March 2006, as they will enter the ‘relevant property’ regime. For existing trusts set up to take advantage of the exemption in IHTA 1984, s 53(2) note that they will typically have been drafted to provide a continuing life interest for the settlor, so as to secure the CGT-free up lift on death under TCGA 1992, s 73. But that will now forfeit the IHT exemption as the property remains settled. If the IHT exemption is more important than the CGT-free uplift, (unless of course the settlor’s interest arises before 6 April 2008 as a transitional serial interest), consider changing the trust to provide that the capital vests outright following the termination of the present life interest.

Bare trusts for minor children

While bare trusts have not yet been mentioned in this series of articles, they carry an important CGT advantage. The anti-avoidance income tax rule in ITTOIA 2005, s 629 does not apply to CGT. Regardless therefore of when the bare trust is made for the settlor’s minor unmarried children, the capital is the child’s and so any chargeable gains can take advantage of the child’s annual exemption of £8,800 for 2006/07 and lower and basic rates of tax – even though any income is assessed on the settlor (subject to the de minimis limit and the rule which applied before 9 March 1999).

It seems somewhat curious that in extending the definition of ‘settlor-interested trusts’ for CGT, FA 2006 did not also conform the CGT treatment of bare trusts with income tax. Of course, when the child attains 18 the capital is his and must be paid to him on demand – and of course will be treated as his in the event of insolvency, matrimonial breakdown etc.

Maximising the advantage of the transitional regime

If it is generally advantageous to be treated under the s 49(1) regime, rather than the ‘relevant property’ regime (and that may not be a foregone conclusion), one will generally want to maximise the advantage of the transitional rules introduced by FA 2006.

In particular, if within a settlement the life tenant enjoying an interest in possession at 22 March 2006 can be replaced before 6 April 2008 with a younger and fitter life tenant with a greater life expectancy, this could prove advantageous in postponing the charge to IHT on death. Only when a person succeeds to a life interest on the death of her spouse, need this replacement life interest not pre-date 6 April 2008.

Hold-over relief

Under general principles, where capital leaves a trust the trustees are treated as disposing of and immediately reacquiring the asset at current market value (TCGA 1992, s 71(1)). If a gain results, it may be ‘held over’ either under s 260 in respect of certain types of transfer or, if it is a defined business asset, s 165. S165 relief will apply to any type of trust. S 260 relief can apply only to accumulation and maintenance (A&M) trusts if a beneficiary becomes entitled to capital without a prior right to income. To achieve this result, it may be necessary for the trustees to change the beneficial interests in the trust deed. However, from 6 April 2008 all old A&M trusts will fall within the ‘relevant property’ regime unless capital vests at age 18 – and so will be eligible for s 260 hold-over.

‘Relevant property’ Settlements

In extending the range of trusts which fall within the ‘relevant property’ regime, FA 2006 has considerably extended the number of settlements which can benefit from s 260 hold-over (as mentioned above with an A&M trust in being at 22 March 2006 where an interest in possession arises thereafter and capital subsequent to that, but after 5 April 2008).

Generally, one must remember that where s 260 hold-over is or could be applied, there can be no hold-over under s 165 (TCGA 1992, s 165(3)(d) ).

Hold-over relief

This is the respect in which discretionary and other ‘relevant property’ trusts come into their own. Assume that the asset in question is not a defined business asset which attracts hold-over relief under s 165 (see above). It is possible under s 260 to hold over a gain which for IHT purposes is a ‘chargeable transfer’. This expression will include a transfer within the nil-rate band. Accordingly, if a settlor wishes to put into trust non-business assets, eg quoted stocks and shares, which stand at a gain when compared to historic base cost, he can do so with a discretionary trust, so that the trustees broadly speaking step into the settlor’s shoes. The trustees may hold over a gain when they advance capital out of trust (whether the rate of IHT on exit within the nil-rate band or alternatively a positive charge to IHT arises, as explained in article two). These principles assume that the trust is not ‘settlor-interested’ (see below).

Bear in mind that, even where an asset is acquired under a hold-over election, the date of acquisition of that asset by the trustees for tax purposes cannot pre-date the actual date. This used to be an important point where a secondary residence is transferred into trust under hold-over. Provided that during the trustees’ period of ownership the property was occupied by one or more beneficiaries entitled to do so as their only or main residence under the terms of the settlement, it was, before 10 December 2003, possible to ‘wash’ the whole of the historic gain under TCGA 1992, s 225.

However, significant restrictions on hold-over relief were introduced by FA 2004, with effect from 10 December 2003. First, whether the hold-over election is under s 165 or under s 260, no election is possible if the trust is ‘settlor-interested’. Further, if a gift effective for hold-over is made and then within broadly six years thereafter the settlement becomes settlor-interested, the relief given is clawed back. Second, for disposals on or after 9 December 2003 it is not possible to combine the benefits of s 260 hold- over into a discretionary trust and s 225 relief for the trustees on disposal of a residence occupied by a beneficiary. If the disposal was already made by that date, the benefit of accrued s 225 relief is preserved. Broadly, the choice is between s 260 relief on ‘going in’ and s 225 relief on ‘coming out’.

And of course, following FA 2006, any trust under which during the tax year the minor unmarried children of the settlor can benefit will be ‘settlor-interested’.

Don’t add!

In calculating the ten year charge, the settlor’s history of chargeable transfers in the seven years in preceding the making of the settlement is taken into account when computing the rate (see article two). If a person adds to a settlement, the effect of IHTA 1984, s 67 is that the seven year cumulative total prior to the addition is then substituted in any future calculation of the ten yearly charge, if that is greater than the seven year cumulative total on making the settlement. One should therefore be wary of adding to a settlement unless quite sure of the implications.

More generally, HMRC Capital Taxes tend to argue that, the definition of ‘settlement’ in IHTA 1984, s 43(2) including a ‘disposition of property’, any addition of property to a settlement constitutes a separate settlement.

Will trusts

Everyone (including the readers of this article) should have a Will, which is regularly reviewed. Where the testator is married or has a registered civil partner, it will generally be important to secure the spouse exemption on the first death for immediate post-death interests (IPDI’s) found in IHTA 1984, s 49A as introduced by FA 2006 explained in Part 2. The Committee Stage amendments have helped considerably, both in removing the need for large number of Wills executed before 22 March 2006 (where the testator is still alive) to be changed but also providing greater flexibility in Will structuring for the future.

If following the second death, the capital does not vest outright (or pass into a ‘disabled person’s trust’ or a ‘bereaved minors trust’) the trust fund will then enter the ‘relevant property’ regime.

A further point to watch with Will trusts is the effect of the ‘related settlements’ provisions of IHTA 1984, s 62.

If on the day that a discretionary trust is created (and a Will speaks from death) the settlor makes some other trust, the initial value of that other trust is always taken into account in completing the rate of the ten yearly charge. Only if that other trust is a life interest for the surviving spouse will this rule not apply. However, if that life interest for the surviving spouse is followed by a discretionary trust, the discretionary trust is treated as made by the survivor on her death (under IHTA 1984, s 80) and therefore related to it will be any trust made by her under her Will. The traditional way to avoid the related settlement problem is for a lifetime ‘pilot’ trust to be made with a normal trust fund and for the Will to add property to that pre-existing trust.

All types of trust: capital gains tax

The gains of all trusts are now charged at 40%. There are some planning points that should be watched.

Hold-over relief

If the trustees advance an asset out of trust and elect for hold-over, whether under s 260 or under s 165, they should be wary. To attract the relief, the beneficiary must be UK resident. If within six years after the end of the tax year of the advance the beneficiary becomes non-UK resident the gain is treated as immediately arising. If the beneficiary does not pay the tax within twelve months the trustees can be assessed. They should therefore protect their position, ideally by retaining legal ownership of sufficient of the assets concerned.

The annual exemption

The rules here and the effect of the anti-fragmentation principles were explained at TPT 2006 pages 132 of article one. These need to be watched. Bear in mind, however, that a settlement made by a husband and a settlement made by a wife may each attract its own annual exemption of up to £4,400 (for 2006/07), subject to other settlements made by that spouse. This is worth £1,760 in tax-free gains each year, as against a single settlement made by both spouses.

Losses

The connected party rules in TCGA 1992, s 18(3) were explained at TPT 2006 page 132 of article one. Subject to general anti-avoidance rules the use of a family trust to ‘warehouse’ assets might be considered. For example, current year losses must always be set off against current year gains, even if the effect is to waste the individual’s annual exemption. If by contrast he were to transfer those loss-making assets into a family trust, which then itself made the sale, the loss would be ‘warehoused’ under s 18(3) until such time in the future as that individual made a disposal at a gain to the same set of trustees.

Looking ahead

One should bear in mind that advice can be given only on the basis of the regime as it is. The introduction of the new IHT regime by FA 2006 may not be the last IHT reform introduced by the present Government. What about, for example:

(a) a reduction in the rates of relief for agricultural and business property to 50%;

(b) either further restriction or complete abolition of the PET regime;

(c) reintroduction of the Finance Bill 1989 measures generally prohibiting IHT efficient post-death rearrangements and appointments out of discretionary trusts; and

(d) revision of the IHT calculation on the ten year anniversary to apply the death rather than the lifetime rates of IHT, so producing a maximum of 12%, every six years, equivalent to 40% of every generation of 33 1/3 years?

It is hoped that this series of articles will have cleared away something of the mystique of settlements and will have illustrated ways in which they can be used in family tax planning. That said, the tax tail should never be allowed to wag the more important family dog. Anyone thinking of doing something purely for tax purposes should be dissuaded, as it may well be vulnerable to future HMRC attack.

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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About The Author

Mark McLaughlin is a Fellow of the Chartered Institute of Taxation, a Fellow of the Association of Taxation Technicians, and a member of the Society of Trust and Estate Practitioners. From January 1998 until December 2018, Mark was a consultant in his own tax practice, Mark McLaughlin Associates, which provided tax consultancy and support services to professional firms throughout the UK.

He is a member of the Chartered Institute of Taxation’s Capital Gains Tax & Investment Income and Succession Taxes Sub-Committees.

Mark is editor and a co-author of HMRC Investigations Handbook (Bloomsbury Professional).

Mark is Chief Contributor to McLaughlin’s Tax Case Review, a monthly journal published by Tax Insider.

Mark is the Editor of the Core Tax Annuals (Bloomsbury Professional), and is a co-author of the ‘Inheritance Tax’ Annuals (Bloomsbury Professional).

Mark is Editor and a co-author of ‘Tax Planning’ (Bloomsbury Professional).

He is a co-author of ‘Ray & McLaughlin’s Practical IHT Planning’ (Bloomsbury Professional)

Mark is a Consultant Editor with Bloomsbury Professional, and co-author of ‘Incorporating and Disincorporating a Business’.

Mark has also written numerous articles for professional publications, including ‘Taxation’, ‘Tax Adviser’, ‘Tolley’s Practical Tax Newsletter’ and ‘Tax Journal’.

Mark is a Director of Tax Insider, and Editor of Tax Insider, Property Tax Insider and Business Tax Insider, which are monthly publications aimed at providing tax tips and tax saving ideas for taxpayers and professional advisers. He is also Editor of Tax Insider Professional, a monthly publication for professional practitioners.

Mark is also a tax lecturer, and has featured in online tax lectures for Tolley Seminars Online.

Mark co-founded TaxationWeb (www.taxationweb.co.uk) in 2002.