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In the third of a series of extracts adapted from his eBook 'Hutton on Estate Planning' (3rd Edition), Matthew Hutton outlines the various types of trust and their Inheritance Tax (IHT) implications.

A Convenient Recipient of Lifetime Gifts

Where a gift is to be made but either the donor wishes to ensure some protection and/or a suitable donee does not present himself, a trust can be a useful mechanism. Even if death follows within seven years, the value charged to IHT will be that prevailing at the date of the gift, not at the date of death, by when the asset(s) may have appreciated. The full range of exemptions and reliefs is available for transfers into trust as for other types of property. Note that, on termination of a qualifying or ‘estate’ interest in possession, use of the life tenant’s Annual Exemption(s) requires notice by the life tenant to the trustees (IHTA 1984 s 57). The same point applies to the life tenant’s Marriage Exemption.

Settlor and Spouse/Civil Partner Should be Excluded

To be effective for IHT purposes the settlor must be excluded from benefit to avoid the GWR regime (FA 1986 s 102). There is no pro rata provision. While generally the pre-owned assets (POA) regime will not apply if either GWR does or would but for certain express exceptions, the two regimes are not completely mutually exclusive. Hence, for example, while GWR requires a dispostion by way of gift, a disposal of land with full consideration which the donor occupies may be caught by POA. The following comments about the spouse/civil partner apply to the POA regime for settled intangible property just as they do to GWR. The settlor’s spouse/civil partner can be included, although this will have Income Tax implications (under ITTOIA 2005 part 5 chapter 5) and, before 2008/09, also CGT implications (TCGA 1992 s 77, repealed from 2008/09). However, these anti-avoidance provisions will not apply if the spouse/civil partner can benefit only after the settlor’s death.

The Key IHT Distinction

In broad terms, the IHT treatment of a lifetime trust will fall into one of what were two categories before 6 April 2008, but are now just two ((a), and (b) below). The age 18-to-25 trust (category (d)) is essentially a type of Will trust, although before 6 April 2008 property within the accumulation and maintenance regime could be converted into such a trust.

(a) The Relevant Property Regime

This applies to discretionary settlements and almost every other type of lifetime settlement made on or after 22 March 2006, except where the beneficiary is disabled (IHTA 1984 s 58).

The general principle with such settlements is that at commencement the settlement inherits a cumulative total equal to that of the settlor on the day prior to creation plus the value of other funds settled by the settlor on the day of creation (related settlements). There are then two principal charges:-

(i) a ten-year anniversary charge, which is applied to the then value of the trust fund, given the initial cumulative total and funds leaving the trust in the preceding ten years (IHTA 1984 s 64). This is computed so that over the course of an assumed generation, some 33 & 1/3 years, the trust fund attracts tax at the 20% lifetime rate. This means a maximum tax charge every ten years of 6% and very often less than that, given availability of the Nil-Rate Band and any reliefs; and

(ii) an exit charge, which varies according to whether it occurs in the first ten years or thereafter (IHTA 1984 s 65). In the first ten years the notional value charged is equal to that of the assets advanced, by reference to a given fraction of the rate at which tax would be payable at the exit date on the funds settled given the initial cumulative total, any related settlements and any added property. This means that if the gross value of the initial funds settled and of any other settlements made on the same day, plus that of any additions to the settlement, fall within the Nil-Rate Band in force at exit within the first ten years, there is no exit charge whatever, on the then value.

TAX TRAP: The rate of tax on exit within the first ten years is found by reference to the value of the assets when settled before BPR or APR (IHTA 1984 s 68(5)(a)). It is not enough therefore for the initial value to be within the Nil-Rate Band solely because of APR/BPR, as this could give rise to a positive rate of tax. However, this will matter only if the property concerned does not itself attract APR or BPR at exit. The exit charge after the first ten year anniversary is an appropriate fraction of the rate charged at the previous anniversary.

(b) ‘Estate’ Interests in Possession

This embraces settlements which are treated as if the underlying trust property were owned beneficially by the beneficiary (IHTA 1984 s 49(1)), namely Interest in Possession settlements made before 22 March 2006 so long as the interest in existence at that date continues or is replaced by a qualifying ‘Transitional Serial Interest’. This point also applies to life interests under Wills whenever the death occurs (called ‘Immediate Post-Death Interests’ or IPDIs). That means that, for example, on death of the beneficiary the trust property to which he has had a right to income is added to his free estate, and a single ‘estate rate’ is calculated, to be applied separately to the free estate and the settled estate (subject of course always to exemptions such as the Spouse/Civil Partner Exemption). 

(c) Accumulation and Maintenance Trusts (A&M trusts) made Before 22 March 2006

These is a special category of settlement (defined in IHTA 1984 s 71), made broadly for children or grandchildren of the settlor, which received special treatment as discretionary settlements from 1975 to 2006 through an exemption from the ten year anniversary and exit charges. However, no new such settlements can be made on or after 22 March 2006 and a transitional regime which applied to such A&M trusts in being at that date came to an end on 5 April 2008.

(d) The 'Age 18-to-25’ Trust

This type of trust, whether arising out of an A&M trust for the settlor’s children or grandchildren or created under a Will for the testator’s children (IHTA 1984 s 71D), suffers an exit charge at a maximum of 4.2%, rather as under the A&M regime.

Impact of Finance Act 2006

For the rich (however one defines that term), it is clear that the FA 2006 ‘Inheritance Tax Alignment of Trusts’ has had a significantly damaging effect. This is because one of the great advantages of making a trust for one’s children or grandchildren – and of course the spouse/civil partner can safely be a trustee, while being excluded from benefit – is that the capital is not available to creditors nor indeed will it generally be vulnerable in matrimonial proceedings. But now, making any lifetime trust with an initial chargeable value – or any addition to a trust - which causes the settlor to exceed his Nil-Rate Band triggers to that extent an IHT liability at 20% (to rise to 40% if he dies within seven years). The only exceptions to this rule are an exclusively charitable trust (exempt) or a qualifying trust for a disabled person (a PET).

The above is an adapted extract from Hutton on Estate Planning 3rd Edition.

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