CHAPTER 9 RELEVANT PROPERTY TRUSTS FURTHER ASPECTS In this chapter you will cover further aspects of discretionary trusts, including: Non-relevant property; Excluded property; Trusts becoming discretionary; S.80 IHTA 1984; Pilot trusts; Protective trusts. 9.1 Non-relevant property effect on exit charges When calculating an exit charge in the first 10 years of the trust, the effective rate of tax is calculated using the value immediately after the settlement commenced of property then comprised in it (s.68(5)(a)) ie, the initial value. IHTA 1984, s.68(5) This initial value will include all assets entering the trust even if those assets are not relevant property at that time. The same principle applies to any added property. Illustration 1 Joe created a trust on 15 May 2005 with 800,000 in cash. The terms of the trust were that Joe's daughter, Tina, was entitled to an interest in possession in 25% of the fund, with the remainder held on discretionary trust for Joe's grandchildren. Joe had made no lifetime transfers prior to 2005 and the trustees paid any IHT arising. In July 2014 the Trustees made a discretionary distribution of 25,000 to each of Joe's 4 grandchildren. The trustees paid any IHT arising. Calculate the IHT on the discretionary distribution. i. Tax on creation Joe is treated as creating 2 separate trusts on 15 May 2005 as follows: DT IIP Gift (75:25) 600,000 200,000 Less: 2 AEs (split pro-rata) (4,500) (1,500) 595,500 198,500 = CLT = PET Reed Elsevier UK Ltd 2014 89 FA 2014
Gifts to IIP trusts prior to 22 March 2006 were PETs. Therefore only the gift to the discretionary part of the trust would have been liable to IHT: CLT 595,500 Less: Nil band 2005/06 (275,000) Taxable 320,500 IHT @ 20% 64,100 ii. The exit charge is as follows: Initial value of trust: Relevant property (600,000 64,100) 535,900 Non-relevant property (IIP) 200,000 735,900 Less: Nil band at exit (325,000) 410,900 Notional tax @ 20% 82,180 Effective rate: 82,180/735,900 100 11.167% Actual rate: 11.167% 30% 36/40 3.015% Gross-up as Trustees pay tax: 3.015/(100 3.015) 100 3.109% Exit charge: 25,000 4 = 100,000 3.109% 3,109 The effect of creating a trust containing non-relevant property is therefore the same as having set up 2 different trusts on the same day ie, the rule mirrors that which applies to related trusts. Joe would have been better advised to have created a separate IIP trust for Tina on the day after he had set up the discretionary trust (ie, 16 May 2005). This would have reduced the lifetime tax on the CLT (as all AEs would have been allocated to the first transfer) and would have reduced the rate of tax applying to the exit charge. 9.2 Non-relevant property effect on principal charges Only relevant property within the trust on its 10-year anniversary will be subject to the principal charge. However to calculate the effective rate of tax we must take account of the value immediately after it became comprised in the settlement, of any property which was not then relevant property and has not subsequently become relevant property (s.66(4)(b)) i.e. we take the initial value of any non-relevant property in the trust. IHTA 1984, s.66(4) Again this rule mirrors that for related trusts where the initial value of a related trust affects the rate of tax on a principal charge. Reed Elsevier UK Ltd 2014 90 FA 2014
Illustration 2 Returning to the example of Joe's trust (above). At 15 May 2015 the trust was valued at 1.2 million of which Joe's daughter Tina had an interest in possession in 25%. Calculate the Principal Charge. The principal charge is as follows: Relevant property at May 2015 (1.2m 75%) 900,000 Initial value of non-relevant property 200,000 1,100,000 Nil band at exit 325,000 Less: Distributions in last 10 years (100,000 + 3,109) (103,109) (221,891) 878,109 Notional tax @ 20% 175,622 Effective rate: 175,622/1,100,000 100 15.966% Actual rate: 15.966% 30% 4.79% Principal charge: 900,000 4.79% 43,110 9.3 Excluded Property Trusts A trust is domiciled where the settlor was domiciled when he created the trust. Therefore a trust created by an individual not domiciled in the UK will be non-uk domiciled for IHT purposes. The trust will remain non-uk domiciled even if the settlor subsequently acquires a UK domicile (either under general law or under the 17-year residence rule in s.267 IHTA 1984). Foreign assets held by a non domiciled person are excluded property. Excluded property is outside the scope of IHT. Therefore any transfers of excluded property are ignored for IHT purposes. IHTA 1984, s.48(3) As such, foreign assets held by a trust which is non-uk domiciled are excluded from a charge to IHT. Note that a trust can be resident in the UK but can still be an excluded property trust for IHT. This can happen if a non-uk domiciled person creates a trust by settling (say) shares in a foreign company. The settlor appoints 2 trustees, both of whom live in the UK. The trust is therefore UK resident but non-uk domiciled. The foreign assets held by the trustees are not therefore subject to IHT. Reed Elsevier UK Ltd 2014 91 FA 2014
This means that: i. There will be no exit charge if those foreign assets are distributed to beneficiaries (even if the beneficiaries are UK resident and/or domiciled); and ii. The foreign assets in the trust are not subject to principal charges. If a non-domiciled trust has a mixture of UK and foreign assets, the UK assets will not be excluded property and will be subject to exit and principal charges. For tax planning purposes, trusts with a non-uk domiciled settlor can avoid an IHT charge by (say) exporting assets prior to either a capital distribution or a principal charge. For example, switching cash from a UK bank to an offshore account just before the 10-year anniversary will save IHT. 9.4 Excluded Property Effect on Exit and Principal Charges Excluded property is not relevant property. Therefore if a trust contains excluded property, those assets are treated as non-relevant property for exit and principal charge purposes. The initial value of any excluded property will therefore have to be taken into account when calculating the rate of tax to be applied on an exit or principal charge (as in illustrations 1 & 2 above). Illustration 3 Mr Ashcroft is resident in the UK but domiciled in Belize. He has lived in the UK since March 1993. In June 2004 he settled the following assets on to a discretionary trust for the benefit of his wider family (himself excluded): House in Belize 400,000 Cash in Belizean dollars (deposited into a Cayman Islands bank) 300,000 UK quoted shares 240,000 Total 940,000 In September 2012, the Trustees made a capital distribution of BZ$100,000 ( 50,000 sterling equivalent) to a UK beneficiary. In June 2014, the trust assets were valued as follows: House in Belize 600,000 Cash in Belizean dollars (held in a Cayman Islands bank account) 400,000 UK quoted shares 300,000 Total 1,300,000 The IHT implications of the above arrangements are as follows: In June 2004 when he set up the trust, Mr Ashcroft was non-uk domiciled. Mr Ashcroft would only therefore have been liable to IHT in respect of transfers of UK assets (his foreign assets were excluded property). The chargeable transfer in 2004 was therefore 240,000 being the UK shares only. This would have been covered by the nil band for 2004/05 leaving no tax payable. Reed Elsevier UK Ltd 2014 92 FA 2014
The trust is non- domiciled. The fact that Mr Ashcroft will have become deemed domiciled in 2009/10 (on account of having been resident in the UK for 17 years) will not change the domicile status of the trust. The distribution of Belizean dollars to the UK beneficiary in September 2012 will not give rise to an exit charge as the Belizean bank account is excluded property. The fact that it is paid to a UK beneficiary is irrelevant. There will be a principal charge in 2014, but IHT will be charged on the UK assets only (being the UK quoted shares of 300,000). The principal charge is as follows: Relevant property at June 2014 300,000 Initial value of non-relevant property (400,000 + 300,000) 700,000 1,000,000 Nil band at exit 325,000 Less: Chargeable distributions in last 10 years (Nil) (325,000) 675,000 Notional tax @ 20% 135,000 Effective rate: 135,000/1,000,000 100 13.5% Actual rate: 13.5% 30% 4.05% Principal charge: 300,000 4.05% 12,150 Note that even though only the UK assets are charged to IHT in 2014, the initial value of the excluded property (being non-relevant property ) must be taken into account to calculate the rate of tax. Therefore even though the trust is non-uk domiciled and has UK assets of less than the IHT nil band, a principal charge still arises. To avoid the charge, the Trustees could have sold the UK shares and transferred the proceeds to an overseas account (although CGT would then need to be considered). 9.5 Trusts Becoming Discretionary It is possible for a non-discretionary trust to be converted into a discretionary trust. For example, a settlor could have created an interest in possession trust before March 2006, under which the property passes to a discretionary trust on the death of the life tenant. If property is later distributed from the discretionary trust, an exit charge will arise. Similarly there will be a principal charge on each 10-year anniversary. The date of commencement of the trust for IHT purposes, is the date on which property first becomes comprised in the settlement. The date of commencement is therefore the date that the interest in possession trust was created. Therefore the principal charges will fall on each 10 year anniversary from the creation of the interest in possession trust. IHTA 1984, s.60 Reed Elsevier UK Ltd 2014 93 FA 2014
When calculating the IHT on the exit charge, we must adjust the number of quarters to reflect that the trust assets have not been relevant property for the full period. IHT is only charged on relevant property, and in the period before the discretionary trust came into being, the trust assets were not relevant property. Therefore when calculating the actual rate on the exit charge, we adjust the quarters as we did for added property. We will do a similar exercise when computing the principal charge. Illustration 4 Leo created an interest in possession trust for his son on 1 April 2005 with 600,000 in cash. His chargeable transfers in the previous 7 years were 163,000. Leo's son died on 15 June 2009 and the trust instrument directed that the property be thereafter held on a discretionary trust. On 21 October 2012, the discretionary Trustees appointed cash of 75,000 to a beneficiary. The first principal charge will fall on 1 April 2015, being 10 years from the date of the original settlement. Trust assets are worth 900,000 at this point. Calculate the exit charge on 21 October 2012 and the principal charge on 1 April 2015. a. Exit charge (21.10.12) ¼s between creation of interest in possession trust (1.4.05) and date of exit = 30 ¼s between creation of interest in possession trust (1.4.05) and establishment of discretionary trust (15.6.09) = 16 Initial value (1.4.05) 600,000 Nil band at exit (2012/13) 325,000 Less: Chargeable transfers in 7 years before creation of trust (163,000) (162,000) 438,000 Notional tax @ 20% 87,600 Effective rate: 87,600/600,000 100 14.6% Actual rate: 14.6% 30% (30 16)/40 1.533% Exit charge (assume tax paid by beneficiary): 75,000 1.533% 1,150 Reed Elsevier UK Ltd 2014 94 FA 2014
b. Principal charge (1.4.15) Value of trust at 1.4.15 900,000 Nil band 2014/15 325,000 Less: Chargeable transfers in 7 years pre-trust (163,000) Less: Distributions in the previous 10 years (75,000) (87,000) 813,000 Notional tax @ 20% 162,600 Effective rate: 162,600/900,000 100 18.067% Actual rate: 18.067% 30% (40 16)/40 3.252% Principal charge: 900,000 3.252% 29,268 9.6 Section 80 IHTA 1984 Section 80 IHTA 1984 applies where: IHTA 1984, s.80 1. The settlor or their spouse had an interest in possession in property; and 2. On their death (or other termination of the IIP), the property becomes held on a discretionary trust. For trusts created on or after 22 March 2006, s.80 only applies if the settlor creates a trust on death of which his spouse/civil partner has an interest in possession. IHTA 1984, s.80(4) The effect of Section 80 is twofold: 1. Trusts within Section 80 are not related settlements for the purpose of calculating exit and principal charges; and 2. The property now held on discretionary trust is treated as a separate trust made by the person who was last entitled to an IIP in it. This means that the settlor of the trust is regarded as the last of either the settlor or his spouse to have an interest in possession. This is important for exit and principal charge purposes because: 1. It is the settlor's clock we take account of when calculating the effective rate; and 2. The initial value of the trust for exit charge purposes, is the value of the trust assets at the date the settlor is deemed to have created the trust (ie, we use the value at the date the trust became discretionary). However, even if Section 80 applies, principal charges are determined by the date of the original settlement i.e., the date the interest is possession trust was created (not the date that the trust became discretionary). Therefore we will need to adjust the number of quarters when calculating a principal charge. Reed Elsevier UK Ltd 2014 95 FA 2014
Illustration 5 Mr Jensen died on 1 August 2005. He made no lifetime transfers. His will directed that his estate (then worth 500,000) be held on interest in possession trust for his wife, with remainder to a discretionary trust for his children and grandchildren on his wife's death. Mrs Jensen died in September 2008, and the assets of the trust (then valued at 600,000) thereafter became held on a discretionary trust. She had made lifetime transfers of 125,000 in the 7 years before her death. The Trustees made a capital distribution of 80,000 to a beneficiary in November 2014. 1. The date of commencement for principal charge purposes is 1 August 2005. The first principal charge will therefore be levied on 1 August 2015. We would then need to adjust the quarters to reflect the fact that the property was not relevant property between August 2005 and September 2008. 2. For all other purposes, the discretionary trust is treated as having been created by Mrs Jensen in September 2008. Mrs Jensen is therefore the settlor of the trust. This means that to calculate the exit charge in November 2014: 9.7 Pilot Trusts a. The initial value we use is that as at September 2008 (ie 600,000 less any IHT paid by the trustees); and b. We use Mrs Jensen's cumulative total of transfers (ie 125,000) to calculate the effective rate of tax; and c. When calculating the effective rate, the number of completed quarters runs from September 2008 to November 2014 being 24. A pilot trust is typically a discretionary trust set up with a nominal amount of cash (often a 10 note attached to the Trust Deed) to which property is then added at a later date. Pilot trusts are used as tax planning vehicles to enable: 1. The settlor to avoid the related trust rules; and 2. Multiple nil bands to be generated to reduce exit and principal charges 9.8 Avoiding the Related Trust Rules Assume a settlor wishes to create 2 trusts in his will being: 1. An interest in possession trust for his sister; and a 2. Discretionary trust for his children and grandchildren. These trusts will be related for IHT as they commence on the same day (being the date of the settlor's death). Therefore when calculating exit and principal charges on the discretionary trust, the initial value of the related settlement (being the IIP) will have to be taken into account in calculating the effective rate of tax. Reed Elsevier UK Ltd 2014 96 FA 2014
This can be avoided by the settlor setting up the discretionary trust with 10 in cash during his lifetime. Property will then be added to the trust on his death. As the two trusts do not now commence on the same day, the related trusts rules do not apply. Note that where the settlor wishes to create an IIP for his spouse on death in addition to a discretionary trust for his children / grandchildren, these trusts will NOT be related. This is because the IIP trust falls within the ambit of s.80 IHTA 1984 and will be deemed to commence when the spouse's IIP ends (not on the death of the settlor). A pilot trust will not therefore be necessary in this instance. 9.9 Multiple Nil Bands If the settlor creates a series of pilot trusts and then adds property to each of the trusts at a later date, each trust will have its own nil rate band when it comes to calculating exit and principal charges. Illustration 6 Mr Rich owns 800,000 shares in a listed trading company (BFG plc) which he intends to transfer to a trust for his grandchildren. The shares are presently valued at 2 each being 1.6 million. The grandchildren are currently in their mid to late teens and Mr Rich envisages that the beneficiaries will be given the shares outright in 7 or 8 years time. In the meantime, dividends from the shares will be used to meet their education costs. Mr Rich has made no previous transfers (other than giving away 3,000 on 6 April each year to use his annual exemption). Mr Rich has agreed to pay any IHT on the transfer to the trust. This will be: Gift to trust 1,600,000 Less: Nil band (325,000) Taxable 1,275,000 IHT @ 20/80 318,750 Assume that the trust is wound up in 8 years time when the trust assets have increased in value to 2.25 million. Assume a nil band of 325,000. Reed Elsevier UK Ltd 2014 97 FA 2014
The exit charge will be: Initial value 1,600,000 Less: Nil band at exit (325,000) 1,275,000 Notional tax at 20% 255,000 Effective rate: 255,000/1,600,000 100 15.9375% Actual rate: 15.9375% 30% 32/40 3.825% Exit charge: 2.25m 3.825% 86,062 Assume instead that Mr Rich sets up 5 trusts (all on the same day) each with 10 in cash. The following day he gives each of the trusts 160,000 shares in BFG plc worth 2 per share (being 320,000). The tax on initial creation of each trust is nil as the transfer is covered by the nil band (Note: the small gifts exemption of 250 does not apply to gifts into trust). The tax on the addition of shares to the trusts on Day 2 is: Gift to trusts (320,000 5) 1,600,000 Nil band 325,000 Less: CLTs in prior 7 years (10 5) (50) (324,950) Taxable 1,275,050 IHT @ 20/80 318,762 The extra tax is therefore 12 (being 50 @ 20/80). Assume again that the trusts are wound up in 8 years time when the trust assets have increased in value to 2.25 million in total (being 450,000 for each trust). Assume a nil band of 325,000. The exit charge for each trust will be: Initial value of trust 10 Initial value of related trusts 40 Initial value of the addition to the trust 320,000 320,050 Nil band at exit 325,000 Less: CLTs in 7 years before creation of trust (Nil) (325,000) Nil The effective rate is therefore Nil giving a zero exit charge. The tax saving is therefore a little over 86,000. This planning can be taken to extremes. Reed Elsevier UK Ltd 2014 98 FA 2014
Assume that (say) the shares were worth 30 million. 100 separate 10 pilot trusts are created on Day 1. The shares are added to each trust on Day 2 (being 300,000 to each). Each trust would have an initial value of 10 + 300,000. Related trusts would be 99 10 = 990. Each trust would benefit from its own nil band such that there would be no exit charge in the first 10 years of the trust. Of course, there is IHT on the transfer of the shares into the trust which cannot be avoided. In his Autumn Statement in December 2013, the Chancellor announced that antiavoidance legislation would be introduced to extinguish the tax planning opportunities offered by the use of pilot trusts. It is likely that this legislation will be enacted in Finance Act 2015. 9.10 Deduction of Liabilities in Relevant Property Trusts The rules introduced in Finance Act 2013 concerning restrictions on deductions of liabilities also apply to occasions when IHT is charged on relevant property trusts. The restrictions apply to transfers made on or after 17 July 2013. Loans are usually deducted against the value of the asset upon which they are secured. IHTA 1984, s.162 However, under s.162b IHTA 1984, if an individual took out a loan on or after 6 April 2013 and used the money to acquire relievable property (being assets qualifying for BPR or APR), the debt is deducted from the value of the business or agricultural property before BPR or APR is applied. IHTA 1984, s.162b This provision is extended to relevant property trusts. For example, assume that the Trustees of a discretionary trust took out a loan on or after 6 April 2013. The loan was secured on an investment property held in the trust. The loan advance was used to acquire shares in an unlisted trading company. When it comes to calculating the principal charge, the loan reduces the value of the shares (before BPR is deducted) and not the value of the investment property. IHTA 1984, s.162b(9) Similarly the FA 2013 rules which prevent a deduction for loans taken out to acquire excluded property will also apply to relevant property trusts. IHTA 1984, s.162a For example, assume a discretionary trust has a non-uk domiciled settlor. The foreign assets of the trust are excluded property and will not be subject to a principal charge. The trust has one UK asset (a UK investment property). This will be subject to a principal charge. To reduce the value of the UK investment property (and thereby reduce the principal charge), the Trustees took out a mortgage which was secured on the UK investment property. The Trustees used the money to acquire foreign assets. This planning no longer works since Finance Act 2013 because under s.162a the loan is disallowed as it represents a liability incurred to acquire excluded property. The full value of the UK investment property will therefore be subject to the principal charge. Reed Elsevier UK Ltd 2014 99 FA 2014
9.11 Protective Trusts A protective trust is an interest in possession trust, under which a beneficiary has a right to income. However, under the terms of the trust, the interest will terminate either if the life tenant becomes bankrupt or if he tries to dispose of his interest in possession. IHTA 1984, s.88 Such trusts are typically established where a settlor does not have full confidence that the beneficiary will deal responsibly with his interest in possession. On the termination of the life interest, the trust property thereafter becomes settled on to a discretionary trust for the benefit of the life tenant and his immediate family. The life tenant no longer has a right to income as it arises, and instead the trustees can deal with the trust property at their discretion. For inheritance tax purposes, the interest in possession is deemed to continue. This means that the value of the trust will still be treated as a qualifying interest in possession in the estate of the previous life tenant in the event of his death (see later chapter for further details). As the trust is not a relevant property trust for IHT purposes, no exit or principal charges will arise. If the trustees make a capital distribution to a beneficiary, this will be treated as a distribution by the life tenant, and in most instances will be a potentially exempt transfer for IHT purposes. Reed Elsevier UK Ltd 2014 100 FA 2014
EXAMPLES Example 1 Mr Darling died on 16 September 2004. He had made no lifetime transfers. His will directed that his estate be divided as follows: 250,000 on a qualifying Accumulation & Maintenance (A&M) Trust for his 3 teenage nephews; 900,000 on discretionary trusts for his children. The terms of the trust are that his wife, Grace, would have an interest in possession for life in one-third of the trust with capital reversion to their grandchildren on her death; The residue of the estate to be divided equally between their 6 grandchildren. Grace Darling died on 3 January 2009. On 5 April 2010, the assets in the A&M trust for the nephews were fully appointed to the beneficiaries and the trust was wound up. On 16 September 2014, the discretionary trust was valued at 850,000. No prior capital distributions had been made. Calculate the Principal Charge arising in September 2014. Example 2 Mr Becker lives in the UK but is domiciled in Germany. On 6 April 2006 he created a trust for his only child, Benjamin, under which Benjamin will receive capital at age 18 (until then, income and capital will be distributed at the discretion of the Trustee). This was Mr Becker's only transfer. Mr Becker is the sole trustee. The assets settled in 2006 were UK quoted shares (valued at 250,000) and an investment property in Germany (valued at 600,000). Benjamin was 18 on 7 October 2014 at which point the shares (then worth 450,000) and the investment property (then worth 575,000) were transferred to him. Benjamin paid any tax arising. Calculate the IHT due (if any) on the transfer to Benjamin in October 2014. Reed Elsevier UK Ltd 2014 101 FA 2014
ANSWERS Answer 1 Relevant property at September 2014 850,000 Initial value of related trust 250,000 Initial value of non-relevant property (900,000 1/3) 300,000 1,400,000 Less: Nil band at principal charge (325,000) 1,075,000 Notional tax @ 20% 215,000 Effective rate: 215,000/1,400,000 100 15.357% Actual rate: 15.357% 30% 4.607% Principal charge: 850,000 4.607% 39,160 Answer 2 The trust is non-uk domiciled as the settlor was non-domiciled when he created the trust. The foreign assets in the trust are therefore excluded property and will not be liable to an exit charge. However the initial value of the excluded property will need to be taken into account to calculate the rate of tax. The exit charge is therefore: Initial value of trust (250,000 + 600,000) 850,000 Less: Nil band at exit (325,000) 525,000 Notional tax @ 20% 105,000 Effective rate: 105,000/850,000 100 12.353% Actual rate: 12.353% 30% 34/40 3.15% Exit charge (UK assets only): 450,000 3.15% 14,175 Reed Elsevier UK Ltd 2014 103 FA 2014