Inheritance Tax: A fairer way of calculating trust charges Response by the Chartered Institute of Taxation

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1 Inheritance Tax: A fairer way of calculating trust charges Response by the Chartered Institute of Taxation 1 Introduction 1.1 The Chartered Institute of Taxation (CIOT) sets out below its comments on HMRC s consultation Inheritance Tax: A fairer way of calculating trust charges published on 6 June It is regrettable that this, the third in the sequence of consultations that started on 13 July 2012 as Inheritance Tax: Simplifying Charges on Trusts, has lost sight of that objective. Instead the result is to be greater complexity and significantly higher charges on trusts. Since trusts are to be subject to rates of tax significantly higher than those applicable to individuals it is difficult to see how this can be a fairer way of calculating trust charges. 2 Executive summary 2.1 HM Revenue & Customs (HMRC) proposals are designed to prevent the use of pilot trusts to reduce the Inheritance Tax (IHT) charged on settlements. To introduce a completely new and complex charging regime is a wholly disproportionate response to that issue, the antithesis of simplification. Compliance burdens for HMRC, individuals and trustees will be increased. 2.2 Furthermore, the effect of the proposed charging structure is to raise revenue. If HMRC s proposals are adopted, a reduction in IHT rates on trusts will be necessary to preserve revenue neutrality. 2.3 We urge HMRC not to proceed with these proposals but instead to consider seriously our alternative approach which we believe offers real simplification, does not discriminate against the proper use of trusts in the family context, and addresses the issue of pilot trusts. 2.4 Our alternative regime for charging IHT on trusts created during a settlor s lifetime

2 would align the IHT treatment of trusts with outright gifts by means of a Settlement Nil-Rate Rate (SNRB) that is renewable every seven years. A de minimis SNRB of one-tenth of the standard Nil-Rate Band (NRB) (currently 325,000) for every trust would remove compliance burdens on trusts valued at under 32,500 the potential tax savings at that level would be no incentive for fragmentation. Finally, we suggest that a flat rate of IHT be levied on trust property above those levels. As analysis suggests that HMRC s suggested 6% might double the IHT yield, a rate of 3% (or whatever rate proper modelling of the figures available to HMRC shows would maintain revenue neutrality) might be more appropriate. 3 Addressing avoidance 3.1 It is clear from HMRC s comments at paragraph 2.27 onwards that the changes are an anti-avoidance measure, designed to prevent the use of pilot trusts. If only for reasons of applying GAAR rules correctly, any anti-avoidance purpose should be clearly identified. This is particularly so when, in the GAAR guidance, the conclusion to Example D26 (pilot trusts) is that the arrangements accord with established practice accepted by HMRC and are accordingly not regarded as abusive. 3.2 At no stage in the consultation process have HMRC provided a coherent explanation as to why they considers it inappropriate to amend Inheritance Tax Act 1986 section 62, whereby settlements are related only if they commence on the same day. We believe that, to discourage fragmentation a longer period of, perhaps, three months would be adequate. We ask HMRC to explain why simple amendment of that section would not be a proportionate response to the perceived problem. 3.3 Instead of addressing that issue, HMRC have chosen to cloud matters by pointing to the supposed practical issues and administrative burdens of record-keeping. These have not been a problem in the past and only became so by the Finance Act 2006 amendments which brought Accumulation and Maintenance settlements into the relevant property regime, whereas previously the information required to make the appropriate calculations had not been obtained since it was not required. HMRC should solve the FA 2006 issues by direct simplification of them, rather than create a wholly different structure which has its own absurdities and inconsistencies. 3.4 The findings in HMRC's 2006 Research Report 25 Research on trusts: experience of setting up and running trusts appear to have been forgotten. We would endorse the findings of the executive summary which concluded that the main motivation to setting up a trust related to having the ability to control assets including, passing them on to children or grandchildren; providing for a beneficiary in a particular way; withholding assets until children reach a certain age; and ensuring money stays within the bloodline. Tax tended to be a secondary motivating element. 3.5 There is obfuscation by HMRC in that they accept that wherever possible there should be parity of treatment between property held absolutely and settled property, but then immediately qualifies the statement but it is not the principle that can be applied in all circumstances without justifying it [paragraph 2.28]. The example in paragraph 2.30 is misleading: the same effect could be achieved by property being given outright, by Potentially Exempt Transfers (PETs) every seven years. Making a settlement every seven years is not an avoidance technique. Allowing the taxpayer to do so gives a broad equivalence between the regime applying to discretionary settlements and the regime applying to individuals. 3.6 The current relevant property regime does indeed provide a degree of parity with the charges on property held absolutely as it passes down the generations. As Joel P/tech/subsfinal/ST/2014 2

3 Barnett (Chief Secretary to the Treasury) said during the Second Reading debate on the introduction of Capital Transfer Tax (Hansard 17 December 1974, Col 1374) The aim is not to penalise the holding of property in settlement but simply to ensure that property held in this way pays its fair share. There will also be a periodic charge at ten-yearly intervals which is designed to produce broadly the same result as the charge on property owned by individuals, where it can be expected that the whole property will on average be subjected to a tax charge once a generation. If policy which has been established for 40 years is to be overturned, the rationale must be expressly articulated: to date it has not. 3.7 As paragraph 2.29 points out, a trust can exist for 125 years (i.e. well over one lifetime, and approaching a second). It could therefore potentially be faced with 12 anniversary charges at 6% = 72% plus an exit charge, which approximates to two death charges (or to express it another way, approaching four lifetime charges of 20%). To achieve the parity mentioned above, the proposed model would need adjustment: either the SNRB should be increased (as 125 years is substantially more than one lifetime, approaching two, then something one and a half to twice the NRB might be appropriate) or the 6% rate should be reduced to (say) 3% (e.g. 12 x 3% = 36% plus exit charge). 3.8 The stated aim of the changes, as recited at paragraph 1.2 is to achieve simplification and reform without jeopardising Exchequer revenue and to reduce unnecessary complexity and administrative burdens for trustees and practitioners where it is feasible to do so. Patently this is not achieved. One of the great advantages of the present régime is that it provided relative certainty to settlors at the outset in that the NRB available to the trust is (subject to the death of the settlor within seven years) known. The replacement, with its convoluted, at times unnecessarily complex, provisions for reallocating the SNRB, fails to achieve this objective. 3.9 As regards the perceived jeopardy of Exchequer revenue it would be perfectly possible to simplify the charge, if such simplification was necessary, by eliminating the scope for creating pilot trusts through the simple expedient, as CIOT had earlier proposed, of making all settlements created within three months of each other related. To suggest that a naked revenue-raising exercise falls within those terms of reference can most charitably be described as disingenuous If Government intends to change policy on trusts, firmly established over many decades, it may of course do so. However these latest proposals are not the result of an open and transparent consultation on such a policy. We fear that settlors may be dissuaded from the proper use of trusts in the appropriate family circumstances mentioned above, because of the disproportionate tax regime being imposed These proposals, far from being broadly neutral as between property transfers during life, into trust or on death, are so weighted that there will be a substantial IHT cost and disincentive to holding property in trust There would be no discrimination against trusts if the SNRB were renewable every seven years. The perceived problem of multiple pilot trusts would be countered, yet the ability for a donor to make the perfectly normal and valid choice between a PET and a gift into settlement would be preserved. We strongly urge that this aspect be re-considered, to avoid policy consequences as damaging as those introduced by the Finance Act This concept of a renewable SNRB forms the basis of our alternative model regime set out at paragraph 7 below. It would be similar in operation to the current regime, but would (as HMRC envisage) remove the link to the settlor s historic cumulative P/tech/subsfinal/ST/2014 3

4 total. 4 Settlement nil rate band 4.1 The introduction of a single SNRB per settlor, and its allocation, will produce difficulties for individuals, their trustees and HMRC. Our suggestions for improvement within this section are made on the basis that, despite their deficiencies, HMRC s proposals for the SNRB are carried forward. Our preference for an alternative regime with a renewable SNRB is set out at paragraph 7 below. 4.2 The inability to re-allocate SNRB is needlessly restrictive, especially in relation to any increase or where one trust has been partially terminated and another remains, which could otherwise have had the benefit of the SNRB; all that is proposed (at paragraph 3.18) is allocation of unused SNRB. Full flexibility to re-allocate SNRB should be available throughout the settlor s life. 4.3 The ability to re-allocate within the period ending two years after death needs to be extended to at least ten years after the death, if it needs to be limited at all: the settlor s personal representatives may well not become aware of the existence of trusts made during the deceased s life within any fixed period. Furthermore, since the personal representatives may have completed the administration of the estate and subsequently two (or more) sets of trustees become aware of each other, and the advisability of adjusting the SNRB. The ability to re-allocate SNRB should be extended so that trustees, by mutual agreement, are able to deal with all situations. Far from simplifying the regime applicable to trusts, the proposals are adding complexity. 4.4 SNRB allocation will be particularly awkward for life policy trusts. The settlor (at latest by the first ten year anniversary) will need to allocate some SNRB to such trusts to avoid the compliance burden for them. But what percentage to allocate? The trustees need to get a valuation of the surrender value of the life policy at the first ten year anniversary. Then, after being found and made aware, the settlor could then allocate exactly the right percentage, but will be stuck with that for all subsequent ten year anniversaries. By the time of the next decennial charge, the surrender value might have increased, the NRB may have gone up (or down) in general. A settlor will not know how much SNRB to allocate, and, inevitably will therefore over-allocate, which seems, in HMRC parlance, unfair. 4.5 There is the further difficulty that many life policies (term policies that pay out a sum only if the life insured dies before say, age 50, are a very common example) may not have a surrender, nor indeed, a market value at all. So how would the settlor allocate any of the SNRB to that trust? 4.6 As drafted, every premium paid after 6 June on a pre 7 June 2014 policy would (in aggregate) be treated as a new post 6 June 2014 settlement. A provision similar to that in s.46a IHTA 1984 for pre- 22 March 2006 policies would exclude from such treatment premiums at the same level as those paid before 7 June There is a strong social policy argument for excluding Will trusts from the SNRB regime altogether. Trusts in Wills are not made for tax avoidance but to manage complex family situations. A testator may wish a second spouse (following remarriage) to have the benefit of assets but then wishes to ensure those assets pass to the children of the first marriage. The FA 2006 changes already impose additional charges on trusts for children over 18, and it seems unreasonable to further penalise the natural wishes of testators to make sensible provision for their families. P/tech/subsfinal/ST/2014 4

5 4.8 It is apparent that even the smallest trust will need to have some SNRB allocated. Otherwise there will be a disproportionate compliance burden on both HMRC and trustees (which the present excepted settlements regime neatly prevents) and a small trust will have to calculate ten yearly and exit charges. The proposals run counter to the policy of the past few years of reducing compliance burdens. 5 A minimum SNRB 5.1 The compliance difficulties for small trusts outlined above could be addressed by having a de minimis SNRB (for an example see the splitting of the CGT annual exemption between related settlements). Given the compliance costs of running a settlement, no-one is going to fragment deliberately to save a small amount of tax. Setting the SNRB at say, one tenth of the NRB ( 32,500 at current figures) would deal with small trusts, but represents a low enough level to make fragmentation impractical. An IHT saving of 195 per year over ten years is not an incentive. 5.2 The minimum SNRB forms part of our alternative model regime set out at paragraph 7 below. 6 Rate of Tax 6.1 The proposals advocate a SNRB and a flat rate of 6% IHT. The 6% came from the formulation of a 20% lifetime charge and 3 x 6% charges over 30 years being the equivalent to a once-a-generation 40% charge. But as HMRC now disagree with that formulation, there is no warrant for aligning charges to the 6% rate. Since a reduced level of nil rate band results in more property being subject to charge, the IHT rate should reduce commensurately. 6.2 At the Appendix, we analyse the available statistics on IHT, and draw conclusions from them. What is apparent is that the extensive changes proposed by HMRC must be considered disproportionate, since only around 700 trusts currently suffer IHT each year. Given the current availability of a settlor's nil rate band and the present charging structure, the effective IHT rate on property held in trust appears to be around 3%. 6.3 Since HMRC have accepted that existing trust arrangements should not be prejudiced, the imposition of a flat rate of 6% on trusts that have also to bear the burden of the SNRB creates a double jeopardy for those new settlements. 6.4 If (as the SNRB model provides) re-using the settlor s NRB is to be withdrawn, to apply a flat 6% rate on property in excess of the SNRB would, in broad terms, result in a 100% increase in IHT revenue raised. 6.5 To maintain a revenue-neutral model, our analysis in the Appendix suggests that a rate closer to 3% would be more appropriate. Further modelling is required of HMRC to ensure neutrality, particularly in relation to our alternative charging model set out at paragraph 7 below. 6.6 At paragraph 6.7 of our 30 August 2013 Response, we lamented the failure of that consultation paper to provide more extensive financial modelling to explore alternative approaches and the failure of the Tax Impact Assessment to provide any indication of the likely yields under the HMRC model. There has been no indication P/tech/subsfinal/ST/2014 5

6 from HMRC as to how many more trusts (above the current 700 per year) are likely to be brought within the scope of the new charges, so the amount of the extra revenue raised not been made clear. It is important that HMRC give credibility to the consultation process by providing proper and cogent analysis of the IHT likely to be paid under these proposals. 6.7 The TIA in the current Consultation states that the measure is expected to have a negligible impact on the Exchequer to which is five years hence. That is, self-evidently, the position since a ten-year charge cannot be expected to have an impact until ten years after its imposition. Accordingly, the TIA is, at best disingenuous, and at its worst misleading. 7 Alternative model regime 7.1 We suggest that the alternative model would meet HMRC s objective of simplifying the IHT charging structure and preventing pilot trusts, but without discriminating between property given outright to individuals and settled on trust. It combines various elements that have emerged from our analysis above of the various parts of the proposals. 7.2 We suggest as an alternative model for lifetime settlements: A SNRB that is renewable every seven years (see 3.12 above); A minimum SNRB per settlement of one-tenth of the NRB (see 5.1 above); and A flat IHT trust rate (3% appears to be revenue-neutral see 6.5 above). 7.3 The alternative regime would work as follows: 1 January 2015 settlor makes Alpha trust with 100,000 and allocates 100,000 of SNRB to it; 1 April 2015 settlor makes Beta trust with 250,000 and allocates remaining 225,000 of SNRB to it; 1 June 2015 settlor makes Gamma trust of a whole of life policy; no SNRB available (subject to a de minimis SNRB of 32,500, say); and 1 February 2022 settlor makes Delta trust with 350,000 and allocates reset SNRB of 325,000 to it. 7.4 It is implicit in this model that there is to be no scope for re-allocation of SNRB: it is clear and fixed when the settlement is made (as is the current position). Settlements created by Will or intestacy would not fall within the new regime but would be treated as they are currently. 7.5 This model meets HMRC s objectives of substantially simplifying the current charging regime, and prevents avoidance through pilot trusts. Unlike HMRC s proposals, ours do not impose increased compliance and operational burdens, such as those attendant on re-allocation of SNRB. We commend them as they represent real simplification. 7.6 We would welcome further discussion with HMRC as to how this model might be enacted. P/tech/subsfinal/ST/2014 6

7 8 The Chartered Institute of Taxation 8.1 The Chartered Institute of Taxation (CIOT) is the leading professional body in the United Kingdom concerned solely with taxation. The CIOT is an educational charity, promoting education and study of the administration and practice of taxation. One of our key aims is to work for a better, more efficient, tax system for all affected by it taxpayers, their advisers and the authorities. The CIOT s work covers all aspects of taxation, including direct and indirect taxes and duties. Through our Low Incomes Tax Reform Group (LITRG), the CIOT has a particular focus on improving the tax system, including tax credits and benefits, for the unrepresented taxpayer. The CIOT draws on our members experience in private practice, commerce and industry, government and academia to improve tax administration and propose and explain how tax policy objectives can most effectively be achieved. We also link to, and draw on, similar leading professional tax bodies in other countries. The CIOT s comments and recommendations on tax issues are made in line with our charitable objectives: we are politically neutral in our work. The CIOT s 17,000 members have the practising title of Chartered Tax Adviser and the designatory letters CTA, to represent the leading tax qualification. The Chartered Institute of Taxation 3 September 2014 P/tech/subsfinal/ST/2014 7

8 APPENDIX IHT raised by the Relevant Property Regime (National Statistics published 31 July 2013) From: In our Comments on the Draft FB 2014 IHT clauses CIOT asked HMRC, how much is raised per trust. HMRC s response referred us to these statistics. The relevant pages are p12 of the Commentary, and Tables 12.1, 12.7 and Methodology The Notes to the various Tables suggest that the figures in 12-1 are distorted by unusually large receipts (double the norm) and that those for will be subject to further revision and should not be regarded as conclusive. So this analysis is based on the three years, to Figures Table 12.1, line 3: mean of to gives 59,966,666 IHT raised per year on trusts (from both ten-year and exit charges). In Table 12.8 (ten year charge only), the mean values for to are: Net IHT raised annually on 10 year charge 38,416,000 Number of trusts paying IHT: 708 Net chargeable asset value per trust 1,801,600 Net exit charge IHT per trust 54,260 IHT as a percentage of net assets 3.012% IHT from 10 year charges (Table 12.8 mean) 38,416,000 IHT from Exit charges (extrapolated) 21,550,666 Total IHT from Trusts (Table 12.1 mean) 59,966,666 P/tech/subsfinal/ST/2014 8