|
||||
|
|
|
|
|
|
Taxation of Trusts and the 2006 Budget
In his Budget, the Chancellor made a number of unexpected announcements around the inheritance tax treatment of trusts which have caused a great deal of confusion and concern. First of all it is important to stress that Potentially Exempt Transfers (PETs) are still very much alive – making a gift to an individual or a gift to a trust for the disabled (specific definitions apply) or a gift into an absolute (or bare) trust will be treated as a PET. If the donor survives 7 years, the gift will fall out of the estate for inheritance tax (IHT). As a result of the Budget all types of trust may now be treated as ‘Relevant Property’ trusts if created or amended post 22nd March 2006 unless specifically exempted (trusts for the disabled, pension trusts and absolute trusts). Effectively, this brings virtually all trusts into line with discretionary trusts. With Relevant Property trusts, there may be an inheritance tax charge on gifts into it, as well as ‘periodic’ and ‘exit’ charges. One of the most significant results of this is the treatment of ‘Interest
in Possession’ trusts (often called a flexible or Power of Appointment
trust). Gifts into IIP trusts are no longer PETs – in the future a gift into such a trust could be chargeable to IHT. In addition, ‘periodic’ and ‘exit’ charges could apply. What about trusts that are already in existence? Adding funds to a pre-Budget trust will cause the new rules to apply to the whole trust. Under the Inheritance Tax Act 1984 the beneficiary of an IIP is treated, for IHT purposes, as owning the capital which supports that interest. So if a beneficiary dies, the trust capital has been treated as part of his/her estate. This will no longer be the case for IIP trusts created or amended post Budget, except for a limited number of interests (immediate post-death, disabled person, transitional serial) - see later. The death of an IIP beneficiary under an interest which commenced on or after Budget Day will not be an event on which IHT is payable unless, as a result, assets leave the trust. In this instance, the assets will be taxed under the trust rules and not as part of the deceased’s estate. Pre Budget, any transfer of the IIP during lifetime was treated as a PET by the beneficiary whose interest was removed or reduced. Post Budget such an appointment under an existing trust will (a) be treated as a chargeable transfer by the original beneficiary and (b) bring the trust within the new rules so that both ‘periodic’ and ‘exit’ charges could apply. So, exercising the trustees’ ‘power of appointment’ to change the beneficial interest in a flexible trust will also cause the new rules to apply to that trust unless the appointment brings the trust to an end. If the trust continues, the new rules will apply. There is to be a transitional period up to 5th April 2008 for trustees
to make any necessary appointments under the pre-Budget rules. Some flexible trusts will have been set up with the initial beneficiary (ies) being expressed as “our children whenever born”. The arrival of a new child would result in the reduction of the original child’s share and thus a chargeable transfer by that child (although it may be within the annual £3,000 exemption) – as well as introducing the new rules. Whilst this is an absurd position, if you have such a trust, it may be worth amending it by 5th April 2008 and, should you have additional children, create a new trust in respect of them. Pre-Budget Accumulation and Maintenance trusts will be caught by the Finance Bill provisions and become ‘Relevant Property’ trusts unless they are amended, prior to 6 April 2008 so that beneficiaries become absolutely entitled to the trust assets by age 18 (currently age 25). So what is the IHT treatment of Relevant Property Trusts? Importantly, if the settlor dies within 7 years of the chargeable
lifetime transfer it will be added back into their estate (as with
PETs) and additional tax may be payable. The lifetime tax paid would
be credited and taper relief is available. Periodic Charge The value will include the value of any ‘related settlements’. To be ‘related’ for these purposes, settlements (trusts) would need to have been created by the same settlor and on the same day. Amounts added to the trust during the ten years prior to the periodic charge are included in the valuation but there is a form of proportionate relief available. IHT is calculated on this valuation (called an ‘assumed transfer’) usually as if the trust had its own nil rate band. The tax is based on an effective rate and can never be more than 6% of the trust value. In reality is it extremely unlikely that the charge would be anything like 6%. Exit Charge The whole of any capital distribution from a relevant property trust is subject to an exit charge which is based upon the tax charge at the most recent ten year anniversary or, if the charge is incurred in the first ten years, the tax rate when the settlement was created (or when the trust became a relevant property trust). The tax charged on an exit is reduced proportionately so that a lower rate applies to assets leaving the trust soon after an anniversary (creation of the trust if the exit is within the first ten years) in which case the tax charge relates to the previous anniversary or, if within the first ten years, to the charge on entry. Since the settlor can control the tax charge on entry by keeping the initial transfer within the nil-rate band (or bands in the case of joint settlors), he/she can also control the exit charge during the first ten years (0% on entry will mean 0% on exit prior to the first ten year anniversary). Much planning around discretionary trusts has centred on removing capital in the first ten years to minimise tax charges and this is likely to extend to the newly created relevant property trusts shortly. For post-Budget trusts the exercise of the power of appointment will not give rise to a chargeable transfer by the beneficiary whose interest in possession is reduced as a result of the appointment. It will be, for this purpose, as if nobody has the IIP. What about lump sum inheritance tax schemes? Where a flexible trust is used, we believe that loan repayments under loan and gift/loan arrangements will not be included in the calculation for periodic or exit charges since they are not ‘trust property’ due to the fact that the settlor has retained his/her rights to these amounts. If your scheme does use a flexible trust, it is important that you understand the new rules but, since gifts are generally extremely small, the changes should not concern you unless large transfers have already been made thus restricting the nil rate band’s availability. Discounted Gift Schemes However, discounted gift schemes are currently designed to be used with power of appointment trusts and thus will be ‘Relevant Property’ trusts. Amounts involved are high and thus the nil rate band must be considered. It is necessary to consider all previous chargeable transfers when setting up these schemes. We believe that it is the discounted amount that will be considered as a chargeable transfer. In addition, we have no clarity as yet as to how these schemes will be valued for the ten yearly periodic charge. In fact we may need to wait for ten years, until the first discounted gift trust reaches its ten year anniversary, before the Revenue’s position becomes clear. The least likely outcome is that the charge will be based on 100% of the value of all assets within the trust. This is unlikely because the right to future ‘income’ reserved by the settlor, like ‘income’ that has already been paid to him/her, is not part of the trust property. If you have or you are considering using a discounted gift scheme, you should be warned that this ‘worst case’ position for valuing the trust, may be the one that prevails. The next least likely position is that the original discount is carried through for the lifetime of the trust so that a, say, 50% discount when the trust is created would be allowed at each ten year anniversary. The most likely position, in our view, is that a discount will be allowed at the ten year anniversary but that it will be based on the settlor’s sex, age and state of health at that time rather than when the arrangement was set up. This, if correct, will add cost to the arrangement since underwriting would be required in order to ensure that the valuation is accurate and such a charge may be passed on to the trust or the settlor. Of course, there is not an enormous difference between the first and third options outlined above. If the discount is calculated each ten years it will get smaller all the time. Are there any exemptions to the new rules? The most likely example of an IPDI trust is a will under which the Transitional serial interest The simplest example of this would be an IIP under a pre-Budget power of appointment trust where the IIP beneficiary’s interest arose because the trustees appointed benefits away from another individual between Budget Day and 5th April 2008. An appointment of benefits after 5th April 2008 will remove TSI status and the trust will become a Relevant Property trust. Both an IPDI and a TSI will be outside the ‘Relevant Property’ trust regime so that periodic and exit charges will not apply. The capital will form part of the beneficiary’s estate for IHT purposes. Ending either an IPDI or a TSI will constitute a PET if the interest ends during lifetime so that another individual becomes absolutely entitled, an exempt transfer if it passes to a charity etc or chargeable in most other circumstances. The transfer of a TSI to a spouse or civil partner will be exempt but will result in a ‘new’ ‘Relevant Property’ trust so that periodic and exit charges will apply. What about life assurance policies in trust? New policies written in trust will come under the new rules unless an absolute trust is used. Existing policies in trust, for example term assurance or whole life plans, will not be affected by the changes provided the premiums and the sum assured remain the same. There are still some uncertainties with regard to indexation of premiums and the ten-year review under whole of life plans. Again, if the trust being used is an absolute one, there is no problem. If a flexible trust is being used with an existing policy, the beneficiaries can be changed before 6th April 2008 and no IHT charges will arise (as discussed above) but any increase in premiums would render the trust a ‘relevant property trust’ with the consequent IHT charges. It should be borne in mind that the value for the periodic charge on a whole life plan would be the higher of the surrender value or the total premiums paid. If the annual premium is high or the policy holders are young, there could be scope for charges under the new rules. The same considerations apply for term assurance policies; use of an absolute trust will remove IHT charges but will also remove flexibility. With regard to terms of less than 10 years, there could be a chargeable transfer on creation of the trust (but use of the nil rate band or normal expenditure out of income would negate this). In terms of a value for the periodic charge, a term policy would have no value unless the life assured was seriously ill at the time of the periodic charge, when it could be argued that the policy would have a value on the open market. In any case, we would continue to advocate the use of trusts with life policies as the advantages outweigh the disadvantages. Although we now have much more clarity around the proposals, some questions remain unanswered and there may be further changes prior to enactment. The above is a summary of the main changes but there are many issues you may wish to discuss. It is absolutely essential that you review your will as a result of these changes – especially around the contentious area of Accumulation and Maintenance trusts being required to ‘vest’ at age 18 to avoid being treated as Relevant Property trusts. I would invite you to contact me as soon as
possible if you wish to
discuss any of the above in detail; in particular it may be necessary
to update your will to reflect these changes. |
||||||||||
 |
The Acumen Investment Partnership • Southlands • Buxton Road • Bosley •
Macclesfield • SK11 0PS |
