Delicate touch: vulnerable beneficiary trust rules

The government is currently consulting on the definition of ‘vulnerable person’ in respect of the tax legislation applicable to trusts set up for the benefit of the most vulnerable members of society.

Such trusts are recognised by the government as an important means of making provision for those in need and can qualify for special tax treatment.

The tax reliefs can be very beneficial:

• following an annual election and claim, the trustees’ tax liability on income and chargeable gains is reduced, broadly, to the rate applicable to the beneficiary, rather than the higher rates usually applicable to trusts;

• the trustees’ capital gains tax annual exemption is increased to the full rate applicable to individuals; and

• the trusts are not subject to the usual inheritance tax charges applicable to relevant property settlements, rather the trust assets are treated as part of the beneficiary’s estate on their death.

Severely disabled

Under current legislation, ‘vulnerable person’ includes bereaved minors (i.e minors who have lost one or both parents) and those with a severe physical or mental disability. At present, the severely disabled include those:

• incapable by reason of a mental disorder within the meaning ?of the Mental Health Act 1983 of administering their property or managing their affairs; or

• in receipt of attendance allowance; or

• in receipt of the higher or middle-rate care component of disability living allowance (DLA).

While there is no intention to amend the legislation relating to bereaved minor trusts, the criteria required to satisfy the severe physical or mental disability needs to change due to the introduction of the Welfare Reform Act 2012 and the abolition of DLA.

From April 2013, DLA is to be replaced with the personal independence payment (PIP), initially for those aged 16-64. Without an amendment to the legislation, the Treasury states that some trust arrangements that would otherwise have qualified will not do so and, in other cases, the trustees will need to be provided with more subjective, possibly upsetting, evidence about the beneficiary’s incapacity.

This could be a particular issue for professional trustees, who may not have the level of personal knowledge of the beneficiary required to claim the relief.

PIP will have two awardable components: the mobility component (based on the individual’s ability to get around), and the daily living component (based on the ability to carry out tasks linked to daily life, such as preparing food and drink, bathing and grooming and making financial decisions).

Although the full details of PIP have not yet been decided, it is proposed that the new definition of ‘vulnerable person’ would include those in receipt of the enhanced rate daily living component of PIP.

It is interesting to note that the consultation document details the projected number of PIP claimants in receipt of the daily living component at the enhanced rate as approximately 540,000. This is less than half of the projected 1,310,000 claimants of the DLA care component at the middle or higher rate.

While the government states that “the vast majority of these claimants are unlikely to be beneficiaries of a trust arrangement”, the truth of the matter is that it is unknown exactly how many people will be affected, as there is no central record of private trusts established for vulnerable beneficiaries.

Additional tests

The government is keen to seek ?views on whether there are other alternative, or potentially additional, ?tests of vulnerability based on the ?use of the term ‘vulnerable adult’ in other legislation.

The Safeguarding Vulnerable Groups Act 2005 includes a list specifying when a person requires assistance in the conduct of his own affairs, while the Police Act 1997 defines a vulnerable adult in the context of enhanced criminal checks for those involved in their regular care, training or supervision.

While it may be preferable to try and align the definition of ‘vulnerable’ across different legislation, there is the obvious problem that the legislation is drafted to deal with specific issues, such as the prevention of physical abuse, which is quite different to the availability of tax relief for those unable to manage their affairs or who are open to exploitation or coercion.

The government believes the withdrawal of DLA may lead to an increase in the number of new applications for vulnerable beneficiary trusts based on the mental incapacity test; namely, whether a person is incapable, ?by reason of a mental disorder within the meaning of the Mental Health Act 1983 (MHA83), of administering his or her property or managing his or her affairs.

This definition is somewhat outdated as it is derived from section 94 MHA83, which was repealed when the Mental Capacity Act 2005 (MCA) came into force. The consultation document states that the ‘lack of capacity’ test under the MCA is unlikely to be satisfactory for ?tax purposes, as it applies to an individual’s ability to make a decision for himself in relation to any matter and is more likely to include those with temporary incapacity.

It is proposed to limit the scope of this test to an individual’s ability to manage or administer only their property and everyday financial affairs and only where the incapacity is permanent.

While the government foresees applications by trustees for vulnerable beneficiaries increasing under the mental incapacity test, it may become more difficult for trustees and their advisers to prove eligibility, particularly where it is unknown whether incapacity is likely ?to be permanent.

Unnecessarily complex

There are also proposals to amend the ways in which trustees can apply trust capital and income for the benefit of vulnerable beneficiaries. Depending on which tax provision is in play, one of two different conditions must be met in terms of the application of capital.

Either, not less than half the property that is applied during the person’s lifetime is applied for that person’s benefit or, if any of the settled property is made during the person’s lifetime, it is applied for the benefit of the person.

The government believes this is unnecessarily complex and proposes that the vulnerable beneficiary should be required to benefit from every application of trust capital that is applied during their lifetime.

In turn, any trust for a vulnerable person would need to expressly exclude section 32 of the Trustee Act 1925, otherwise the trustees may have power to advance up to half the trust capital to non-vulnerable beneficiaries during the vulnerable beneficiary’s lifetime.

In practice, this may prove difficult for existing trusts. There are similar proposals in respect of trust income.

Fortunately, the proposed changes will not be retrospective for inheritance tax purposes. The qualifying status of ?the trust is determined at the time the trust is established, so, provided that no further funds are settled, relevant property charges will not apply to trusts which no longer qualify as vulnerable beneficiary trusts.

Of course, many settlors will continue to opt for a simple discretionary trust over a vulnerable beneficiary trust so as to ensure that the vulnerable beneficiary continues to receive any means-tested state benefits to which ?they are entitled.

However, this assumes that those beneficiaries remain eligible for ?benefits under the Welfare Reform Act 2012, which is set to be the most significant change to the welfare system in many years.

?For more information see www.info4local.gov.uk/documents/consultations/2201691. The closing date for comments on the consultation is 8 November 2012.

Kelly Hardcastle is a solicitor at Hewitsons LLP https://www.hewitsons.com/Homepage