Thursday, June 29, 2006



A lot of people are describing the IHT changes to the rules on trusts in the budget as the death knell of the use of trusts in tax planning. The income tax and capital gains tax rules already tax the settlor on both income within the trust and capital gains of the trust in place of the trustees, where the settlor or his spouse have an interest in the trust. However to misquote Mark Twain, rumours of the death of trusts are, in my view, greatly exaggerated.

What has the Chancellor done (or, rather, proposed)?
(a) He has simplified IHT by having a single set of rules for trusts instead of having two completely different rules with some trusts having some assets within one regime and some within the other. The two regimes are different; not one is better than the other. Under the discretionary trust regime (which now applies to almost all trusts) there is a tax charge of up to 20% on creating the trust, a tax charge of up to 6% of the value of the assets in the trust on each tenth anniversary, and a tax charge of up to 6% when assets leave the trust. There is no IHT charge on the death of the principal beneficiary. In addition if assets ripe with capital gains are put into the trust the CGT can be deferred until the trustees sell the asset concerned (and can be deferred again if they distribute it to a beneficiary). Under the interest in possession regime there was no IHT charge on creating the trust but a charge at, normally, 40% when the beneficiary died. CGT had to be paid by the settlor on assets put into the trust.

I stress that the charges are “up to”, because the £285,000 nil rate band can have a significant impact on the effective tax rate; i.e.

Tax on settling % 10 yearly charge % Tax on death under IIP regime %
£ 250,000 nil nil £100,000 40%
500,000 £43,000 8.6% £ 6450 1.29% 200,000 40%
1,000,000 143,000 14.3% 21,450 2.15% 400,000 40%
1,500,000 243,000 16.87% 36,450 2.43% 600,000 40%
2,000,000 342,000 17.15% 51,450 2.57% 800,000 40%

I have taken 40% on death as the individual normally has sufficient other assets to use up his nil rate band. The tax on the 10-yearly charge is actually 15% of the taxable amount (6% is 15% of 40%). On a distribution from a discretionary trust the tax is at the same rate as on the previous tenth anniversary but pro-rated for the part of the current 10-year period that the property was in the trust (e.g. a distribution of £1m at the end of year 18 would attract a rate of 11.44% - 14.3% x 8/10th). The 20% rate assumes that the seller survives for seven years.

(b) He has taken the value of an interest in possession out of the beneficiary’s estate, so that no tax at all is now payable on the beneficiary’s death, or on a gift by the beneficiary, of an interest in the trust (unless it remains within the pre 22 March 2006 IIP trust regime or is a trust for a bereaved minor or one with an immediate post death interest).

(c) He has left all interest in possession (and accumulation and maintenance) trusts set up before 22 March 2006, including trusts of insurance policies, within the old IIP regime, with the exception that if a new interest in possession arises after the death of the current life tenant the trust is brought within the new regime at that stage – but with no initial 20% charge as 40% IHT will have been paid on the death of the previous life tenant.

(d) He has created a new rule for trusts for bereaved minors, namely a trust created by a person’s will (or a statutory trust on intestacy) for the benefit of his child who is under 18 provided that the beneficiary becomes absolutely entitled to the assets and any accumulated income when he reaches 18. There is no IHT on such a trust when the assets pass to the child at 18 (or are paid to him or for his benefit under that age) or when the child dies – but a tax charge will arise on a payment to anyone else or on the trust ceasing to be solely for the benefit of the child. If the above conditions would have been met but the property vests at 25 (or earlier) rather than 18 an exit charge arises when the child reaches that age for the period the property is in the trust subsequent to his 18th birthday. If property is held on trusts established under the will of a deceased parent for a beneficiary under 25 (and which otherwise would have qualified as a trust for a bereaved minor) and the property was transferred to that trust on the termination during the holder’s lifetime of an interest in possession the transfer is a potentially exempt transfer.

(e) He has created a new type of trust, one with an “immediate post-death interest”. This is a will trust (or one arising on an intestacy) which grants an immediate interest in possession (to anyone, not necessarily a spouse or civil partner). Such a trust remains within the old IIP regime. It accordingly enables the spouse exemption to be preserved on death.

(f) He has amended the reservation of benefit rules so that where a person is entitled to an interest in possession in a post 22 March 2006 trust and that interest comes to an end during the individual’s life the individual is taken to have disposed of the property by a way of gift for the purpose of those rules. The effect seems to be that if the property comes out of the settlement to an individual no inheritance tax is payable (apart from the trust exit charge) provided that he survives for another seven years but if the property remains in the settlement the deemed gift will trigger a new 20% IHT charge.

What does this mean?
It does not mean the end of IHT planning using trusts. It means that trusts will in future in some cases be used differently.

What can still be done?
1. It no longer makes any difference for IHT purposes if a new trust is a discretionary trust, an accumulation and maintenance trust or an interest in possession trust. This decision can now be based solely on family considerations.

2. It is still worth putting business assets into a trust if they attract 100% BPR and are likely to be sold at some stage. There is no IHT on the initial transfer and when the assets are sold and replaced by non-business assets the only IHT is the future 10 yearly charges and exit charge.

3. Similarly it is still worth putting into trust assets worth less than £285,000, which are likely to increase in value. Again this avoids the entry charge and gets the assets out of the settlor’s estate subject only to the 10-yearly and exit charges.

4. When the value exceeds £285,000 it may be worth selling the asset to a trust at a £285,000 undervalue leaving the sale proceeds outstanding. The outstanding amount remains in the donor’s estate but the growth in value is in the trust and subject only to the 10 yearly and exit charges.

5. A nil rate band discretionary trust in a will still makes sense. So does an interest in possession trust, particularly one where the IIP is in favour of the deceased’s spouse or civil partner. Discretionary will trusts are probably no longer sensible unless there is no surviving spouse (so that the 40% IHT charge on death displaces the normal 20% trust creation charge).

6. The creation of a trust is still virtually a must for those who are non-UK domiciled and not yet deemed domiciled here. And remember that if a person is deemed domiciled here his infant children may well not be, as they have to themselves meet the 17 year test to become deemed domiciled. Of course a very young child probably does not have the legal capacity to create a settlement but a teenager is likely to be competent to do so.

7. Bare trusts can still be used where the beneficiary is under 18 and unmarried as the beneficiary is deemed to be beneficially entitled to the assets in the trust.

8. If the main concern that prevents a gift direct to the beneficiary is a fear that the beneficiary might squander the money, a gift subject to a condition, e.g. that management of the money is carried out by a specified third party and that the beneficiary will not call on the fund until he is 25 or 30 or whatever, is worth considering. However that would not protect the assets from creditors of the beneficiary.

Things to avoid
1. It no longer normally makes sense to create a trust of which the settlor is a beneficiary. This triggers the initial IHT charge but the property remains in the settlor’s estate under the reservation of benefit rules so it creates double taxation.

2. Similarly it will normally no longer make sense to create a lifetime trust of which the settlor’s spouse or civil partner is the main beneficiary, as a gift direct to the spouse avoids the trust creation charge of up to 20%.

3. Careful thought needs to be given to the use of a trust for CGT planning where a person is non UK domiciled but is deemed domiciled for IHT purposes: in such a case it has been sensible in the past to set up an offshore IIP trust for the settlor’s own benefit to obtain the CGT and income tax advantages of such a trust. This may no longer make sense if it will trigger an immediate IHT charge – although it might still be worth selling the assets to the trust rather than gifting them.

4. A similar issue arises where a person wants to let his principal private residence but wants to stop time apportionment eroding the exemption already achieved. In such cases putting the property into trust for oneself has achieved that objective in the past. Again a sale to a trust rather a gift may still be viable.

Robert W Maas


Post a Comment

<< Home