TRUSTS AND INHERITANCE TAX THE IMPACT OF FINANCE ACT 2006 While the 2006 Finance Act incorporates many of the proposals set out in March s Budget in respect of inheritance tax (IHT) without significant concessions to those who had clamoured for amendment, its enactment does at least allow a line to be drawn (for the time being at least) and for trustees and individuals to review their affairs with a degree of certainty. The new rules, most of which take effect from 22 March 2006, are complex and have a wide ranging effect on capital transactions and trust structures both old and new. It is beyond the scope of this article to set out the Finance Act provisions in full, but the following summary should help to identify those areas where problems might arise and in respect of which further advice should be taken. Gifts into trust At the centre of the Budget proposals was an extension of the discretionary trust (or relevant property ) regime, under which gifts into discretionary trusts are subject to IHT at the lifetime rate of 20% and the trust fund suffers both 10 yearly periodic IHT charges and an exit charge on capital distributions (both capped at 6% of the value of the property concerned). This regime now applies more or less across the board, so that from 22 March 2006 a gift into any type of trust (including additions to existing trusts) by an individual domiciled in the UK for IHT purposes is regarded as a chargeable transfer and is subject to tax (at the lifetime rate of 20% or the death rate of 40%, as appropriate) unless it falls within one of the exceptions below. The surviving exceptions It remains the case that gifts into trusts established for charitable purposes and gifts of qualifying conditionally exempt heritage assets are free from IHT. Gifts into qualifying disabled persons trusts (now redefined) continue to be regarded as potentially exempt transfers (PETs), with no IHT payable if the donor survives for seven years from the date of the gift. Finally, the spouse exemption will still be available in respect of gifts under a Will where the surviving spouse or civil partner takes a life interest, even if the trustees retain a power to revoke that interest, and in respect of a successive spousal life interest where the deceased spouse had an interest in possession on 22 March 2006 (see below). It is also the case, of course, that no IHT will be due in respect of gifts into trust that qualify for an exemption (such as gifts out of normal income) or a 100% relief (such as qualifying business or agricultural property) and those that fall within the donor s
available nil rate band (currently 285,000). For those not regarded as UK domiciled for IHT purposes, transfers of non UK property into a non resident trust will continue to be treated as excluded property. The new exceptions IPDIs, BMTs and 18 25 trusts Finance Act 2006 also sets out the rules for three new types of trust that are outside of the relevant property regime the immediate post death interest in possession trust (IPDI), the bereaved minor trust (BMT) and an extension of the BMT that benefits children beyond the age of 18 (the 18 25 trust ) each of which can be established only under a Will (or, in the case of a BMT, under the statutory trusts of intestacy). The term IPDI covers any new life interest trust established under a Will. These will be taxed in the same way as old style interest in possession trusts and their introduction will save amending numerous Wills that provide a spouse or child with a life interest in residue. A BMT must benefit a minor child of the testator and must provide for capital to vest at age 18, but in return it enjoys exemption from periodic and exit charges. The assets concerned will not form part of the child s estate for IHT purposes until they become absolutely entitled at age 18. Finally, a BMT that provides for capital to vest at 25 rather than 18 will fall within section 71D of the Inheritance Tax Act and will be caught by the relevant property regime when the beneficiary reaches 18 (albeit with any IHT charge restricted by reference to the period since that date, such that it cannot exceed 4.2% of the value of the trust property). The trust property will not form part of the beneficiary s estate for IHT purposes while they remain under 18. Existing interest in possession (IIP) trusts As noted above, gifts into IIP trusts on or after 22 March 2006 will be chargeable to IHT (they were previously treated as PETs) unless one of the exceptions applies. Capital added to new or existing settlements will also come within the wider regime of 10 yearly and exit charges. IIP trusts that existed prior to Budget Day will continue to be taxed under the previous rules (i.e. treated as if the assets formed part of the estate of the life tenant) until the later of the death of: a) the holder of the life tenancy as at 22 March 2006; b) a spouse of (a) who has taken a successive life interest; or c) a non spouse who succeeded to (a) s life interest (either on death or earlier termination) on or before 5 April 2008. If the trust continues upon the termination of the interest of (b) or (c) (either during their lifetime or on death) other than as a disabled trust or (if the interest in possession is an IPDI) as a BMT, its entry into the relevant property regime will trigger an IHT charge at
the lifetime rate of 20% or the death rate of 40% as appropriate (see Termination of life interests below). Existing Accumulation & Maintenance (A&M) trusts A&M trusts have historically enjoyed preferential treatment from an IHT point of view, remaining outside of the relevant property regime despite the fact that the trustees enjoy discretionary powers over income until the beneficiaries acquire a right to it (often not until the age of 25). The Government have taken exception to this, with the result that A&M trusts that do not provide for beneficiaries to receive capital at the age of 18 will become subject to the relevant property regime from 6 April 2008. The tax charges will be restricted where capital is to be taken at or before the age of 25, however, in the same way as for 18 25 trusts (with the result that the tax charged again cannot exceed 4.2% of the value of the trust assets). The period until 6 April 2008 constitutes a window of opportunity for the trustees of A&M trusts to consider changes to their terms (subject, of course, to any limits on the powers available to them). Existing discretionary trusts No changes have been made to the treatment of discretionary trusts, whether created during lifetime or by Will. With reference to Will Trusts, however, it is worth noting that it will still be possible for HM Revenue & Customs to argue that a beneficiary s interest in a particular asset for example, their occupation of a trust property could be deemed to be an interest in possession for IHT purposes if that interest in possession comes into existence within two years of death. The creation of discretionary trusts (or, indeed, other relevant property trusts) using the available part of the nil rate band remains an effective planning option. There will be no IHT to pay on the trust s creation nor on any distribution of capital within ten years. It will be necessary to file a return upon the trust s 10 th anniversary, but there will be no tax to pay if the capital value falls within the then IHT exemption. After seven years the settlor will have the benefit of a fresh nil rate band and can set up a new trust. Thus, even without any increase in exemptions, husband and wife (or civil partners) can together plan to give over 1.7million into trust over a 15 year period without incurring any IHT liability. Wills It remains the case that an outright bequest to a UK domiciled spouse and the creation of a Will Trust in which they have a life interest is exempt from IHT. Likewise, a bequest to or the creation of a trust for any other individual remains chargeable to IHT. A major change will, however, hit those Will Trusts that provide for children either directly or subject to the prior interest of a spouse. These will be subject to the relevant property regime in the same way as new A&M trusts unless they fall into one of the category of an IPDI, BMT or 18 25 trust (see above).
Life policies Life policy trusts entered into before 22 March 2006 will remain subject to the old IHT rules, even if varied within the terms of the original policy, and further premiums will still qualify as assets of a pre Budget Day trust. Policies written into trust from 22 March onwards, however, will fall within the relevant property regime unless any of the exceptions listed above apply. Payments into a new life policy trust will therefore constitute chargeable transfers (subject to the exemption for gifts out of income) and, should the value of the policy exceed the nil rate band, 10 yearly and exit charges will apply. Capital Gains Tax Accompanying the Finance Act changes to Inheritance Tax is an extension of Capital Gains Tax holdover relief to all trusts within the relevant property regime other than those from which the settlor, his spouse or a dependent child may benefit. This will be of significant benefit in cases where the value or nature of the trust property is such that a transfer into or out of a trust will trigger a nil (or very low) IHT liability. It should be borne in mind, however, that those interest in possession trusts that fall within the relevant property regime will no longer be able to benefit from a tax free uplift of CGT base costs upon the death of the life tenant. Termination of life interests From 22 March 2006 the termination of a life interest under an old style IIP trust or an IPDI will be treated as a gift by the life tenant for the purposes of the gift with reservation of benefit rules. This will be particularly relevant where the life tenant continues to occupy a trust property or to benefit under new discretionary trusts (in both cases the value of the settled assets will continue to fall within their estate for IHT purposes). Subject to transitional rules, the termination will also be treated as an immediately chargeable transfer for IHT purposes unless the settlement ends at that point or the property is then held on disabled person s trusts or, if the interest is an IPDI, as a BMT (in each of these cases the termination will be treated as a PET). The transitional rules allow a pre 22 March 2006 IIP trust to remain under the old rules if the existing interest is replaced by one or more new life interests ( transitional serial interests or TSIs) before 6 April 2008. In the case of spouses, a successive life interest will qualify for the IHT spouse exemption if it comes into effect on death or termination of the existing interest before 6 April 2008; after that date, only interests that terminate on the death of the existing life tenant will attract this relief. For non spouses, a termination of a pre 22 March 2006 IIP in favour of ongoing life interest trusts other than on death before 6 April 2008 will be a PET and will be subject to IHT only if the person whose interest is terminated dies within seven years.
It remains the case that the winding up of a pre 22 March 2006 IIP trust by way of an advance to the life tenant is IHT free and that an outright advance to any other beneficiary constitutes a PET. Conclusion It is advisable for all existing Wills and all trust arrangements to be reviewed in the light of Finance Act 2006. Even if the changes have no immediate impact, they may well restrict or, in a few cases, extend options for future planning. It goes without saying that those planning a new Will or a gift into trust should take appropriate advice beforehand. It should also be said that, while these changes were not exactly welcome, the trust is far from dead as an asset protection or tax planning tool and that a few new opportunities (particularly with regard to CGT holdover relief) have actually been opened up as a result. UHY Hacker Young is a top 20 group of Chartered Accountants that can provide expert advice and assistance in respect of all aspects of tax and financial planning. If you would like further advice in respect of your current position, please speak to your local UHY Hacker Young contact or to the author of this article: Mark Giddens, Trust Manager 020 7216 4651 m.giddens@uhy uk.com Note: This article is based upon our understanding of Finance Act 2006. We are grateful to Robert Brodrick, a senior solicitor in the private client department of Trowers & Hamlins (www.trowers.com), for his assistance in reviewing and contributing to the text. Every effort has been made to ensure that the facts in this document are correct at the time of going to press. No responsibility for loss occasioned to any person acting or refraining from acting as a result of any material in this publication can be accepted. Regulated for a range of investment business activities by the Institute of Chartered Accountants in England and Wales.