Update: trusts

Trust practitioners are still reeling from the shock of the unexpected changes to the inheritance tax (IHT) treatment of trusts announced in the Chancellor's 2006 Budget and now largely enacted in Sched 20 of the Finance Act 2006.

The bad news is that we now have to grapple with a fundamental overhaul of the capital taxes regime, which in concept has survived more or less intact since the introduction of capital transfer tax (CTT) in 1974. The good news is that as a result of lobbying from STEP and other professional bodies the initial proposals have been modified so that some of the provisions causing most concern have not been carried through.

The basic premise of the new legislation is that the relevant property regime for IHT, which formerly applied only to discretionary trusts, will now be extended so that it applies to all trusts created on or after 22 March 2006, unless the legislation specifically provides otherwise.

The relevant property regime itself remains the same. Broadly speaking, this provides that lifetime transfers into trust attract an immediate lifetime charge to tax at 20 per cent, there are periodic tax charges at a maximum of 6 per cent on the value of trust assets over the IHT threshold on each ten-year anniversary of the trust, and an exit charge on assets leaving the trust between ten-year anniversaries. The latter is a proportion of the periodic charge, rising according to the length of time that has elapsed since the last such anniversary.

Inter vivos trusts created on or after 22 March 2006

All trusts created inter vivos are now subject to the discretionary trust regime unless they meet the criteria for trusts for disabled beneficiaries set out in ss 89, 89A and 89B Inheritance Tax Act 1984 (IHTA). Such trusts include self-settlements by a person with a condition expected to lead to a qualifying disability, eg, someone not currently disabled, but having a known degenerative disease. In such disabled trusts, the beneficiary will be treated as being beneficially entitled to the property for IHT.

This means that for IHT, most interest in possession trusts will no longer be treated as if the life tenant owned the trust assets. There will be an immediate IHT charge (rather than a potentially exempt transfer (PET)) on creation if the assets exceed the nil rate band and further charges on ten-year anniversaries. On the death of the life tenant, the trust assets will not be aggregated with his or her free estate. In fact, the death will be irrelevant unless it happens to trigger property vesting absolutely in a beneficiary, in which case, there will be an exit charge for IHT and a deemed disposal for capital gains tax (CGT), but with the opportunity to hold over.

Similarly, accumulation and maintenance trusts have lost their favoured status, and in the context of new lifetime trusts, those trusts that would formerly have met the s 71 criteria will be taxed in exactly the same way as a discretionary trust.

Trusts arising on death after 22 March 2006

Once again there is no change to the treatment of discretionary trusts created by will and, as with lifetime trusts, those trusts created on death where there is a disabled person's interest are not subject to the relevant property regime.

The position is more complicated than with lifetime trusts because the legislation creates three new types of trust which have special IHT status:

• immediate post death interest trusts (IPDIs);
• trusts for bereaved minors (TBMs); and
• age 18-25 trusts.

What is an IPDI?

A person has an IPDI under s 49A of the IHTA 1984 if he becomes entitled to an interest in possession on the death of a testator or on intestacy. The original proposals for IPDIs were very restrictive and, for example, it was feared that spouse exemption would not apply where the spouse had a flexible life interest that was subject to the trustee's overriding power of appointment. The rules have been relaxed following representations from professional bodies, so that it is still possible to give a life interest to a surviving spouse by will tax-free and for the spouse to then make a lifetime gift. However, this will only be a PET if it is an absolute gift or a gift into a disabled person's trust or bereaved minor's trust and, additionally, the gift with reservation of benefit provisions can apply (see below).

IPDIs are treated in the same way as old interest in possession trusts '“ the trust assets are aggregated with the free estate on the death of the life tenant and there will be a CGT uplift on such a death. However, if there is a successive life interest to a spouse, spouse exemption will not apply and the ongoing trust will be subject to the relevant property regime. If there is a lifetime termination of an IPDI, this will be a PET only if the trust property vests in someone absolutely, if it is a gift into a disabled trust or a bereaved minor's trust. In all other circumstances, the lifetime termination will be a chargeable transfer.

Trusts for bereaved minors

Under s 71A, a trust will be a TBM if it is a statutory trust on intestacy for a bereaved minor or if it is established under the will of a deceased parent or under the Criminal Injuries Compensation Scheme (CICS) and the beneficiary becomes absolutely entitled to capital, income and accumulations on or before reaching 18. While the beneficiary is under 18, any capital applied for the benefit of a beneficiary must be applied to the bereaved minor and either the bereaved minor must be entitled to all income or it must not be applied for the benefit of any other person. However it is expressly provided that such a trust may include a s 32 power of advancement extended to the whole of the fund and still qualify as a TBM. This gives some scope for making settled advances to the bereaved minor, to avoid absolute vesting at 18, without incurring a tax charge. A bereaved minor is a child under 18, at least one of whose parents has died '“ parent is widely defined to include stepparents and anyone with parental responsibility.

TBMs are taxed in much the same way as old-style accumulation and maintenance (A & M) settlements. There is no charge to IHT when the beneficiary becomes entitled to the property at 18 or on other exit, nor are there charges on ten-year anniversaries. On the beneficiary becoming entitled on attaining age, there is a deemed disposal for CGT, but there is an ability to hold over. If someone other than the bereaved minor receives assets there is a tax clawback under the penal provisions of s 70 of the IHTA, as used to be the case in A & M trusts.

18-25 trusts

This category of trust did not appear in the first draft of the Finance Act, but was subsequently inserted in s 71D of the IHTA to meet the concerns of trust practitioners who felt that bereaved minors trusts with their insistence on absolute vesting at 18 were not always going to be a good idea in practice.

Again these are trusts for bereaved minors and they must be created either under the CICS or under the will of the deceased parent. The child need not take an absolute interest at 18, but must do so on or before reaching 25. While the beneficiary is a minor, there will be no ten-year anniversary charges or exit charges and if he or she takes absolutely at 18, no charge to IHT will arise. However, on exits after age 18, including absolute vesting at 25, there will be an exit charge calculated in the usual way but as it can only apply to a seven-year period the maximum rate will be 4.2 per cent, rather than 6 per cent.

As with TBMs, there will be a clawback, if assets are appointed out to a beneficiary other than the bereaved minor.

Transitional provisions for existing trusts

Where there is a pre-22 March 2006 settlement, the old rules for interest in possession trusts will continue to apply where a life tenant in place at 22 March 2006 remains beneficially entitled or if there is a transitional serial interest (TSI)

There are two sorts of TSI. The first is contained in s 49C of the IHTA. Under this section if there is a pre-22 March 2006 settlement in which a beneficiary has an interest in possession at that date, and this interest comes to an end prior to 6 April 2008, at which point another beneficiary becomes entitled to an interest in possession, a TSI will arise. This could happen on the death of the pre-22 March 2006 life tenant if there is a successive life interest, or during his or her lifetime, for example, if a life interest to a surviving spouse ceases on remarriage or the life tenant releases his interest.

The second type of TSI is found in s 49D IHTA 1984. Where there is a pre-22 March 2006 trust in which a beneficiary had an interest in possession at that date, and the interest in possession terminates on the death of that life tenant on or after 6 April 2008, with that life tenant's spouse taking a life interest, a TSI will arise. This means that, unlike in the case of post-22 March 2006 IPDIs, the spouse exemption will be available on the life tenant's death and the trust will continue to be treated as an interest
in possession trust until the death of the surviving spouse.

Transitional provisions for A & M trusts

The scope for taking advantage of the transitional provisions in relation to A & M trusts is considerably more restricted than in the case of interest in possession trusts. Pre 22 March 2006, A & M trusts (created inter vivos or on death) will only continue to have favoured status under s 71 if either they already provide for property to vest absolutely in the beneficiaries at 18, or if the terms of the trust are amended prior to 6 April 2008 to provide this. In the case of a will trust, it may also be possible to convert this to an 18-25 trust so that the trust will only become subject to the relevant property regime after the beneficiary attains 18, and some such trusts will fall into this category automatically at 6 April 2008. All other former A & M trusts will automatically become subject to the discretionary trust regime for IHT on 6 April 2008, even though the change in tax status on that date will not itself trigger any tax charge. Where a former A & M trust has been catapulted into the relevant property regime as at 6 April 2008, the ten-year anniversary charge will only occur if the anniversary falls after 6 April 2008. The trust property will only be treated as having been relevant property from 6 April 2008 so that if, for example, the anniversary arose shortly after that date, the charge would be modest in practice.

Life policies

There are special provisions in s 49E of the IHTA providing for TSIs in relation to life policy trusts. Where a person had an interest in possession in a pre-22 March 2006 settlement which consists of, or includes, a life policy as at 22 March 2006 and that person dies after 6 April 2008 whereupon that interest terminates in favour of another life interest, a TSI will arise. If the subsequent life tenant dies and there is another life interest arising, the later life interest will also be a TSI and so it will continue provided the chain of life interests is unbroken.

Life policy settlements created post-22 March 2006 will be subject to the discretionary trust regime, although in most cases there will be no actual charge on creation or on ten-year anniversaries, as long as the beneficiary is not too old and in reasonable health, because little value will attach to the policy.

Gifts with reservation of benefit

Whereas it used to be possible for a life tenant of an interest in possession trust to bring his or her interest to an end inter vivos and escape the gift with reservation of benefit provisions despite retaining a benefit in the settled property, this is no longer the case after the Finance Act 2006. The act extends the gift with reservation of benefit (GROB) regime so that in essence a person who is treated as having an interest in possession for inheritance tax purposes will be treated in the same way as a donor who owns property in his or her own right. This means that lifetime terminations of pre-22 March 2006 interests in possession, or post-22 March 2006, IPDIs, TSIs or disabled persons interests will be subject to the GROB provisions if the life tenant retains a benefit.

If a settlor creates a new settlement post-22 March 2006, giving himself a life interest, then as he is no longer to be treated as beneficially entitled for IHT purposes, the relevant property rules will apply and there will be a GROB. In this situation, even if there is no GROB, there could potentially be a liability to pre-owned asset tax because, again, as the settlor is no longer deemed to own the assets for IHT,it is no longer possible to benefit from the exemption that formerly arose in life interest settlements where the property was retained in the estate of the taxpayer.

CGT and trust modernisation

In the flurry of activity that has followed the introduction of the new IHT rules, it would be easy to overlook some of the other changes that have been introduced more gradually and following consultation as part of HMRC's trust modernisation project in relation to the income tax and CGT treatment of trusts.

This process started in the Finance Act 2004, which introduced the 40 per cent CGT rate for all trusts while retaining differential rates for income tax, with the rate applicable to trusts (RAT) still only applying to discretionary trusts. This was followed in the Finance Act 2005 by a £500 standard rateband for discretionary and A & M trusts, rising to £1,000 in 2006/7. The Finance Act 2005 also introduced a special tax regime for trusts for vulnerable beneficiaries for both CGT and income tax, but backdated to 6 April 2004.

The Finance Act 2006 aligned the rules for income tax and CGT in certain respects so that there is a common definition of settlor and settled property.

Also, provided certain conditions apply, trustees will have the ability to elect that a sub-fund of a settlement is treated as a separate settlement for both income tax and CGT. Trustees will need to make an irrevocable election that cannot take effect before 6 April 2006 . While this is potentially useful where sub-funds have separate trustees, it is important to be aware that the election will trigger a CGT disposal of the assets in the sub-fund, and this is likely to act as a real disincentive to trustees to take advantage of the election.

Settlor interested trusts

Before the Finance Act 2006, where a settlor created a discretionary trust, but retained an interest, the income was taxed on him at his own tax rate rather than being subject to RAT. From 6 April 2006, such income will be subject to RAT in the hands of the trustees despite it still being deemed the income of the settlor. However, HMRC has said in correspondence that it will not assess the settlor to further tax on this income. Other beneficiaries who receive income payments from the trust have in practice never been subject to income tax on such payments, and this is now legislated in the Finance Act.

Trustee residence

Currently there are separate tests to determine where a trust is resident for income tax and CGT with the rather anomalous result in some cases that a trust can be resident for income tax but not CGT. The Finance Act 2006 changes this position from 6 April 2007 '“ from this date the income tax test will apply to determine residence for both income tax and CGT. A trust will therefore be UK-resident if either all trustees reside in the UK or if at least one trustee is UK-resident and the settlor was UK-resident, ordinarily resident or domiciled on creation of the settlement. One important point to note is that the special CGT rules that applied to UK professional trustees acting in trusts where the settlor was non-domiciled and non-resident, allowing them to be deemed non-resident will cease from 6 April 2007. This means that some such trusts will become automatically UK-resident on that date unless steps are taken to for example to appoint a non-resident trustee. On an ongoing basis, it will be necessary to keep a close eye on foreign settlor trusts and ensure that all trustees are aware that their own residence could affect that of the trust. Otherwise, for example, a trust where all trustees are UK-resident could inadvertently become non-resident and suffer a CGT charge because one trustee emigrates.