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In the fourth and final 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 considers important capital gains tax implications of the IHT trust regime, a IHT reservation of benefit issue, some practical implications and possible action points. 

Matthew Hutton

Capital Gains Tax Consequentials

Part 4 of Sch 20 amends TCGA as follows.

Section 72 Termination of Life Interest on Death of Person Entitled

This is the CGT-free uplift market value on the death of the life tenant.  The rule is now qualified so that where the interest arises on or after 22 March 2006, it applies only if the interest is an Immediate Post Death Interest (IPDI), a Transational Serial Interest (TSI) or a disabled person’s interest or (interestingly, because these are not treated as s 49 interests in possession for IHT purposes) if there is a trust for a bereaved minor (s 71A) or an age 18-to-25 trust (s 71D) and in either case the beneficiary dies under the age of 18.

A similar qualification is made to s 72(2), interests pur autre vie, where the beneficiary of the autre vie interest dies but the autre vie remains alive and so the interest in possession continues.

Section 73 Death of Life Tenant:  Exclusion of Chargeable Gain

Where the life tenant’s death results in an absolute entitlement, again the deemed disposal and reacquisition by the trustees at market value does not trigger a chargeable gain (though if there is an absolute reverter to the settlor, the settlor’s base cost is the trustees’ acquisition cost, not market value at date of death).

Again, where the interest in possession arises on or after 22 March 2006, the rule applies only if the interest in possession is as set out above.

Section 260 Hold-Over

Any gift into or out of a settlement where the interest is not treated as owned by the life tenant under s 49(1) is capable of hold-over under s 260, as a chargeable transfer (even at the nil rate).  There is an amendment to s 260(2) to include the case where the beneficiary becomes absolutely entitled (or dies) on attaining the age of 18 (or lower age) under a bereaved minors trust or becomes absolutely entitled under an age 18-to-25 trust or where the individual beneficiary dies under that age. 

The CGT impact of Sch 20 on A & M settlements in being at 22 March 2006 was discussed earlier in this series.

Reservation of Benefit

Handling the Home in the Will

A useful structure under the Will of the first spouse to die in relation to the family home (and also perhaps other assets) has in the past been allowed by the traditional view of the application of the reservation of benefit (GWR) provisions in FA 1986.  Where under the terms of the Will trust the trustees remove or cut down the life interest in favour say of the children, the widow is treated as making a PET but if she continues to enjoy the property, eg the family home, she is not treated as having made a disposition by way of gift.  Indeed, in the 2003 Court of Appeal decision in Eversden & Eversden (Greenstock’s Executors) v CIR 75 TC 240 Carnwarth LJ noted that if the result argued by the Inland Revenue, namely that there would be a GWR on the part of the life tenant in those circumstances, were to follow, it would have to be achieved by a change in the legislation. 

Arrangement Blocked by FA 2006

That legislation has now been made, with effect from 22 March 2006, by new FA 1986, 102ZA.  The rule applies where a person is entitled to an interest in possession to which he became entitled before 22 March 2006 or, if on or after that date, it is an IPDI, a disabled person’s interest or a TSI and it comes to an end during the person’s life.  For purposes of the GWR regime the individual is taken to dispose of ‘the no-longer-possessed property’ by way of gift when the interest in possession comes to an end.  This is defined to be the property in which the interest in possession subsisted other than any part to which he becomes absolutely entitled.

There is a similar new para 4A REPLACE ed into Sch 20 of FA 1986 which deals with terminations of interests in possession in the case where the property continues to be settled.  Where under s 102ZA the beneficiary is treated as disposing of property by way of gift, the GWR regime applies as if the property comprised in the gift consisted of the trust assets on the material date (except in so far as it neither is nor represents nor is derived from property originally comprised in the gift).  Any property which is on the material date comprised in the settlement and is derived directly or indirectly from a loan made by the beneficiary to the trustees is treated as derived from property originally comprised in the gift.  Similarly, if the settlement ends before the material date, any property which would have been treated as comprised in the gift on the beneficiary’s death (other than property to which he becomes entitled and where consideration is given by him for any of the property) is treated as comprised in the gift. 

A strict construction of s 102ZA might suggest that it can apply only where the beneficiary’s interest in possession comes to an end in whole and not in part, though this would seem to cut across the thinking behind the new provision.  It seems likely that a court would apply a purposive interpretation, to include partial terminations.

There seems to be the potential for a double charge under the new rule, as noted by Chris Jarman of Counsel.  If, in a s 102ZA situation, the beneficiary does not survive the seven year risk period, she will be treated both as having made a now chargeable transfer under general principles, as well as the deemed PET under the GWR regime, with no protection under the 1987 Double Charges Regulations (as amended). HMRC need to address this point.

Some Practical Implications in Particular Cases

Reverter to Settlor Trusts

(a) The effect of Schedule 20

The twin capital tax advantages of reverter to settlor trusts made before 22 March 2006 are as follows.  For IHT purposes, there is an exemption from IHT under IHTA 1984, s 53(3), so that any appreciation in value in the trust property between entering and leaving the settlement escapes IHT.  And, provided that the settlement continues and the property does not immediately vest outright in the settlor, there is the CGT-free uplift to market value on death accorded by TCGA 1992, s 72(1)(b). Where, however, the property vests outright, the settlor is treated by s 73(1)(b) as having taken the property at the trustees’ (indexed) base cost.  The accepted wisdom therefore has been to have the property revert to the settlor on a life interest trust, with power to advance capital which the trustees would then exercise.

What is the effect of the new regime on the above structure?  While the CGT-free uplift will be achieved, there will be no IHT relief, as on the death of the life tenant the trust will enter the ‘relevant property’ regime.  To secure the IHT relief, the property must vest outright, so losing the CGT-free uplift.

In consequence, failing the TSI analysis with death of the life tenant before 6 April 2008, one must generally decide (while the life tenant is alive) between the balance of advantage as between IHT and CGT.  If, as is likely, the IHT advantage is preferable, it looks as though the terms of the trust should be changed on 6 April 2008 to provide for an outright reverter.

However, if on the death of the life tenant, the property reverts absolutely to either the UK domiciled spouse of the settlor or, where the settlor has died within the last 2 years, the UK domiciled widow or widower, there is still freedom from IHT.  But the CGT-free uplift is secured, as TCGA 1992, s 73(1)(b) refers only to the settlor.

(b) The need to act on 6 April 2006

While the TSI point remains should the life tenant die before 6 April 2008, it is suggested that on 6 April 2008 the trusts are changed to provide (other things being equal, as between the spouses) for an outright reverter to the named spouse.  If the settlor dies more than two years before the life tenant, the tax position is no worse than it would have been otherwise.

Obviously, where the trust fund comprises a dwelling, this mechanism would be unnecessary if it was possible to obtain main residence relief on a sale of the house 36 months after it had ceased to be used as such by the beneficiary, typically on his death.  (Note that this would presuppose a sale by the trustees either before the life tenant’s death or in the event of continuing trusts following it.  If the trust came to an end on the death, it would be the settlor who made the disposal, ie with no uplift in base cost to market value on the life tenant’s death and with no main residence relief.) 

However, in any other case, eg where the trust fund was comprised of property not attracting main residence relief or was stocks and shares, the suggestion is a good one.  Bear in mind, in the case of settled intangible property, the issue of a POA income tax liability for the settlor, which would be excluded if it was only the spouse who could benefit.

Might the idea be vulnerable to attack under general avoidance principles?  The answer should be no.  First, because no IHT is being avoided, nor indeed CGT: rather, one would simply be ensuring a higher base cost than might otherwise have been available.  More generally, however, there is no reference to tax avoidance in the relevant sections and so the point should not arise.

There would of course be a problem with the suggestion if the spouse were to predecease the settlor.  However, one could then, subject perhaps to a remarriage (!), reintroduce the settlor as the absolute beneficiary on termination of the life interest – and one would be no worse off.

(c) New reverter to settlor trusts?

The question remains:  is there any point in creating a reverter to settlor trust now?  Consider, for example, one traditional use, viz on father’s death (mother surviving) where he might leave his half of the house to his daughter who would then, subject to some caveats, eg bearing in mind the provisions of IHTA 1984, s 143 (precatory trusts), make a reverter to settlor trust on her mother for life, remainder to daughter for life with power of advancing capital.  Recognising that such a trust would enter the relevant property regime, it would still be effective to ensure mother’s security of tenure. However, would this lead to the CGT relief for the trustees on selling at a gain under TCGA 1992, s 225?  The question is whether mother is a person entitled to occupy for purposes of the Trusts of Land and Appointment of Trustees Act 1996.  There would be no question of a CGT-free uplift on her death, though the property could be sold shortly thereafter, with it is hoped the benefit of main residence relief and the proceeds advanced to the daughter.  There would be no reverter to settlor exemption from IHT, even if an absolute reverter were provided in the trust, but the IHT cost should be zero if the exit happened within the first ten years and thereafter with only a small cost (if any) under the relevant property regime to the extent that the then value of the property exceeded the nil-rate band at a ten year anniversary.

Additions of Property

Ever since Budget 2006, the question has been raised whether the addition of property to a Budget Day settlement would in any way taint it or alternatively might perhaps even secure continuing s49 treatment for the addition.  HMRC have said quite distinctly that such addition would constitute a new settlement and by implication would not taint the s49 status of the pre-Budget Day settlement.  And, as not so much an exception to but an underlining of the principle, HMRC have confirmed that the payment of premiums on a life policy written in trust at Budget Day 2006 would not constitute additions but would rather be enhancements of value already in the settlement. 

Note HMRC Response to Question 37 for a strict view of this principle on additions of funds to meet trust expenses, ie without the ability to rely on TCGA 1992, Sch 5 para 9(3).

This approach is consistent with HMRC’s longstanding position in relation to additions, especially in the context of excluded property settlements where a now UK deemed or actually domiciled settlor adds to the settlement.  RI 166 (February 1997) states the following:

‘In the light of the definitions of ‘settlement’ and ‘settled property’ in s 43, [the Revenue’s] view is that a settlement in relation to any particular asset is made at the time when that asset is transferred to the settlement trustees to hold on the declared trusts.  Thus, assets added to a settlor’s own settlement made at an earlier time when the settlor was domiciled abroad will not be ‘excluded’, wherever they may be situated, if the settlor has a UK domicile at the time of making the addition. 

In determining the tax treatment of particular assets held in the same settlement it may, therefore, be necessary to consider the settlor’s domicile at times other than when the settlement was first made.  And if assets added a different times have become mixed, any dealings with the settled fund after the addition(s) may also need to be considered.’    

The rationale for this view is the definition of ‘settlement’ in IHTA 1984, s 43(2)(b) as meaning ‘any disposition or dispositions of property …’.  A counter argument (not accepted by HMRC) is that the provisions of s 67 in relation to relevant property trusts (to do with added property) imply that a person can make an addition to the settlement in such a way as to increase the value of the property comprised in the settlement without constituting a new settlement.  And, indeed, the tension between the two positions is emphasised by the fact that the ‘relevant property’ regime envisages, in calculating the ten year charge, that property might have been added to that settlement during the previous ten years (see IHTA 1984, s 66(2)).

For practical purposes, it would probably be as well to assume that HMRC are correct, at least in terms of additions now to pre-22 March 2006 settlements.  Note that for general CGT purposes there is no definition of ‘settlement’ (as distinct from the anti-avoidance rules) and so it is possible to add to a settlement made by another person without constituting a new settlement - a point which needs to be watched in the context of bounty contributed by a beneficiary ‘tainting’ a settlement where hold-over has been claimed on a disposal made since 10 December 2003, so triggering a claw-back of that hold-over relief under s 169C.

Matrimonial Breakdown

This is one of those ’hard cases’ put to the Government during the passage of Finance (No 2) Bill 2006 through Parliament over the summer of 2006, but in this case without specific response.  Transfers of assets between spouses up until decree absolute will be exempt (subject to the limitation for transfers from a UK to a non-UK domiciled spouse under s 18(2)).  But is there a problem, anyway?

Transfers even after decree absolute will be exempt either if:

(a) not intended to confer a gratuitous benefit (s10); or

(b) for the maintenance of the family, which includes an ex spouse as well as another member of the family as defined (s11).

An article by Malcolm Gunn in TAXline September 2006 finds rather puzzling the suggestions that the FA 2006 provisions relating to trusts will adversely affect property placed in a trust for one of the parties to a marriage under the terms of a consent order between a husband and wife on a divorce.  Neither of the s 10 or the s 11 exemptions has been affected by anything in FA 2006 and they still apply to financial provision on divorce. So in the majority of cases, where there is no gratuitous intent between the parties, there cannot be any IHT charge where the consent order provides for one of the parties to place assets in trust for the other.  Accordingly, far from a trust being unsuitable for the financial arrangements between the parties, it may in fact be quite tax efficient. Without the entry charge, the trust will only give rise to IHT ten-yearly charges and it is not difficult for these to be reduced or eliminated. Without the trust, 40% IHT liability might well be payable on the death of the transferee.

The above said, however, each of s 10 and s 11 will bear careful analysis.  In particular, under s 10, what is the meaning of ‘gratuitous’?  Presumably from the donor’s viewpoint?  And one should consider carefully the other conditions for s 10 to apply, which would not always be straightforward.  Section 11 might seem more promising, but consider the conditions where one or more children are concerned, that is under age 18 or in full-time education or training.  And with a spouse the provision must be for ‘maintenance’:  to what might this amount in the case of a soon to be former spouse?  Certainly in the ’big money’ cases, a matrimonial settlement would typically involve passing over more money than was needed by the other party for maintenance.

With disabled trusts, might s 11 help where the amount intended for settlement exceeded £285,000 or (for 2007/08) £300,000?

That apart, however, the creation of a trust will immediately fall into the chargeable transfer regime, whereas where made before 22 March 2006 it could secure PET treatment and be made in such a way as to provide for the former spouse while ensuring that capital would ultimately pass to the children. 

Crowe v Appleby Cases

The decision in Crowe v Appleby [1975] STC 502 held in broad terms that where individuals become successively entitled to an absolute interest in real property, they do not together become absolutely entitled as against the trustees for CGT purposes until the last of them become so entitled, typically upon attaining an age.  And so, although various approaches have been adopted to such cases in the past by HMRC officers, the strict position is that there is no deemed disposal and reacquisition within TCGA 1992, s 71 until the beneficiaries as a whole are absolutely entitled. 

The problem is really two-fold, relating to the presumptive shares of any beneficiaries other than the youngest (or younger).  When, say under an 18-to-25 trust, a beneficiary reaches the age of 25 there will be an exit charge under IHTA 1984, s 71E, but that beneficiary will not become absolutely entitled as against the trustees for CGT purposes.  When that beneficiary does become absolutely entitled when the youngest sibling attains 25, hold-over relief will not be available on any shares apart from that of the youngest.  Further, if a beneficiary dies over the age of 25, but at least one other beneficiary is under 25, there will be an IHT charge under general principles but, because she does not have a qualifying interest in possession for CGT purposes, there will be no CGT-free uplift to market value at that point.  These two points were put to HMRC and their Responses to Questions 34 and 35 have confirmed the analysis.  Given that this scenario does present a problem, one solution would be to appoint out the whole of the property on bare trusts, although this is rather going to defeat the object of an age 18-to-25 trust.

Bare Trusts for Minors

There were scares in late 2006 and early 2007 that HMRC would treat as a substantive relevant property settlement a bare trust under which, but for his infancy, the beneficiary is absolutely entitled.  This view, if confirmed, would have had implications for both entry and ten year charges.  Happily, however, following pressure from both CIOT and STEP, HMRC stated on 23 March that they agreed that a bare trust for a minor (as for any other beneficiary) would be treated for IHT (as for CGT purposes) as beneficial ownership by the beneficiary.

Action Needed

Accumulation and Maintenance Trusts in Being at Budget Day 2006: the  Four Options

For trusts potentially caught by the s 260(2)(d) trap, hold-over for non-business assets was in the past precluded in the case where income entitlement preceded capital entitlement; this problem has of course gone in principle where the income entitlement arose on or after 22 March 2006.  Note the one exception to the general rule that hold-over will be available on an exit of capital from 22 March 2006.

The trustees of such a settlement have until 6 April 2008 - or until such time before then as an interest in possession arises - to decide what if any action to take, no doubt in consultation with the settlor and the family’s professional advisers.  Until that date the favoured regime established by IHTA 1984, s 71 will continue.  The four options are (depending always on the terms of the trust) were described earlier in the series.

Assuming that an interest in possession is not going to arise meanwhile, it may be  sensible where possible (that is, no interest in possession is about to arise) to defer   any action until late 2007 or even early 2008, in case further material changes are made to the regime (albeit thought unlikely given the lack of developments on this subject in Budget 2007).

Life Interest Trusts Protected by the Transitional Rules

Here, on the assumption that the s 49 regime is generally preferable to the relevant property regime (far from a foregone conclusion), consider whether it might be IHT advantageous to trigger the TSI regime.  This will be a PET.  Otherwise, when the life interest comes to an end, there will generally be a chargeable transfer (with the CGT-free uplift on death, except where the property reverts to the settlor outright) and any continuing trust will enter the relevant property regime.  If the life interest terminates inter vivos in favour of an individual, there will be a PET. 

Consider application of the transitional regime to life policy life interests in being at Budget Day 2006, with possible action as above.  For life policies not written in trust that date, consider doing so as soon as possible.  It should be confirmed whether the current market value of the policy is within the intending settlor’s available nil-rate band, to avoid an immediate IHT charge at 20% on any excess.

Will Trusts

Where made before Budget Day 2006, these are likely still to be IHT efficient in terms of the spouse exemption, though should ideally be reviewed in the light of the new regime for IPDIs, trusts for bereaved minors and (subject to further HMRC guidance on particular issues) age 18-to-25 trusts.  Note that, for deaths on or after 22 March 2006, a significant change has been made to s 144 by FA 2006, REPLACE ing (in particular) new sub-section 144(3)(c). The effect is to disapply the Frankland trap, in circumstances where an appointment within 3 months after death creates either an IPDI, a bereaved minors trust, or an age 18-to-25 trust (but not an absolute interest, a disabled person’s trust or a charitable trust, when the Frankland principle would still apply). 

New Trusts on or After Budget Day 2006

These, other than disabled trusts and indeed TSIs, and any additions of property to existing trusts, will automatically enter the ‘relevant property’ regime.  Once a person or married couple starts to consider IHT mitigation seriously (in their late fifties, say?), consider each spouse making a nil-rate band trust every seven years.   On the assumption of survival until age 80 or thereabouts, this could get a total of something around £2m out of the combined estates (through three ‘bites at the cherry’), so prospectively saving some £800,000 in IHT.

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.