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In the second part of a series of notes on the inheritance tax (IHT) treatment of trusts after Finance Act 2006, Matthew Hutton MA, CTA (fellow), AIIT, TEP looks at Transitional Serial Interests, Accumulation and Maintenance Trusts and Trusts of Life Insurance Policies. 

Transitional Serial Interests (TSIs)

Restriction of the Section 49(1) Deeming Provision

FA 2006 amends s 49(1) of IHTA 1984 to provide that it shall apply to an interest in possession arising on or after 22 March 2006 only if (under new s49(1A)) it is:

(a) an Immediate Post-Death Interest (IPDI);
(b) a disabled person’s interest; or
(c) a Transitional Serial Interest (TSI).

A further amendment applies to interests in possession arising before 22 March 2006 so as to exclude the basic s49 rule in a case where the trust property satisfies the conditions of s71A as a bereaved minors trust.

TSI’s are defined by s 49B as covering three cases dealt with separately below.  Section A of the HMRC Responses confirms that a generally relaxed view will be taken in determining when a TSI arises.  For example, TSIs can arise separately in relation to different funds in a settlement.  The exercise by the trustees of a power of advancement before 6 April 2008 extending a Budget Day 2006 interest in possession will rank as a TSI.  But the answers to Questions 8 and 9 warn that the replacement interest must, to be a TSI, arise in ‘the same settlement’ as subsisted at 22 March 2006.

Section 49C TSI:  Interest to Which Person Becomes Entitled During Period 22 March 2006 to 5 April 2008

The four conditions effectively require:

• a pre-22 March 2006 settlement immediately before which B or someone else was entitled to an interest in possession (the ‘prior interest’);  
  
• the prior interest came to an end between 22 March 2006 and midnight on 5 April 2008; 
  
• B became beneficially entitled to the current interest at that time; and 
  
• the property is not a bereaved minors trust or a disabled person’s interest.

Example

Jane, now aged 75, is the life tenant under a Will trust made by her late husband who died ten years ago.  Feeling fairly healthy and thinking of IHT mitigation of her own estate, she feels that she can do without the income from the Will trust.  So before 6 April 2008 and at Jane’s request the trustees exercise their powers to terminate Jane’s interest in favour of a continuing interest in possession for Jane’s son Gerald aged 49 (but if the trustees do not have such powers, Jane could assign her income interest, as an interest ‘pur autre vie’. In either case that would be a PET by Jane.) That will create a TSI for Gerald and so an interest to which Gerald is treated as beneficially entitled under IHTA 1984 s 49(1A)(c).  The only qualification is that if Jane continues to enjoy a benefit from any of the trust property (whether bricks and mortar or not), she will be treated under FA 1986 s 102ZA as having made a gift with reservation of benefit. 

Section 49D TSI:  Interest to Which Person Becomes Entitled on Death of Spouse or Civil Partner on or after 6 April 2008

The five conditions are in broad terms that:

• the settlement began before 22 March 2006 and immediately before then there was an interest in possession to which someone other than the person with the current interest (E) was entitled, that is ‘the previous interest’;
  
• the previous interest came to an end on or after 6 April 2008 on the death of the spouse or civil partner of E (‘F’); 
  
• F was immediately before he died the spouse or civil partner of E; 
  
• E became beneficially entitled to the successor interest on F’s death;  and 
  
• the property is not either a bereaved minors trust or a disabled person’s interest. 

Section 49E TSI:  Contracts of Life Insurance

These provisions expressly extend TSI treatment to trusts of a life insurance policy made before 22 March 2006 where:

1. at 21 March 2006 there was an interest in possession to which C or someone else was beneficially entitled (‘the earlier interest’);

2. the earlier interest came to an end on or after 6 April 2008 (‘the earlier-interest end-time’) on the death of the life tenant and C became beneficially entitled, whether

(a) on the earlier-interest end-time or on the death of a previous life tenant who had become entitled at the earlier-interest end-time or on the termination of the second or last in an unbroken sequence of two or more consecutive interests in possession (to the first of which someone became beneficially entitled at the earlier-interest end-time and each of which ended on the death of the previous life tenant); or

(b) on the termination on death of the beneficiary of a TSI under s49C; or

(c) on the coming to an end of the second or last in an unbroken sequence of two or more consecutive interests in possession, the first of which was a TSI under s49C and each of which ended on the death of the beneficiary;

3. rights under the contract were comprised in the settlement throughout the period beginning with 22 March 2006 and ending with C’s becoming beneficially entitled; and

4. the property is not either a bereaved minors trust or a disabled person’s interest. 

Summary:  a Comparative Illustration

In general terms the TSI provisions present something of a concession to the strictness of the removal of the s49(1) rule once an interest in possession in being at Budget Day 2006 has come to an end.  They assume of course that, generally speaking, the s49(1) regime is preferable to the ‘relevant property’ regime.  That of course will not be true in every case.  In very broad terms, compare (subject always of course to the nil-rate band) two alternative scenarios involving property which attracts neither agricultural nor business property relief: 

(a) In Scenario A, the property is owned beneficially (or, on a pre Budget Day 2006 basis, comprised in successive life interests where deaths occur every six years, sufficient to avoid the benefit of quick succession relief under IHTA 1984 s141).  Here there will be an IHT charge at 40% on the chargeable value at death; and
(b) Scenario B, where instead the property concerned is comprised in a discretionary trust where there will be charges under the present regime at a maximum of 6% every ten years, but there will also be an immediate IHT ‘hit’ @ 20% (subject to the availability of the nil-rate band). 

Starting off with say 100 therefore and assuming deaths of grandfather, father and son at years 5, 15 and 25 there would, disregarding capital appreciation, and the nil-rate band, be just 21.6 left under Scenario A at say year 30, whereas in Scenario B there will be 66.4 left.  If under future legislation the death rates were to be applied in working out the ten year charge, the 66.4 would fall to 54.5 - though still vastly preferable to Scenario A. 

The arguments in favour of Scenario A are that, generally:

(a) deaths do not follow so quickly and with at least say 33 1/3 years between them (the notional generation on which the FA 1975 charging structure was based);
(b) people do not like the regularity of a system which imposes tax at fixed ten-yearly intervals – on the ill-founded assumption that they are immortal!; and
(c) connected with both the previous points, it seems in principle easier to make provision for IHT payable on death through life assurance written under appropriate trusts than for automatic charges occurring every ten years where the investment returns on a traditional endowment policy have hardly proved overwhelming.   

Accumulation and Maintenance Trusts

Overview

The effect of IHTA 1984 s 71 is to exclude from the ‘relevant property’ regime for discretionary trusts property which satisfies the conditions set out in s 71, but only in relation to property for as long as those conditions are fulfilled.  Thus, the expression ‘A & M trust’ is something of a misnomer and a settlement satisfying the s 71 conditions is better described as falling within the ‘A & M regime’.  Someone with a trust subject to the s71 regime as at 22 March 2006 has broadly four choices: 

(a) Wind the trust up before 6 April 2008. 

(b) Leave the trust as is, accepting that, depending on its terms, the relevant property regime will start to apply at least from 6 April 2008, subject to (b) and (c) below.  Of course, if an interest in possession arises at any time after 21 March 2006, whether under Trustee Act 1925 s31, there being no subsisting period of accumulation, or expressly under the terms of the Deed, the property concerned will at that point fall into the relevant property regime with its system of 10 year and exit charges. 

(c) Change the terms of the trust (if necessary) to provide that the beneficiaries will become entitled to capital on or before attaining the age of 18.  Para 3 of FA 2006 Sch 20 effectively provides that as from 6 April 2008 the s 71 regime will continue to apply in those circumstances and that, specifically, no charge to IHT arises on the attaining of an absolute interest.

(d) The trusts of the settlement are changed (if necessary) to ensure  that, in relation to any presumptive share, capital arises on or before 25; income need not arise at age 18 to the extent that there is a  subsisting accumulation period.  This is achieved by ss (3) and (4) of new s 71D which apply s 71D(6), taken from the age 18-to-25 trust for Wills, under which in broad terms capital must vest on or before age 25 and any application of income or capital before that age must be for the beneficiary and for no-one else under the trust. In that case, the assets underlying a presumptive share will not enter the special charging regime (which imposes an exit charge similar to the A & M regime under IHTA 1984 s 65) until the relevant beneficiary attains the  age of 18. Specifically, a s 71D age 18-to-25 trust is excluded from the definition of relevant property in IHTA 1984, s 58(1)(b).

However, do note that if step (c) or (d) above is not taken before an interest in possession arises, at some time after 21 March 2006 and before 6 April 2008, a new relevant property settlement will come into being at that stage.  Equally, note the important difference between (c) and (d): under (d) the strict conditions of s71D require the establishment of presumptive shares in which only the respective beneficiaries can benefit, whereas with (c) prospective entitlement to the presumptive shares can be varied, in line with the traditional flexibility of s 71.  Section D of the HMRC Responses considers what is required to establish an age 18-to-25 trust: this is the subject of continuing correspondence between CIOT/STEP and HMRC.

Capital Gains Tax Implications

Prior to 22 March 2006 where a beneficiary became absolutely entitled as against the trustees of an A & M trust and a gain arose under TCGA 1992 s 71, a gain on non-business assets could be held over only where a beneficiary became entitled to   capital without being entitled to a prior interest in possession (s 260(2)(d)).  Hold-over relief on business assets was of course available under s 165. That will continue to be the case on absolute entitlements arising before 6 April 2008 (without a prior interest in possession).  Thereafter, the rule in s 260(2)(d) will remain for non-business property, but the position will be substantially improved in so far as a number of A & M trusts created before 22 March 2006 will enter the relevant property regime, with general hold-over available under s 260.  On the whole, such hold-over under s 260(2)(a) will be available to defer a gain arising on an absolute entitlement at any time on or after 22 March 2006, subject, however, to one, possibly important, exception.  This is the case where the absolute entitlement occurs either on, or within one quarter following, the day after the date of a ten year anniversary.  This is the consequence of s 69(4) and s 65(4), effectively disapplying s65(1) which brings in ss 68 and 69: see Example. 

Bear in mind that the FA 2004 restriction for settlor-interested trusts under TCGA 1992 s169B applies only to property entering, and not to property leaving, such trusts.

Knock-on IHT Implications for Old A & M Trusts Entering the Relevant Property Regime

The calculation of the ten-year charge arising under IHTA 1984 s64 depends in particular upon being able to ascertain both the commencement date, that is when property first became comprised in a settlement (s 60) and this of course might have been at any time since 1975 (if not even earlier), but also more materially, in calculating the rate of the ten-yearly charge under s66, the cumulative total of the settlor’s chargeable gifts history in the seven years immediately preceding commencement of the settlement.  This may not be always easy to ascertain.  Further, the initial value of any ‘related settlements’, that is those which were made by the same settlor and commenced on the same day (s62), will affect the calculation of each ten-yearly charge.  If on the same day in the past the settlor made both an   A & M trust and an interest in possession trust, the related settlements rule (which has an impact only for purposes of Chapter III of Part III) would not have been of concern to him.  Indeed, he might expressly have made both settlements on the same day, so that in the event of his death within seven years, each of them would have a pro rata call on any available balance of the nil-rate band.

Example

Reginald made an A & M settlement for his three children on 1 June 1996.  The terms of the trust were:  entitlement to income to arise on the later of expiry of the 21 year accumulation period from the date of making the settlement and any child’s attaining the age 18, with capital deferred until his grandchildren attained 18, with wide powers of advancing capital meanwhile.  Reginald had on 1 December 1990 made a discretionary settlement of £100,000 for a wide class of beneficiaries (not including his wife or himself, however).  Reginald was aware in June 1996 that were he to die before 1 June 2003 the PET constituted by £300,000 worth of stocks and shares would have become a chargeable transfer and that the £100,000 put into the 1990 discretionary settlement would have had ‘first call’ on his nil-rate band (whereas, had he waited until 1 December 1997 to make the A & M, death within seven years would not have had the same effect in terms of cumulation of the discretionary trust transfer).  Indeed, on surviving until 1 June 2003, a bottle of champagne was duly enjoyed. 

Now, however, and following professional advice Reginald and his wife Alicia do not wish to change the terms of the A & M settlement to provide either for capital to vest at age 18 or for an age 18-to-25 trust and so the trust property will enter the relevant property regime on 6 April 2008.  The first ten-year charge under the new regime will arise on 1 June 2016 when the relevant property then in the settlement will fall into charge.  However, the rate of tax to be applied will take into account the £100,000 settled on discretionary trusts in 1990. 

There was no way that Reginald or his advisers could have known in 1996 that a completely separate trust would under a new IHT regime affect IHT liabilities and actions taken years later in relation to his A & M settlement. 

Example

Developing the above example, on 1 June 1996 Reginald also made an interest in possession settlement in the sum of £125,000 for his spendthrift sister Ruth.  Again, this was a PET.  However, Reginald now finds, for reasons explained above, that the £125,000 initial value is brought into account as a related settlement in computing the first and subsequent ten-year anniversary charges on the settlement for his children, which expressly had been kept outside the ‘relevant property’ regime in 1996 when Reginald set up the trust for his sister. 

Exit before the first ten year charge

Assume a pre-22 March 2006 A & M settlement which enters the mainstream trust regime from 6 April 2008.  Let’s take the above Example and consider an exit of property on say 31 May 2016. 

The chargeable amount is fixed under s 65(2) as that by which the relevant property in the settlement is reduced, whether in whole or in part.  The rate is found under s 69 ‘rate between ten-year anniversaries’ (s 68 ‘rate before first ten-year anniversary’ not applying).  Under s 69(1) this is ‘the appropriate fraction’ (ie depending on the number of quarters that have elapsed since the last anniversary) of the rate at which it was ‘last charged under s 64 (or would have been charged apart from s 66(2))’ Section 66(2) then applies where, as in our case, property which was comprised in the settlement immediately before the most recent ten year anniversary [viz 1 June 2006] but was not then relevant property has become relevant property.  And s 69(3) provides that, for purposes of the exit charge, the assumed previous ten year anniversary charge adopts the value of the property when it became relevant property, with, however, under s 69(4) a discount in calculating the exit  charge for the number of complete quarters since the ten year charge during which it was not relevant property.

Example

Assume that the value of the trust fund of Reginald’s settlement on 1 June 2006 was £1m and on 6 April 2008 £1.2m.  The trustees advance the whole fund (now worth £2m) to Reginald’s children in equal shares on 31 May 2016.  What is the exit charge?

Note that, depending on the level of the nil-rate band in 2016/17, it may be cheaper to accept a ten year anniversary charge on 1 June 2016 and pay out the capital on say 3 September 2016, at a cost of a small further exit charge but so as to ensure CGT hold-over (see above).

Changing the trust to vest capital at age 18

This assumes that the presumptive shares in capital are held on trusts under which capital vests absolutely at age 18.  In this case the relevant property regime will not apply to a presumptive share during such time as elapses between 6 April 2008 and the beneficiary attaining  age 18 (FA 2006, Sch 20 para 3).

Changing the trust to comply with s 71D (the age 18-to-25 regime)

In this case the capital is preserved from being ‘relevant property’ under IHTA 1984 s 58(1)(bd).  In relation to a prospective share in capital, the capital will come into charge on the later of 6 April 2008 and attainment by the beneficiary of age 18:  the charge will apply as illustrated in the Example below.  There is no IHT charge on entry into the s 71D regime (whether under s 70(6) or otherwise).  See also below for the detail of the s 71E charge.

Example

Harold made a settlement for his children on 1 January 1980.  Under the terms of the settlement there was a direction to accumulate income for 21 years (now therefore expired) with children becoming entitled to income at age 18 and capital deferred broadly until grandchildren attained 18, with wide powers of advancement of capital before that age.  Harold has three children: Arabella, Bertha and Charles.  Each of Arabella and Bertha is in line for substantial inheritances from godparents and so before either attained an interest in possession under the settlement they were effectively excluded, leaving Charles as the sole prospective beneficiary.  Charles becomes 18 on 1 January 2010.  Before 6 April 2008 the terms of the trust are changed to become compliant with s 71D.

In the seven years before he made the settlement Harold had cumulative chargeable transfers of £100,000 and there were no related settlements.  The initial value of the settlement was £200,000.  The trust assets are now worth £500,000.  When Charles becomes 25 on 1 January 2017 when, let us suppose, the fund is worth £1m and that the rates of tax are as in 2006/07 but with a nil-rate band of £630,000, the calculation under s71F of the s71E exit charge proceeds as follows:

The tax is: chargeable amount x relevant fraction x settlement rate (s 71F(3)).  The ‘chargeable amount’ is £1m (assuming that any tax is paid out of it and not out of any property remaining subject to s 71D trusts, in which case there would be grossing up (s 71F(4)).  Although the ‘chargeable amount’ is expressed as a bare value, the HMRC Responses to Question 23 confirm that any available agricultural or business property relief will go to reduce the amount, the charge falling within Chapter III of Part III of IHTA 1984. The ‘relevant fraction’ is 3/10 x 28/40 (the number of complete successive quarters in the period, viz 0.21 (s 71F(5)).  The ‘settlement rate’ is the effective rate found under s 71F(7)-(9) as follows:

Therefore the settlement rate is 0%.

So, in this case, the IHT is zero: £1,000,000 x 0.21 x 0.

Suppose that Charles had a brother, David, whom the trustees also wanted to benefit.  David was born two years after Charles and so the capital of around £1 million is divided between them, David inheriting his share on 1 January 2019.  The calculation of the rate of tax applicable on the exit would be exactly the same for David as it is for Charles. 

The s 71E Charge:  Possibility of Double Charges?  No!

Consider an age 18-to-25 trust, whether made under a Will or through an amendment of an existing A & M, it matters not.  There are two beneficiaries, Adam and his sister Belinda.  Adam dies aged 24 at a time when Belinda is aged 19.  The capital in Adam’s share now passes presumptively to Belinda and is held on s 71D trusts.  The question is whether there is an exit charge on Adam’s death and, if so, when the capital vests in Belinda at age 25 from the share previously owned by Adam, how many quarters are taken into account in computing the relevant fraction, which under s 71F(5)(a) might be more than 28.

HMRC Response 30 confirms that there is no exit charge on Adam’s death as the property continues to be subject to s71D trusts.  And, when Belinda becomes 25, the share previously attributed to Adam is taxed on the basis of 28 quarters only, ie disregarding any which elapsed after Adam, but before Belinda, attained 18: see s 71F(5)(a).

Playing the System, to Defer Ten Year Charges?

It has been suggested on the lecture circuit that one might set out to create an age 18-to-25 trust out of a Budget Day A&M, with a view to avoiding the 10 year charge, and then just before the 25th birthday of the beneficiary with the prospective share change the trusts to extend them beyond age 25, relying on an extended section 32 power of advancement.  Similarly with a bereaved minors trust.  There would, in the case of an 18-to-25 trust, be an exit charge under s 71E, in many cases at rather less than the ‘standard’ 4.2%.  Only then would the trust fund in either case enter the relevant property regime.  Of course one would have to be able to satisfy the benefit test in section 32, though the 1964 House of Lords’ decision in Re Pilkington’s Will Trusts: Pilkington v Pilkington [1964] AC 612 would help.   However, if HMRC got wind of such a move becoming widespread they might act to try and stop it.  Clearly there should be no expressed intention that that was likely to happen in the fullness of time!

Trusts of Life Insurance Policies

Life interest trusts of life insurance policies in being at 22 March 2006, and in certain circumstances life interests replacing such, attract transitional treatment under new IHTA 1984, s 49E – see above. 

Further, somewhat surprising, ameliorating measures touch on life assurance policies made before 22 March 2006, either in which there is an interest in possession or which fall within the A & M regime at that date – covered by new ss 46A and 46B respectively.  They address the cases where premiums are paid, or ‘allowed variations’ are made, on or after 22 March 2006.  In either case the rights secured by either the payment of the premium or the ‘allowed variation’ are regarded as having been comprised in the settlement as at 22 March 2006.  An ‘allowed variation’ is defined as a variation which ‘takes place by operation of, or as a result of exercise of rights conferred by, provisions forming part of the contract immediately before 22 March 2006’. 

Premiums paid by an individual to trustees of such a policy will, if not covered by the annual or normal expenditure out of income exemptions, be PETs (IHTA 1984 s 46A(4) for interest in possession trusts and s 46B(5) for A & M trusts).

NOTE: While I have taken every care in writing this Summary Note to reflect the provisions of FA 2006 Schedule 20 and to analyse those provisions in the Worked Examples, I can accept no responsibility for any loss occasioned to any person acting or refraining from action as a result of the material in this Note.  Specialist advice should be taken as necessary in all cases.

Inheritance Tax 2007/08: Practical Solutions

New Connaught Rooms, London WC2

Wednesday 20th June 2007

Only £350 plus VAT per delegate (with 10% discount for those coming to one of Matthew Hutton’s Estate Planning Conferences in Autumn 2007) 

Inheritance Tax Mitigation continues to be at the forefront of the priorities of many individuals and families. And, especially following the FA 2006 'Alignment of IHT for Trusts', the issues do not get any easier. At least Budget 2007 has given us all some respite from last year’s pace of change.  This full-day Conference has been designed to give an up-to-date and cutting edge analysis of the options open to your clients and the practical steps they should take - or indeed avoid. To this end Matthew Hutton has assembled a first class panel of Speakers. This Conference is designed as a prelude to Matthew’s more general Estate Planning Conferences to be held (this year, only) in the Autumn.

• Business Property Relief - John Tallon QC, Pump Court Tax Chambers

• Trusts - Chris Jarman, Thirteen Old Square

• The Family Home - Nick Hughes, Director of Estate Planning & Trusts,     
           Chiltern plc

• Agricultural Property Relief- Adrian Baird, Chief Taxation Adviser, CLA

• The Use of Insurance Products in IHT Mitigation - Penny Bates, Partner, Menzies & Co

• Wills and Post-Death Arrangements - Matthew Hutton, Chartered Tax Adviser

Matthew Hutton Conferences 2007

On 20 June Matthew has organised an all-day Conference in London on Inheritance Tax Planning 2007/08 at which the Speakers will be John Tallon QC (Pump Court Tax Chambers), Chris Jarman (Thirteen Old Square), Nick Hughes (Director of Estate Planning & Trusts, Chiltern plc), Adrian Baird (Chief Taxation Adviser CLA), Penny Bates (Partner, Menzies & Co) and Matthew himself.

The cost is £350 plus VAT per delegate or, for those coming to one of Matthew’s Estate Planning Conferences in the Autumn, £315 plus VAT per delegate.

Matthew’s six round the country Estate Planning Conferences in September and October 2007 will be held on the following dates and at the following venues:

East - Thursday 6 September: Cambridge Belfry Hotel, Cambourne CB3 6BW           

North - Wednesday 19 September: Tankersley Manor, South Yorkshire S75 3DQ          

Midlands - Tuesday 25 September: Woodland Grange, Leamington Spa CV32 6RN            
West - Thursday 4 October: Hilton Bristol Hotel BS32 4JF                   

South - Wednesday 17 October: Norton Manor Hotel, Sutton Scotney, nr Winchester SO21 3NB

London - Wednesday 31 October: New Connaught Rooms, London WC2               

The subject matter has yet to be finalised, although brochures will be available in June.  The cost is £295 plus VAT per delegate or for those who have attended a previous Matthew Hutton Estate Planning Conference £270 plus VAT per delegate.

Enquiries for all these Conferences should be made to Matthew on mhutton@paston.co.uk.