commercial property
commercial litigation
company & commercial law
employment law
debt collection
corporate tax services
VAT consultancy
notary public services
agricultural & rural affairs
taxation farms & landed estates
charities
trusts
employment law
rural disputes
Budget Day 2006, 22nd March, produced a major surprise for all professionals dealing with Inheritance Tax (“IHT”). For some eighteen months earlier a long consultation process had been underway with HM Revenue and Customs (“HMRC”) into what at different times was called by them the “simplification” or “modernisation” of trusts.
These proposals had originally been aired in the Chancellor’s Pre-Budget Report in November 2003. But they dealt only with Income and Capital Gains Taxes in relation to trusts. HMRC had responded to suggestions made by professional bodies. Nothing had been said about the IHT bombshell that Gordon Brown dropped.
His initial proposals, contained in the Finance Bill, were draconian in the extreme. A huge campaign was launched by the professional bodies, supported by the Press, which did have some impact when in late June Mr Brown toned things down so far, mainly, as will trusts are concerned. Notwithstanding this element of backtracking by him, we are now faced with a wholly different regime from that in place almost since the inception in 1974 of Capital Transfer Tax, the forerunner of IHT.
To understand where we now are does initially require an examination of the old (pre 22nd March) rules, particularly as the new rules will catch all existing trusts, even those in place pre-Budget, from 6th April 2008 at the latest. Indeed, it is not only the major change in the rules, but the fact that they are retrospective, with complex transitional rules, that has made the whole process so difficult.
The pre-Budget rules
Before the Budget trusts, for IHT purposes, were broadly divided into two categories – Interest in Possession Trusts (“IIP”) and all other trusts, known as Relevant Property Trusts (“RPT”).
In general terms an IIP is a trust where someone has an automatic right to the income from the trust without anyone’s say so. The most common is a trust for A to receive the income during his life, with the capital going to B on A’s death. A is known as the “life tenant” and B as the “remainderman”. If the right to income is dependent in any way on someone else’s decision, usually the trustees, it will be an RPT.
Certain RPTs were given less severe tax treatment, the most common and popular being the Accumulation and Maintenance Trust (“A&M”). These were trusts set up, usually by parents or grandparents, for their children or grandchildren. Capital and income could be applied by the trustees for the beneficiaries at the trustees’ discretion until the beneficiaries reached a maximum age of twenty five, at which time the beneficiaries had to become entitled either to both capital and income or simply the income. These were frequently used in connection with the funding of education.
A gift to an IIP or A&M was treated as a potentially exempt transfer (“PET”), i.e. no taxable event occurred, and nothing was reportable to HMRC, unless the person making the gift (“the donor”) died within seven years of the gift (or without time limit if the donor retained an interest in the trust), in which event the value of the gift would be added back to the donor’s estate.
Contrast this with a gift to an RPT where the gift was an immediately chargeable transfer (“ICT”) reportable to HMRC. To the extent that the gift exceeded the donor’s allowances, IHT was immediately charged at 20%. If the donor died within seven years of the gift (or without time limit retained an interest in the RPT) the gift was taken into account as was the case with a PET but in addition a further 20% IHT became payable.
(Please note the net effect of either a PET or ICT if the donor died within seven years (or without limit if the donor retained an interest) is in fact the same. However, both the immediate position and the position if the donor outlives the gift by seven years without retaining a benefit is very different).
The taxation of each of these three types of trusts also differed. In the case of an IIP the life tenant was treated for IHT purposes as owning the underlying capital assets of the trust. Any activity that meant that the entitlement of the life tenant to the income was brought to an end was treated as if the life tenant had made a gift of that underlying capital. In other words, if the life tenant died the capital was taxed as part of his estate. If the life tenant gave up or had his interest in the income terminated in his lifetime that would be treated either as a PET or an ICT in exactly the same way that it would have been if the life tenant had actually owned the capital.
A&Ms were very favoured since there was no IHT payable at any time during their existence so long as they conformed with the conditions to make them A&Ms.
The taxation of RPTs was much more complex. A dual system of IHT applied, the ten yearly charge and the exit charge. So long as the RPT continued it was subjected to IHT every ten years. The actual calculation of the tax charge is too complex to explain in detail in this article, but suffice it to say that every ten years a maximum IHT charge of 6% would be levied on the trust assets. If capital was taken out of the trust during an intervening ten year period, effectively, a proportion of the IHT charged at the previous ten yearly anniversary would be levied, the proportion being calculated by reference to the number of quarters that had elapsed since that charge, eg. capital extracted from the RPT five years after the last ten yearly charge would be taxed at half the rate applied at that earlier ten yearly charge.
Please note that these rules applied consistently to both trusts created in life and on death.
The post-Budget rules
We now have different rules depending on whether the trust was created in lifetime or on death. This in itself is a major change; but those differences themselves make the new position a “whole new ball game”.
- Lifetime Trusts
In a way these are the easier to understand. With the exception of certain trusts for disabled beneficiaries, disabled being quite narrowly defined, any trust set up on or after 22nd March 2006 will be an RPT. The taxation of an RPT, both in its set up and onging, remains unchanged. There are a number of important things to bear in mind:
First, the spouse exemption is effectively lost. Pre-Budget setting up an IIP for one’s spouse or civil partner was exempt. This is no longer the case.
Secondly any lifetime trust set up with assets having a value after any reliefs (eg, the annual exemption, agricultural or business property relief) in excess of the nil rate band, currently £285,000, will be immediately taxable.
Thirdly A&Ms have been abolished.
- Will Trusts
Here the picture has changed less as a result of the Chancellor’s last minute change of heart, but is more complex as he has retained some of the old pre-Budget rules, but overlaid these with the new lifetime rules. There are effectively four exceptions to the new rule that all post-Budget trusts will be taxed as RPTs.
Certain trusts for disabled persons (the same as with the lifetime position)
An Immediate Post Death Interest (“IPDI”)
Bereaved Minors Trusts (“BMT”)
An 18 to 25 Trust
I will say no more about the disabled trusts as they are a specialised and narrow category of trust, important where they apply, but of less general application. It is here only that the life and death rules coincide. The other three categories are all of considerable relevance. Before examining them in detail, please bear in mind that if the will trust does not fall into one of these new classifications it will be an RPT and subject to ten yearly and exit charges even if one’s spouse or civil partner is a beneficiary.
An IPDI is simply an IIP that takes effect on death, e.g. income to my wife for life with capital to my children on her death. The pre-Budget rules applying to IIPs apply during the life tenant’s interest. The difference comes after the IIP ends. Under the pre-Budget rules if the life tenant’s interest terminates on death, the value of the assets in the IIP are, as previously explained, added to the life tenant’s estate. If the interest ends during the life tenant’s life, then, unless the interest passes into an RPT, the transfer will be a PET. Another IIP can then come into existence with the same rules applying. However, under the new rules, whilst the position on death is the same, if there is a further trust that follows, even if another IIP, that trust will be an RPT. A termination in life will be treated as a PET if the trust ends and an individual becomes absolutely entitled; but if there is a further trust then the transfer will be an ICT so there will be an IHT charge and the new trust will be an RPT. In simple terms, one immediate IIP is allowed under the old rules, but otherwise the new rules will apply.
A BMT is a new invention. This is a trust where the beneficiaries are the children or stepchildren of the deceased and they become entitled absolutely at the age of 18 both to capital and income. If these conditions are satisfied, there is no IHT when the child or stepchild inherits nor any periodic charges. As mentioned previously A&Ms have been abolished. A BMT is no replacement. It is restricted to the next generation only; applies only on death; there is no real flexibility and the interest at 18 has to be absolute. Many clients do not trust their offspring to be sensible with money at 18. They prefer an older age. This cannot be a BMT. Grandparents and other relatives have no benefit from BMT’s.
A further new invention is the 18 to 25 Trust. In his original Budget proposals a BMT was the only option without being caught under the new rules. The Chancellor bowed to pressure to an extent by introducing this hybrid trust. Again the trust is restricted to gifts on death to children or step children, but what it does is tone down the full RPT rules that would otherwise apply. The trust must provide that the child or step child inherits absolutely at age not exceeding 25. Initially there is no IHT charge. If the trustees decide to wind the trust up on or before the beneficiary is 18 then it will be treated as a BMT and there will be no IHT charge. If the trust continues beyond the age of 18 then there is a sliding scale whereby IHT is charged at the rate of 0.15% for each quarter from the beneficiary’s 18th birthday till the trust terminates. If the trust continues till the beneficiary is 25 the maximum IHT payable is 4.2%.
Beyond these exceptions, a trust created on death will fall into the new rules as an RPT.
- The Transitional Provisions
As I said earlier, the new rules are retrospective so affect trusts in existence before 22nd March 2006. These rules are probably the most complex part of the new legislation. Please note that if you have made a will and are still living that trust has not come into existence so on death the new rules will apply fully. We are therefore concerned with all trusts set up either in lifetime or on a death before Budget day. If you have such a trust it will immediately be caught by the new rules if you add to the trust assets after Budget day. Otherwise there is a moratorium on existing trusts until 6th April 2008 after which the new rules will apply. The position is, however, very complicated. Different rules apply to different sorts of trust.
So far as an existing IIP is concerned, if you wind this up before 6th April 2008, the pre-Budget rules apply. If the IIP continues after that date then the new rules will apply as soon as the life tenant’s interest ends. This is the same position as with and IPDI.
There are, however, two exceptions. If an IIP in existence at Budget day, terminates before 6th April 2008 and is followed by another IIP, the transitional rules will apply to that new IIP (but only that one) even though it is a new trust interest. The second exception relates to an IIP in existence on Budget day which terminates after 6th April 2008 if this is followed by a further IIP provided the life tenant is the spouse or civil partner of the first life tenant. The old rules apply to both of these IIPs until they terminate when the new rules will apply.
If on the other hand, you have an A&M, your choices to avoid the new rules are, before 6th April 2008, either to wind up the trust and distribute the assets outright to the beneficiaries, convert the trust into the equivalent either of a BMT or an 18 to 25 Trust. Please note the right to convert is not automatic. The trustees have to have the power to do this in their Trust Deed. If there is no such power you are stuck. For the purposes of the Transitional Rules only, BMTs and 18 to 25 Trusts apply to exiting life and death trusts and can include grandchildren since the original A&M may have been set up by grandparents. An existing A&M Trust where under the original provisions the beneficiaries took the income only at 25 cannot have the benefit of the Transitional Provisions. The beneficiaries must either take outright immediately, if the A&M is wound up; at 18, even if that is after 6th April 2008, if the A&M is converted into a BMT equivalent; or on or before 25 if the A&M is converted into an 18 to 25 Trust.
If you do not take any such action, the A&M will be caught by the new rules and be taxed as an RPT after 6th April 2008. There is one slight concession only. The first 10 yearly charge after 6th April 2008 will be scaled down. This works as follows. If for example you created your A&M on 5th April 1998, your first 10 yearly charge will fall on 5th April 2018 and will be levied in full as ten years have elapsed since the new rules applied. If, however, the date of creation was 5th April 2006, the first 10 yearly charge will be on 5th April 2016. The normal charge is calculated but only eight tenths of the IHT is payable, ie the number of years after 6th April 2008, ie 8. Apart from this the new rules will apply.
The final category of trust affected by the Transitional Provisions is trust of life policies. Special rules apply here. Provided that nothing additional is added to the policy other than the payment of premiums under the terms of the policy and the terms of the policy trust are not changed, the pre-Budget rules will continue to apply.
Summary
I have only set out the broad outlines of the changes. There is a huge number of issues to be considered when one comes to look at the application of these rules in practice. There is simply no easy answer.
If you have an existing trust much the effects of the changes outlined above are dependent on a number of factors:
the value of the Trust Fund;
its IHT exposure in relation to the tax position when the trust was set up;
the attitude of the trustees, and often the settlor, to re-writing trusts which presumably were considered to be appropriate at the time they were set up;
the ability to change the trust anyway etc.
Each case needs careful thought and consideration, full discussion with all relevant persons, a sound grasp of the new law in all its complexities and, to an extent, foresight. The major objection here must be that the Chancellor has again “moved the goalposts” and sought to levy tax very differently from that due when the trust was formed.
You may well need to review your will. Whilst the toned down final provisions so far as will trusts are concerned are less draconian than originally stated by Gordon Brown (which we considered would have meant a review of every will made by us for clients), many wills have gifts to children at an age over 18, or by grandparents or others to minor relatives. These will need to be reconsidered. For those contemplating setting up lifetime trusts, we have a whole new set of rules to think about.
The Tax Team at Halesowen has spent many hours, probably days, not only learning and discussing the new rules and their implications, but also considering in real life situations their application and ways in which to mitigate the effects of the new regime. We are more than happy to review any situation you may have where the new tax rules apply, about which you are concerned or uncertain.
 |
contact
| Meet the Team: |  Alan Neal |
