Heritage property is very often held in discretionary trusts.

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1 HERITAGE PROPERTY AND THE ROLE OF THE DISCRETIONARY TRUST by William Massey QC William Massey s practice covers all areas of personal and corporate taxation, with an emphasis on private client, trust and estate tax planning and heritage and agricultural property, including tax appeals and other tax related litigation. WHY IS HERITAGE PROPERTY HELD IN DISCRETIONARY TRUSTS? Heritage property is very often held in discretionary trusts. One might ask why. The starting point is perhaps to ask why any property is held in discretionary trusts. The discretionary trust is a relatively recent phenomenon. It owes its popularity more than anything else to estate duty planning. Professor Burn wrote 1 in 1972, shortly after the passing of Finance Act 1969 The common practice over the last generation has been to create a discretionary trust. Property is conveyed to trustees upon trust to sell and to hold the income until sale and the proceeds of sale upon trust as to capital and income for such members of a class of beneficiaries as the trustees shall in their absolute discretion decide. The trust must be restricted to the period of perpetuity; firstly, because each exercise of the discretion by the trustees is a separate disposition, 2 and, secondly, because provision must be made for the vesting of the property in someone at the conclusion of the trust. The trustees have complete freedom as to the allocation of income and capital; but the settlor may make written or oral suggestions to them - without restricting this freedom - and they will be likely to follow his wishes. No member of the class of beneficiaries is entitled to anything. He has no interest in the property; and therefore, until the statutory changes introduced by the Finance Act 1969, no property passed on his death and no estate duty was payable. 3 In this way, it was possible for a settlor to create a trust, live another seven years, and thus avoid estate duty on any part of the fund for the period of the trust, that is, the period of perpetuity. The Finance Act 1969 however changed all this. It provided that, under a discretionary trust, estate duty was to be payable upon the capital of the fund on the death of any beneficiary who had received any income; the proportion of the fund liable being that proportion of the income which the beneficiary had received during the relevant seven year period, usually, the seven years before his death. 4 Thus, many of the estate duty saving attractions of discretionary trusts have been taken away; but the impact of the Finance Act of 1969 can be minimised by ensuring that payments of income are made to beneficiaries with small free estates (to reduce estate duty in case they die within seven years) or to younger beneficiaries (so as to reduce the likelihood of the death of a beneficiary). Payment of capital creates no estate duty liability upon the trust so long as all available income has been paid out, and this is a way in which payments can safely be made to wealthy and aged beneficiaries. Five years on from the sea change in 1969, the new capital transfer tax replaced the estate duty and with it came the new regime applicable to settlements in Schedule 5 Finance Act Discretionary trusts were viewed with disfavour, and a statutory incentive was provided in the form of a substantial discount to the tax rate, on termination of existing 5 discretionary trusts or their conversion into interest in possession or accumulation and maintenance trusts before 1st April The 1975 capital transfer tax regime for settlements was regarded as byzantine and barely operable even by those charged with its administration in Capital Taxes Office. The authors of Dymond s Capital Transfer Tax 7 commented - It was said in the First Edition of this book that [paragraphs 6 to 15 of Schedule 5] could be regarded either as a masterpiece of subtle, intricate and esoteric logic or as a monstrosity of repellent and well-nigh unfathomable convolution, according to taste, and that probably most readers would prefer the latter description. It soon became clear that the edifice was no masterpiece. It was no surprise that the initial capital transfer tax discretionary trust regime was repealed in 1982 and replaced with the provisions now in place in Chapter III of Part III of the Inheritance Tax Act The twin pillars of the current IHT regime for discretionary trusts are a 10-yearly IHT charge 8 at a rate of tax of up to 6%; and an exit charge (at a rate up to 6%) where the discretionary trust property ceases to be relevant property 9, being appointed or advanced to beneficiaries absolutely or upon interest in possession or accumulation and maintenance trusts; or is reduced in value in certain defined circumstances 10. Into this framework is woven the conditional exemption code for heritage property 11 by the addition of two important provisions Sections 78 and 79 IHTA. In essence Section 79 allows heritage property to be held on discretionary trusts throughout the period of the settlement without the 10-year periodic WINTER ISSUE

2 charge to IHT applying, for so long as the requisite undertaking is given and observed by the trustees. Section 78 prevents an exit charge from arising where the occasion is accompanied by designation of the property by the Inland Revenue under Section 31 and the giving of a requisite undertaking by the appropriate person ( the conditionally exempt occasion ) and it applies the chargeable event legislation to cases where an exit charge has in this way been prevented. The period from 17th March 12 to 31 July 1998 saw a surge in the creation of settlements of heritage chattels on discretionary trusts, as a means of entering this favourable regime. In particular chattels which were considered to be of museum quality only and which, if transferred after 31 July 1998, would not fall within the narrow pre-eminent standard introduced with effect to undertakings made on or after that date, were prime candidates for such settlements. PERIODIC CHARGE EXEMPTION FOLLOWING EXEMPTED TRANSFER INTO SETTLEMENT The purpose of Section 79 IHTA is to exempt heritage property in discretionary trusts from the periodic charge to IHT under Section 64 IHTA, and also to impose a charge in certain limited circumstances equivalent to the chargeable event 13 charge which arises under Section 32 IHTA, where it would not otherwise arise. One might have expected the charge to be levied in all circumstances where the trust property, having been exempted from the periodic charge to IHT, suffered an occasion equivalent to a chargeable event but was not otherwise charged on that occasion. But Section 79 does not go this far. Where property is settled on discretionary trusts under a conditionally exempt transfer 14 (I refer to this as an IHT Heritage Transfer ), there is no periodic charge in respect of the property on any 10-year anniversary before a chargeable event occurs. 15 The same is true if the property has been settled on discretionary trusts under the earlier conditional exemption regime under Section 31 Finance Act or on a death in relation to which the value of the settled property has been left out of account under Section 40 Finance Act The periodic charge to IHT is also disapplied where property is settled under a disposal which, although not relieved from any form of estate duty, capital transfer tax, or inheritance tax on the transfer, is relieved from capital gains tax under Section 258(4) TCGA I refer to this as a CGT Heritage Disposal. The same is true where the disposal has been relieved from CGT under the predecessor enactments to Section 258(4) TCGA 1992, Section 147(4) Capital Gains Tax Act 1979 or Section 31(3) and (4) Finance Act It is perhaps surprising that an exemption from the periodic charge to IHT can result from a CGT relief, and even more surprising that a sale and distribution of proceeds thereafter may have no IHT consequences. If for example trust property settled under a CGT Heritage Disposal is sold immediately after a 10-year anniversary and the proceeds are then distributed within 3 months of that 10-year anniversary, there is no IHT charge either on the sale or distribution. There is no charge under Section 64 IHTA by reason of Section 79(2). And Section 65(4) will prevent an exit charge under Section 65. Property acquired by the trustees of a discretionary settlement pursuant to a CGT Heritage Disposal may therefore spend 70 years or more within the settlement free of IHT, and may then be sold in such a way that the proceeds of sale (net of CGT) can be distributed free of IHT to the beneficiaries. It may be observed that the treatment would be markedly less beneficial if the trustees were to have acquired their property under the more general hold-over relief for gifts to settlements 20 and subsequently claimed exemption from the periodic IHT charge under Section 79(3) IHTA. DISCRETIONARY TRUST HERITAGE PROPERTY SUBJECT TO ESTATE DUTY EXEMPTION In a number of cases heritage property has passed into discretionary settlements under an estate duty exemption pursuant to Section 40 Finance Act Such property will be exempt from the periodic IHT charge. But it remains subject to the overhanging estate duty charge on sale unless and until it passes under a conditionally exempt transfer on death 21. The estate duty charge may be significantly higher than any corresponding IHT rate. It will often be worthwhile to appoint a pre-eminent object to or on interest in possession trusts for an individual, on whose subsequent death a claim to conditional exemption will be made 22. The appointment on interest in possession trusts within the same settlement will not trigger an estate duty charge since there is no disposal. An absolute appointment is likely to be less advisable, given the resultant disposal for CGT purposes 23 and also, if relevant, estate duty purposes 24. The conditional exemption on death will eliminate the overhanging estate duty charge, so that on a sale subsequently, only IHT will be payable on the net proceeds of sale at the rate current on that death. The optimum timing of such an appointment will be within three months after a 10-year anniversary, since there will be no IHT exit charge WINTER ISSUE 2005

3 PERIODIC CHARGE EXEMPTION WHERE NO INITIAL EXEMPTED TRANSFER Section 79(3) and the remainder of Section 79 relate to the case where there has been no IHT Heritage Transfer or CGT Heritage Disposal on or before transfer of the property into the settlement. This will be the case where the trustees have bought the property from a third party or where it has been put into the settlement without any IHT or CGT conditional exemption or estate duty exemption. If the trustees thereafter claim and obtain designation from the Inland Revenue for the property under Section 31 IHTA and give the requisite undertaking, the periodic charge under Section 64 IHTA has no effect in relation to the property in relation to anniversaries subsequent to the designation and undertaking 26. But the quid pro quo is that there is a charge to IHT on the first occurrence of an event which would have been a chargeable event with respect to the property, if it had been the subject of an IHT Heritage Transfer. The rate is stated to depend not, as one might expect, on the period ending with the chargeable event and commencing on the 10-year anniversary on which the exemption first arises, but on the period ending with the chargeable event, but commencing with the latest of (a) the day on which the settlement commenced, (b) the date of the last 10-year anniversary of the settlement to fall before the day on which the property became comprised in the settlement, and (c) 13th March This is referred to as the relevant period. An incremental rate is applied, 10% for the first 10 years plus respectively 8%, 6%, 4% and 2% for each of the successive 10 year periods comprised in the Relevant Period. The effect is capricious. By way of example, suppose that the trustees of a settlement established on 1st January 1975 buy a painting on 1st January 1984, pay the Section 64 charge on each of 1st January 1985, 1995 and 2005, then apply for Treasury designation under Section 79(3) on 1st January 2006, and ultimately sell the painting in February 2015 shortly after the 10 year anniversary exemption. They will suffer an IHT charge under Section 79(3) of nearly 28% of the net proceeds of sale, a severe rate when one bears in mind that three periodic charges have already been levied in respect of the painting and only one exemption from the charge obtained. It is even arguable, on a literal interpretation, that a charge under Section 79(3) may arise without any exemption at all having been obtained from the periodic charge. If, in the earlier example, the Trustees sell the painting not in 2015 but in 2010 (after the claim and Revenue designation but before the Section 79(3) exemption has had a chance to apply), Section 79(3), on a literal interpretation, would apply and a 26% charge would arise. It is understood that the Capital Taxes Office accepts the argument that at least one exemption from Section 64 must have occurred in relation to the property for a charge under Section 79(3) to arise, and that therefore such a charge will not be levied if the Revenue designation of the property is followed by a sale or other chargeable event before the Revenue designation has resulted in any exemption under Section 64. EXIT FROM THE DISCRETIONARY TRUST AND RATE OF TAX A Section 79(3) charge (at a maximum rate of 30%) will be severe if the property has been in the settlement for a long time. If trustees are considering an event which will trigger a Section 79(3) charge at a severe rate, they should consider whether the preferable course is to appoint the property to, or on interest in possession trusts in favour of one or more beneficiaries with a further requisite undertaking being given by the appropriate persons to the Inland Revenue, the conditionally exempt occasion referred to in Section 78. Such an occasion may 28 not only disapply the Section 65 exit charge if there would otherwise be such a charge. It will also eliminate any Section 79(3) charge 29. In the earlier example, if the Trustees had appointed the painting before its sale to beneficiaries, the beneficiaries had given a new requisite undertaking, and they had then in due course sold the painting, so triggering a chargeable event, the rate of IHT would have been limited to 20% 30. Taking chattels or their proceeds of sale out of discretionary trusts needs to be examined with some care, bearing Section 79 and 65 to 69 IHTA carefully in mind. Suppose that S has created a discretionary settlement into which the only property settled is settled under an IHT Heritage Transfer. The Trustees, 29 years later, decide to sell the collection at auction. If they sell shortly before the 30th anniversary of the settlement s commencement, they will suffer first the IHT charge on the chargeable event on sale (at the rate of 20%). And they will almost immediately suffer a further 6% charge on the net proceeds of sale (after deduction of CGT and the IHT on the chargeable event) on the subsequent 30th anniversary, without any credit for the tax on the chargeable event. If instead the Trustees sell just after the 30th anniversary, they are relieved from the further 6% periodic charge. Furthermore, a subsequent distribution of the net proceeds of sale (or appointment on interest in possession or accumulation and maintenance trusts) at any time before the WINTER ISSUE

4 next 10-year anniversary carries no further IHT liability. The rate of charge on exits between ten-year anniversaries is governed exclusively by Section 69 IHTA. The rate of tax is the appropriate fraction of the rate at which it was last charged under Section 64. Where Section 64 has been disapplied by Section 79, there is no charge under Section 64 and accordingly no rate at which tax was last charged under that section. The position is complicated where in addition to conditionally exempt property, other property has been settled. Suppose S has, in June 1995, created a discretionary settlement into which he has settled property under an IHT Heritage Transfer and also other property, the heritage property being worth, at the first 10-year anniversary, 5 million and the other property being worth 500,000. Assuming that S had no chargeable transfer history before the making of the settlement, the periodic charge will be 30% of 20% of (500, ,000), i.e. 13,500, the percentage of tax on the 500,000 charged being 2.7%. Suppose that at some time during the following 10 years the Trustees sell the heritage property and distribute the net proceeds of sale (after deduction of CGT and the IHT on the chargeable event) amounting to, say, 3 million. What is the rate of the exit charge under Section 69(1) IHTA? It is the appropriate fraction of the rate at which it was last charged under section 64. On one view, the literal interpretation, the rate, expressed as a percentage of tax on the amount charged is 2.7%. But it is hard to see why the 2.7% rate charged on one part of the relevant property under Section 64 should be taken as the rate for a quite different part which suffered no Section 64 charge. Should one not look at the relevant property in question and ask, as far as the 3 million net proceeds of sale is concerned, what rate was last charged on it, or on the original property which it now represents, under Section 64? If there was no charge, by reason of Section 79(1) IHTA, then should not that nil charge follow the distribution of the proceeds of sale? Although this analysis is in certain respects preferable, not least because it produces a rate of tax which relates to the rate at which the distributed property (as opposed to completely different property) was last charged, one may struggle to reconcile it with Section 65 IHTA. Section 65 operates not by imposing a charge on the value of particular property ceasing to be relevant property but on the diminution in the value of the relevant property caused by the disposition 31. A possible alternative analysis, which addresses the oddity of applying an apparently unconnected rate of tax to the distribution of proceeds of sale of previously exempted property, is to construe the reference in Section 69 IHTA to the rate at which [tax] was last charged under Section 64 as the rate of tax, taking into account the value of all the relevant property then comprised in the settlement, including the value of the previously exempted heritage property. In the example this would lead to a rate given by the fraction 13,500 divided by 5.5 million. Certainly the literal interpretation leads to capricious results. In the earlier example, a sale of a conditionally exempt painting and appointment of the net proceeds immediately before a 10-year anniversary would give rise to a 2.7% charge, whereas the same events shortly after the 10 year anniversary would produce no charge (none at the 10 year anniversary because of Section 79(1) and none on distribution in the first 3 months thereafter). The possible application of Section 69 under the literal interpretation suggests that, where a settlement consists of heritage property part of which is sold, there is an advantage in the trustees taking steps which ensure that there is no amount on which IHT can be charged under Section 64 on the next 10-year anniversary, either by investing the proceeds of sale in property which will then be eligible for agricultural or business property relief at the 100% rate, or by appointing it out absolutely or upon interest in possession or accumulation and maintenance trusts. The purpose is to ensure that on any further sale and distribution subsequent to the next 10-year anniversary the rate of tax on exit under Section 69 IHTA is nil. THE INADVERTENT INTEREST IN POSSESSION Trustees of heritage chattels held in discretionary settlements will be concerned to ensure that no interest in possession comes to subsist in the chattels inadvertently. If such an event occurred, whilst there would not inevitably be a chargeable event 32, there would be an exit charge under Section 65, unless the event became a conditionally exempt occasion upon new designation by the Inland Revenue under Section 31 IHTA and the giving of a further requisite undertaking pursuant to Section 78(1). The property would also become comprised in the estate of one or more individuals, a state of affairs which the trustees and the family would no doubt wish to avoid. It is, I think, unlikely that an interest in possession could occur inadvertently. In a sensibly drafted trust instrument, the trustees will be bound to exercise their dispositive powers by deed, so that in the absence of a deed, the property would remain held on the original discretionary trusts set out in the original instrument. Powers inserted into the administrative provisions of the trust instrument will often permit the trustees to allow beneficiaries to reside in or make use of trust property upon such terms as the 18 WINTER ISSUE 2005

5 trustees may determine. In such circumstances, the exercise of such a power may perhaps give rise to an interest in possession, as suggested in the Inland Revenue statement of practice of 15 August 1979 (SP 10/79). In the statement which relates to residences, the Inland Revenue accepts that the exercise of such a power creates no interest in possession if the effect is merely to allow non-exclusive possession or to create a contractual tenancy for full consideration. It is also accepted that no interest in possession is created where a lease for a term or periodic tenancy is created for less than full consideration 33. The statement continues On the other hand if the power is drawn in terms wide enough to cover the creation of an exclusive or joint residence, albeit revocable, for a definite or indefinite period, and is exercised with the intention of providing a particular beneficiary with a permanent home, the Revenue will normally regard the exercise of the power as creating an interest in possession The classic definition of this term, undefined by statute, is that it is an interest which carries the present right of present enjoyment 34. Crucially, it is the interest which must confer this right 35. It is not sufficient that the trustees confer a right of personal use or enjoyment without conferring a beneficial interest 36. Commonly trustees of discretionary trusts have entered into custody agreements whereby a discretionary object agrees under a terminable agreement to take custody of trust property in his home, on terms that he will keep them insured and will on behalf of the trustees provide such access to the public as is required, and that he will be permitted with his family and household to derive from them such personal use and enjoyment as the terms of the agreement permit, and for so long as the agreement lasts. In practice it is not unusual for trustees to negotiate a charge in respect of the personal use and enjoyment of the property so as to enable them to derive some income for distribution to the other discretionary objects under the settlement. Whether or not a charge is made, there is nothing in Pearson or Lloyds Private Banking 37 which supports the proposition that any interest is conferred by such an agreement in the items in question. Section 50(5) IHTA shows that mere use and enjoyment of settled property will not of itself create an interest in possession. The provision makes clear that it is only where the person referred to in Section 49(1) above [i.e. the person who is beneficially entitled to an interest in possession in settled property] though not entitled to any income of the property is entitled, jointly or in common with one or more other persons, to the use and enjoyment of the property, that his interest [in possession] is to be taken to subsist in such part of the property as corresponds to the proportion which the annual value of his interest bears to the aggregate of the annual values of his interest and that or those of the other or others. It is noteworthy that Section 50(5) does not provide that an interest in possession is taken to subsist, whenever a beneficiary who is not beneficially entitled to an interest in possession is permitted to use and enjoy trust property. William Massey QC Pump Court Tax Chambers 16 Bedford Row London WC1R 4EF Tel: (0) B wmassey@pumptax.com WINTER ISSUE

6 FOOTNOTES 1 Cheshire s Modern Law of Real Property (11th edition, pub. Butterworths) at p Re Coleman [1936] Ch. 528; [1936] 2 All ER Gartside -v- IRC [1968] AC 553; [1968] 1 All ER 121; IRC -v- Holmden [1968] AC 685; [1968] 1 All ER FA 1969 s.36 enacting the substituted FA 1894, s.2(1)(b). 5 Those made before 27 March Schedule 5 Paragraph 14 Finance Act Period extended to 31 March 1983 by Section 102 Finance Act Roy Greenfield and Reginald Johns, former Deputy Controller and Assistant Controller respectively of the CTO - (Dymond s Capital Transfer Tax, 2nd Edition (1983), pub. Oyez Longman) at p Sections 64 and 66 (and 67) IHTA. 9 Section 65(1)(a) IHTA. 10 Section 65(1)(b) IHTA. 11 Section 30 to 35A IHTA. 12 Budget Day 1998, when the conditional exemption changes were announced. 13 A failure to observe the undertaking in a material respect; or a disposal (otherwise than under a private treaty sale to a body designated under Schedule 3 IHTA or by way of acceptance in lieu), except where the disposal is otherwise than on sale and a further requisite undertaking is given by the appropriate person. See Section 32 IHTA. 14 Whether under Section 30 IHTA or its predecessor Section 34 Finance Act Section 79(1) IHTA. 16 Section 79(10) IHTA. 17 Schedule 6 paragraph 4(3) IHTA. 18 Section 79(2) IHTA. 19 See Section 159(2) Capital Gains Tax Act 1979 and Schedule 11 paragraph.29 Taxation of Chargeable Gains Act 1992, under which references to the provisions of that enactment in any statute are to be construed as including a reference to the corresponding provision of the repealed enactment. 20 Section 79 Finance Act 1980 as extended by Section 78 Finance Act 1981 and now in Section 260 TCGA See Schedule 6 paragraph 4(2)(a) IHTA. 22 An uplift to the CGT base cost will also be achieved by this means on the subsequent death under Section 72 TCGA Under Section 71 TCGA Where the original estate duty undertaking was given on or after 5th August 1965 and is still in force, a disposal otherwise than on sale will crystallise the estate duty charge unless the appointee gives a further undertaking. See Section 31(7) Finance Act 1965, preserved for estate duty purposes by Schedule 11 paragraph 20 TCGA The estate duty undertaking may not still be in force: for example, A died in 1969 leaving heritage property to his son B who claimed exemption giving the estate duty undertaking; B then died in 1980, leaving property by will to discretionary trustees, IHT being paid on the property; no estate duty undertaking was required under Section 31(7) Finance Act 1965 in the absence of an actual disposal; accordingly no further estate duty undertaking is required under Section 31(7) on appointment out. 25 Section 65(4) IHTA. 26 Note that it is not sufficient that a claim and undertaking has been made for the exemption to apply, Revenue designation must also have been given before the anniversary in question. Accordingly the process needs to be begun well before the 10-year anniverssary. 27 Section 79(7) IHTA. 28 This will be the case provided that the property has been comprised in the settlement for at least six years. See Section 78(1) IHTA. 29 See Section 79(4) IHTA. 30 See Section 79(4) and Section 78(3) IHTA. Note also that where heritage property is the subject of a conditionally exempt occasion before the first 10-year anniversary to fall after it becomes comprised in the settlement, the rate of charge applicable under Section 78 is reduced to 30% of what it would otherwise be; where the occasion occurs after the first but before the second 10-year anniversary to fall after it becomes comprised in the settlement, the rate is reduced to 60% of what it would otherwise be. 31 See Section 65(2) IHTA. 32 Under Section 32 IHTA. This would only occur if the trustees disposed of the property or breached the terms of their undertaking. 33 Although it is pointed out that the grant of such a tenancy may give rise to an exit charge if the value of the settled property is reduced. 34 See Pearson v IRC [1981] AC See IRC v Lloyds Private Banking Ltd [1998] STC 559, where the Court recognised the issue as being whether, on its true construction, the terms of the Will disposed of an interest in the Testatrix s half share in the house to the testatrix s husband (which would be an interest in possession), or merely laid down administrative directions to the trustees (the carrying out of of which would not). As a matter of construction, particularly bearing in mind that under the second construction the directions would be of no effect, the Court preferred the first construction. See also Executors of Woodall deceased v IRC [2000] STC (SCD) 558 and Faulkner v IRC [2001] STC (SCD) This point is highlighted by Section 46 IHTA, which provides In its application to Scotland, any reference to interest in possession in settled property is a reference to an interest of any kind under a settlement, by virtue of which the person in right of that interest is entitled to the enjoyment of the property or would be so entitled if the property were capable of enjoyment... ; and the person in right of such an interest at any time shall be deemed to be entitled to a corresponding interest in the whole or any part of the property comprised in the settlement. (Emphasis added). 37 Nor in the earlier estate duty case Gartside v IRC [1968] AC 553 where Lord Reid gave his understanding of the phrase (page 607): " In possession must mean that your interest enables you to claim now whatever may be the subject matter of the interest. For instance, if it is the current income from a certain fund your claim may yield nothing if there is no income, but your claim is a valid claim, and if there is any income you are entitled to get it; but a right to require trustees to consider whether they will pay you something does not enable you to claim anything. If the trustees do decide to pay you something, you do not get it by reason of having the right to have your case considered; you get it only because the trustees have decided to give it to you." (Emphasis added) 20 WINTER ISSUE 2005