Background TAXATION OF TRUSTS TRUSTS AND PROBATE MANAGERS SESSION M5 CONFERENCE Since 2012 HMRC have undertaken an initiative to change the way that inheritance tax is calculated in relation to Relevant Property Trusts. This has moved from the original aim of simplification to a focus on fairness within the system. There have been three consultation documents published by HMRC: 1. Inheritance Tax: Simplifying the charges on trusts 13 th July 2012; 2. Inheritance Tax: Simplifying charges on trusts the next stage 31 st May 2013; and 3. Consultation on a fairer way of calculating IHT trust charges 6 th June 2014. Areas of change There were three areas of change identified in the second consultation document: 1. Changes to the way that the periodic and exit charges are calculated. 2. Introduction of a rule relating to the accumulation of income for the calculation of periodic and exit charges. 3. Alignment of filing and payment dates for periodic and exit charges. Current position The statutory provisions relating to the second and third changes were included in the Finance Act 2014. The first change has proved to be more difficult and the intention is that this will be included in the Finance Act 2015 and will take effect from 6 th April 2015. The third consultation document deals just with the changes to the way that periodic and exit charges are calculated. The responses period closed on 29 th August 2014, with a summary of responses to be published and the draft legislation expected in Autumn 2014. It is not anticipated that there will be significant changes to the scope of the changes included in the third consultation document. Calculation of periodic and exit changes Applicability Although it is not intended that the new rules will become applicable until 6 th April 2015, after that date they will apply to the following trusts: 1. Relevant Property Trusts established after 6 th June 2014. 2. Additions of property to Relevant Property Trusts established before 6 th April 2014. 3. Existing trusts which have entered the Relevant Property Regime after 6 th April 2014, so for example an Immediate Post Death Interest trust which becomes a discretionary trust after the death of the life tenant. 203486600_1/20 Sep 2014 1
Proposed changes The third consultation document proposes the following changes to the calculation of periodic and exit charges: That the following historic data will be ignored for the purposes of calculating the available nil rate band allowance: o o the settlor s lifetime transfers in the seven years prior to the commencement of the settlement, non-relevant property. Instead, a single nil rate band will be split between the number of Relevant Property Trusts which the settlor has created, in such proportions as the settlor elects. A simple rate of 6% will be used for the calculations. Trustees will be required to self-assess the amount of tax due. The old regime There will now be two regimes relating to the calculation of periodic and exit changes within the Relevant Property Regime. The following trusts will be taxed under the old rules: 1. Trusts set up before 7 th June 2014 to which no additions or amendments have been made after 6 th June 2014. 2. Where assets have been added to a pre-7 th June 2014 trust, the proportion of the trust fund that was settled previously (treated as a separate fund). 3. Part of a trust which was taxed as part of the Relevant Property Regime prior to 6 th June 2014 where another part of the trust only entered the Relevant Property Regime for the first time after 6 th June 2014. Charges arising before 6 th April 2015 on any trusts, regardless of when the trust was created, will be charged under the old rules. The old rules will remain largely the same but it is anticipated that the legislation will include a couple of key amendments. Applicability of the flat rate of 6%. The value of property held in a related settlement will in the future be left out of account. Changes applying to both the old rules and the new rules - The flat rate of 6% As stated above, it is anticipated that this will apply to both the old rules and the new rules and will replace the current lengthy calculations involving the effective rate and the settlement rate. The proposed flat rate of 6% does not remove the need to consider the number of quarters which have expired since commencement of the settlement or the last periodic charge, in the case of exit charges or to calculate the amount of time that the property has been relevant property for periodic charges. 203486600_1/20 Sep 2014 2
Example Samit settles 175,000. After 5 years (the 20 th quarter) 100,000 is distributed from the trust. The available nil rate band is, say, 150,000 as at the date of distribution. The value taken to determine the rate of tax applicable to the transfer of 100,000 is 25,000 ( 175,000-150,000). Existing rules: Value to determine rate of tax: 25,000 Charge at 20%: 5,000 Effective rate (5,000/175,000): 2.857% Settlement rate (2.857% x 3/10): 0.857% Charge on exit ( 100,000 x 0.857% x 20/40) : 428.50 Flat rate of 6% Value to determine rate of tax: 25,000 Charge at 6%: 1,500 Settlement rate (1,500/175,000) 0.857% Charge on exit ( 100,000 x 0.857% x 20/40) 428.50 Changes applying to both the old rules and the new rules - Disregard of non-relevant property Under the old rules, the rate of IHT on an exit or periodic charge is increased by the presence of: 1. non-relevant property in the same settlement (IHTA 1984, s66); 2. a related property settlement (IHTA 1984, s66 (4)(c)). Under the current rules it is reasonably rare to combine relevant and non-relevant property in the same settlement. One situation would be where the settlor sets up a trust which is partly an interest in possession trust for a disabled beneficiary and partly a discretionary trust. Another would be where a non-domiciled settlor settles UK and non-uk assets in the same discretionary settlement. Note that where a testator establishes a nil rate band trust and an IPDI of residue for his widow under his Will, these trusts (with one containing relevant property and one containing non-relevant property) are not related trusts as the IPDI is not treated as being established on the date of the first death (IHTA 1984, s80(1)) for the purposes of the inheritance tax calculations. The third consultation document suggests that non-relevant property and related settlements will be ignored for the purposes of the calculations for all trusts moving forward. Example Bob created two Relevant Property Trusts on 1 February 2008, with 300,000 in each. He had made no lifetime transfers in the previous seven years. The trustees of Trust 1 made payments to beneficiaries in February 2012 of 100,000 and in February 2016 of 50,000. 203486600_1/20 Sep 2014 3
Exit charge in February 2012 Historic value of relevant property 300,000 Historic value of related settlement 300,000 Assumed transfer 600,000 Less nil rate band 325,000 Value to determine rate of tax 275,000 Tax at 20% 55,000 Effective rate of tax (55,000/600,000) X100 9.167% Reduced to 3/10ths 2.75% Charge on exit ( 100,000 x 2.75% x 16/40) 1,100 Exit in February 2016 Historic value of relevant property 300,000 Less nil rate band 325,000 Value subject to tax Nil (Without the proposed changes, the exit charge would have been 1,100). There may not seem many circumstances where this would be beneficial (given that a settlor creating multiple Relevant Property Trusts on the same day would be rare and considering that nil rate band trusts and life interest trusts of residue created in the same Will are not related) but note the following situation: Charles and Camilla put in place mirror wills, with a nil rate band discretionary trust and a life interest trust of residue on the first death and a fully discretionary residuary trust taking effect on the second death. Charles dies prior to 6 th June 2014 but the nil rate band trust and the life interest trust are not related by virtue of IHTA 1984 s80. The nil rate band trust has a full nil rate band allowance. On Camilla s subsequent death, also before 6 th April 2014, the life interest trust automatically converts into a discretionary trust and Camilla s estate passes into a separate discretionary trust. If a charge were to arise on either of the residuary trusts prior to 6 th April 2015, they would have to share a nil rate band allowance. If the charge occurs after 6 th April 2015, the trusts would be taxed under the old rules but all three of the trusts would qualify for a full nil rate band allowance. Changes applying to both the old rules and the new rules self-assessment Trustees will be required to self-assess the tax due. This will be dealt with by changes to the IHT100 form and will be supported by toolkits and further guidance. Penalties can be levied against trustees who have over-claimed the SNRB as a result of their careless or deliberate actions. 203486600_1/20 Sep 2014 4
Changes applying to the new rules only disregard of settlor s lifetime transfers It is proposed that the settlor s lifetime transfers in the seven years prior to the creation of the trust will be ignored in determining the available nil rate band for the purposes of the charges. This affects the periodic and exit charges only and does not relate to the entry charge under the Relevant Property Regime. Therefore, if the settlor has made chargeable transfers in the seven years prior to establishing the trust, he or she can only settle assets up to the nil rate band (taking into account the value of the chargeable transfers) without incurring an immediate inheritance tax charge of 20%. This will not change. This is intended to reduce the investigative burden on trustees. Examples 1. Periodic Charge - Catherine sets up a trust in 2016 and allocated 50% of her SNRB (see below) to the trust. Value of settled property in 2026 500,000 Less allocated SNRB (50%) 162,500 Value subject to tax 337,500 Charge at 6% 20,250 Settlement rate (20,250/500,000) 4.05% 2. Exit charge after ten year anniversary the trustees of Catherine s trust decide to pay 50,000 to one of the beneficiaries in 2031. Value of relevant property at date of TYA 500,000 Exit of 50,000 in 2031 50,000 Settlement rate from ten year anniversary 4.05% Charge on exit ( 50,000 x 4.05% x 20/40) 1,012.50 3. Exit charge after addition of property to trust if the trustees had decided to pay 50,000 to one of the beneficiaries but Catherine had added another 100,000 to the trust in the meantime. Value of property at TYA 500,000 Addition 100,000 600,000 Less allocated SNRB 162,500 (half) Value subject to tax 437,500 Charge at 6% 26,250 203486600_1/20 Sep 2014 5
Settlement rate (26,250/600,000) 4.375% Charge on exit (50,000 x 4.375% x 20/40) 1,093.75 Changes applying to the new rules only the settlement nil rate band From 6 th April 2015, it is intended that each person will have an individual nil rate band ( NRB ) and a settlement nil rate band ( SNRB ), each of the same value. However, in contrast to the NRB, which renews each seven years, the SNRB has to be shared by each qualifying Relevant Property Trust set up by the same person (during their lifetime or on death). The settlor must make an election (on a form prescribed by HMRC) specifying in percentage terms, how much of their SNRB they will allocated to each trust. Unless the trustees can prove that their trust has been allocated some or all of the SNRB (the easiest way would be by keeping a copy of the election), they must assume that they have no SNRB and prepare the calculations on that basis. An election can be made and varied up to the date of the first charge. After that time the allocation of SNRB can be increased by not decreased while the trust remains in being. However, the wording of the consultation suggests that once a charge has taken place, an increase in the allocated SNRB can only take place if more assets are added to the trust. Why should it not be possible to increase the SNRB without making a further addition of capital to the trust? If a trust is wholly wound up, the SNRB allocated to that trust can then be reassigned to another trust if the settlor is still alive. If the settlor has died and the trust is wound up, that allocation of the SNRB is lost. This doesn t seem entirely fair. If relevant property becomes settled on charitable trusts or a disabled person becomes entitled to an interest in possession, the SNRB can also be reallocated. If property is added to a pre-6 th June 2014 trust, SNRB can be allocated to that portion of the trust fund. Where the settlor has died, the personal representatives may make the election to allocate the SNRB within two years but only relating to the SNRB which has not already been allocated during lifetime. There doesn t seem to be a provision to allow PR s to vary an election on a lifetime trust which has not yet suffered a charge. If the trustees have appointed assets out of the trust which is in excess of the available SNRB, there will be no SNRB to use at the time of the periodic charge. However, as with the current rules, if at the time of the next periodic charge, there have been no exits of capital out of the trust in the previous ten years, the full amount of the allocated SNRB will again be available to set against the charge. Examples using the SNRB after death. 1. Jordan dies in 2020 leaving a will including a discretionary trust. He has made no lifetime settlements. a. His personal representatives would be able to allocate a full SNRB to the trust within 2 years. 203486600_1/20 Sep 2014 6
2. Mike made a settlement in 2015. He allocates 100% of his SNRB to that settlement. In 2017, part of the capital of the trust is appointed to a beneficiary. He dies in 2020 leaving a will including a discretionary trust for the benefit of his grandchildren. a. None of the SNRB can be allocated to the Will Trust. b. The SNRB has already been fully allocated to the lifetime settlement and cannot be varied. 3. Sally made a settlement in 2015, and at the same time makes a Will including a discretionary trust for the benefit of her grandchildren. She allocates 50% of her SNRB to the lifetime trust, and does not change that allocation prior to her death. She dies in 2026, when the lifetime settlement is still in place. a. Sally s personal representatives are entitled, within 2 years of her death, to allocate the unallocated 50% of the SNRB to the Will Trust. b. They cannot reduce the allocation of the lifetime trust below 50% or increase the allocation to the Will Trust above 50%. 4. Callum makes a settlement in 2015, and at the same time makes a Will including a discretionary trust for the benefit of his grandchildren. He makes no election to allocate the SNRB before his death. He dies in 2020. Age 18-25 trusts a. His personal representatives have 2 years to make an election to either allocate the whole of the SNRB to the Will Trust, or split it between the lifetime and the Will Trust in such proportions as they elect in order to achieve the maximum tax saving. b. Callum could include guidance with his Will regarding the division of his SNRB. The calculation of inheritance tax on 18-25 Trusts is based on the Relevant Property Regime. The third consultation document indicated that the legislation setting out the inheritance tax treatment of these types of trust is likely to change in line with the proposed new rules. Treatment of undistributed income (see attached legislation) For various reasons trustees may choose not to accumulate income generated by trust investments to capital fund of a trust, where this is allowable under the terms of the trust. Previously it was not clear how long trustees could carry on adopting this tactic before the income would be deemed to be accumulated to capital. This is relevant because capital is included in the calculation of periodic and exit charges and income is not. The Finance Act 2014 amended s64 IHTA 1983, with the following effect: Trust income which has remained undistributed for a period of 5 years at the date of a ten year anniversary will be automatically treated as part of the trust capital for the purposes of calculating the periodic charge on or after 6 th April 2014. In contrast to the usual rules, there is no proportional reduction for the fact that the income may not have formed part of the trust capital for the entire ten year period. 203486600_1/20 Sep 2014 7
When distributing income, trustees are deemed to distribute the earliest net income first. Unless the income is formally accumulated by the trustees, when the income is paid out of the trust, it will be subject to income tax in the hands of the beneficiary (with the relevant tax credit) rather than an exit charge as capital. The income paid out will be net of the inheritance tax paid at the relevant ten year anniversary. Undistributed income, situated outside the UK and held within a settlement made by a non-domiciled settlor will not be treated as capital for the purposes of these rules. Alignment of filing and payment dates (see attached legislation) Changes in the Finance Act 2014 aligned the filing and payment dates to 6 months after the month in which a chargeable event occurred. 203486600_1/20 Sep 2014 8
Finance Act 2014 Schedule 21 Inheritance Tax Ten-year anniversary charge 4 (1) In section 64 (charge at ten-year anniversary), after subsection (1) insert (1A) For the purposes of subsection (1) above, property held by the trustees of a settlement immediately before a ten-year anniversary is to be regarded as relevant property comprised in the settlement at that time if (a) it is income of the settlement, (b) the income arose before the start of the five years ending immediately before the tenyear anniversary, (c) the income arose (directly or indirectly) from property comprised in the settlement that, when the income arose, was relevant property, and (d) when the income arose, no person was beneficially entitled to an interest in possession in the property from which the income arose. (1B) Where the settlor of a settlement was not domiciled in the United Kingdom at the time the settlement was made, income of the settlement is not to be regarded as relevant property comprised in the settlement as a result of subsection (1A) above so far as the income (a) is situated outside the United Kingdom, or (b) is represented by a holding in an authorised unit trust or a share in an open-ended investment company. (1C) Income of the settlement is not to be regarded as relevant property comprised in the settlement as a result of subsection (1A) above so far as the income (a) is represented by securities issued by the Treasury subject to a condition of the kind mentioned in subsection (2) of section 6 above, and (b) it is shown that all known persons for whose benefit the settled property or income from it has been or might be applied, or who are or might become beneficially entitled to an interest in possession in it, are persons of a description specified in the condition in question. (2) In section 66 (rate of ten-yearly charge), after subsection (2) insert (2A) Subsection (2) above does not apply to property which is regarded as relevant property as a result of section 64(1A) (and accordingly that property is charged to tax at the rate given by subsection (1) above). (3) The amendments made by this paragraph have effect in relation to occasions on which tax falls to be charged under section 64 of IHTA 1984 on or after 6 April 2014. 203486600_1/20 Sep 2014 9
Delivery of account and payment of tax 5 (1) In section 216(6) (time for delivery of accounts), before paragraph (b) insert (ad) in the case of an account to be delivered by a person within subsection (1)(c) above, before the expiration of the period of six months from the end of the month in which the occasion concerned occurs;. (2) In section 226 (payment of tax: general rules), after subsection (3B) insert (3C) Tax chargeable under Chapter 3 of Part 3 of this Act on the value transferred by a chargeable transfer, other than any for which the due date is given by subsection (3B) above, is due six months after the end of the month in which the chargeable transfer is made. (3) In section 233 (interest on unpaid tax) (a) (b) in subsection (1)(a), after transfer insert not within paragraph (aa) below and, after subsection (1)(a) insert (aa) an amount of tax charged under Chapter 3 of Part 3 of this Act on the value transferred by a chargeable transfer remains unpaid after the end of the period of six months beginning with the end of the month in which the chargeable transfer was made, or, and (c) in subsection (1)(b), for any other chargeable transfer substitute a chargeable transfer not within paragraph (a) or (aa) above. (4) The amendments made by this paragraph have effect in relation to chargeable transfers made on or after 6 April 2014. 203486600_1/20 Sep 2014 10