Simon's Tax Briefing
STB 21 August 2006, 1
A matter of trust Part 1
Taxation Of Trusts
Matthew Hutton
is the author of 'Trusts and Estates' one of six volumes to be
published in the Tottel's Core Tax Annuals 2006=9607 series which can be
ordered from Marston Book Services on 01235 465500 cost =A319.95. The
ISBN is 1845923235.
=A9 Reed Elsevier (UK) Limited 2006
The taxation of trusts described by Matthew Hutton, following Finance
Act 2006.
Trusts (or settlements) have for many hundreds of years been an
established part of the English legal system. While their creation and
maintenance might be dictated largely by non-fiscal issues, the tax
advantages (or disadvantages) of particular types of trust should not
be overlooked -- and this is the subject of a new three-part series.
This first article in the series considers in broad terms the income
tax and capital gains tax (CGT) treatment of different types of UK
resident trust. Part 2 will deal with inheritance tax (IHT) and Part 3
will focus on planning op****tunities and pitfalls, suggesting in which
cir***stances trusts of one type or another might be used.
Although the new regime introduced by Finance Act 2006 has generally
sought to impose the single 'relevant property' IHT regime on all
trusts created on or after 22 March 2006, there remains a transitional
regime for trusts in being at that date -- and for other reasons the
distinctions between various types of trusts do remain significant --
even though no new ac***ulation and maintenance settlements can be
made after 21 March 2006. The articles will be limited to the three
main types of trust found in practice, viz discretionary, ac***ulation
and maintenance and interest in possession (or life interest) -- and
will be restricted to trusts made by and for UK resident and domiciled
persons. Remember, however, that there are a variety of other types.
The consultation on modernisation
This series of articles is written in the light of (a) the current
modernisation of the income tax and CGT treatment of UK resident
trusts; and (b) the new IHT regime for trusts introduced without
warning on 22 March 2006. 2004/05 saw an increase in the 'rate
applicable to trusts' (RAT) from 34% to 40%, as well as the
introduction of the special regime for vulnerable beneficiaries. In
2005/06 a special standard-rate band was introduced for discretionary
and ac***ulation trusts, the first =A3500 of income (increased to =A31,000
from 2006/07) of such a trust in any tax year not being taxed at more
than 22%. Most recently, in 2006/07 FA 2006 confirms certain
definitions for income tax and CGT, introduces an extended definition
of 'settlor-interested' for CGT purposes and provides a special sub-
fund regime for CGT.
New rules for residence for CGT from 2007/08 have been enacted by FA
2006 adopting the present income tax rule, but without the ability for
certain UK resident trustees to elect in relation to a trust made by
someone resident and domiciled outside the UK that they should be
treated as non-UK resident. (The original proposal for an equivalent
provision having been withdrawn as constituting unauthorised State
Aid.)
There remains one outstanding issue, namely the 'income streaming'
proposal that income distributed to a beneficiary from an ac***ulation
or discretionary trust on or before the 31 December following the end
of the tax year should not attract the RAT, but should be treated as
if (subject to deduction of the dividend ordinary rate or lower or
basic rates) it were the income of the beneficiary. Aligned to this,
also deferred, is the suggestion for gradually phasing out existing
tax pools over a period of time, whether three or more years. No
mention was made of these issues at Budget 2006 and it is unknown
whether they will proceed.
Income tax
Trustees in receipt of income are a taxpayer like any other. This
means that, under self *****sment, the trustees must duly return their
income and pay the correct amount of tax by, generally, the 31 January
following the end of the tax year. It is good practice when making a
trust to notify its existence by sending the non-statutory form 41G
Trusts to one of the three specialist trust districts within HMRC.
This will generate the annual self *****sment SA 900.
On making a payment of income to a beneficiary, the trustees must also
complete a tax voucher (R185) showing the gross income, tax at the
10%, lower or basic rate or the RAT and the net sum to which the
beneficiary is entitled. This voucher will then enable the beneficiary
to complete his own self *****sment.
Settlor-interested trusts
Where the settlor has an 'interest in the settlement', viz the trust
property or any property derived from it could be applied for his
benefit or for the benefit of his spouse, the entire trust income is
treated as that of the settlor (ITTOIA 2005, s 624).
Under a further anti-avoidance rule, in ITTOIA 2005, s 629, a
settlement for the benefit of the settlor's minor children will or may
have the income *****sed on the parent settlor (subject to a de
minimis limit of =A3100 per child per parent per annum for all such
income). Where the settlement was made before 9 March 1999, the rule
applies only to the extent that income is paid out. However, for
settlements made on or after that date and for income from capital
added on or after that date to existing settlements, s 629 applies
whether the income is paid out or is retained by the trustees.
The settlor has a statutory right of indemnity to claim back from the
trustees any tax which he has paid on income which he has not
received. Significantly, FA 2006 provides that the trustees will be
liable to the RAT on the income of a discretionary or ac***ulation
settlor-interested trust. HMRC have said that the settlor will receive
a credit for tax paid by the trustees.
Life interest trusts
Where the beneficiary is entitled to the income as it arises, he has
an interest in possession or life interest. While the trustees may
deduct proper income expenses, the income will otherwise be his. Note
that there may be some trustees' receipts which are capital as a
matter of trust law but income for tax purposes (eg premiums received
under leases granted for less than 50 years, under ITTOIA 2005, s
277); however, such receipts do not become income of the life tenant.
Although the life tenant may not physically receive the income until
after the end of a tax year, it is his income for that tax year and it
is the rates of tax in force for that year which determine both how
much tax the trustees should withhold on account of lower rate or
basic rate tax and the liability of the beneficiary to higher rate tax
if any.
Discretionary or ac***ulation trusts
Here, the same income tax treatment applies where the trust is
discretionary or ac***ulation in character. The first =A31,000 (=A3500 for
2005/06) of income in any tax year cannot attract more than the
standard 22% rate (subject to anti-fragmentation rules for settlements
made by the same settlor). Above this limit, the trustees have to pay
the RAT at such a rate as brings the total tax paid by them to 40% (or
32.5% for dividends). The mechanism for the RAT arises under TA 1988,
s 686: note that there is quite a separate procedure under s 687 which
arises where payments are made by trustees to the beneficiary.
Trustees may receive income falling into different categories:
=B6 Dividend income from UK companies will carry a non-repayable
tax credit of 10%. This is dividend income which in the hands of
discretionary or ac***ulation trustees is subject to tax at the
'dividend trust rate' of 32.5%, of which 10% is met by the tax credit,
leaving a further 22.5% of the gross to be paid by the trustees.
=B6 Interest income received subject to deduction of the lower
rate of 20%. Here out of gross income of =A3100 the trustees receive =A380
and must pay to HMRC a further =A320 to produce a total tax liability of
40%.
=B6 Income received gross, eg rental income. Here the trustees
must pay 40%.
Discretionary payments
A special charging regime operates under TA 1988, s 687 where trustees
make payments of income in exercise of a discretion. By definition s
687 cannot apply to ac***ulations of income, which are generally added
to capital net of the s 686 charge. That said, however, a trust deed
may empower trustees to make payments out of ac***ulated income as if
they were income of the current year. In that case s 687 will apply.
Liability of the beneficiary
The thinking behind s 687 is that, for any payment made to a
discretionary beneficiary, it must be clear that tax of 40% (or 32.5%
when dividend income) has been borne by the trustees and paid over to
HMRC. Except to the extent that that tax relates to the 10% non-
repayable credit on dividends, the beneficiary may then recover all or
part of the tax.
The tax pool
The trustees may not have to pay 40% tax, because their liability can
be covered by tax which they have already paid (known as the tax
pool). At the beginning of each tax year a discretionary settlement
will typically have a tax pool (except for example in the cir***stance
where it was set up since 6 April 1999 and has only ever had dividend
income or where it simply pays out all its income each year). The
change in dividend taxation from 6 April 1999 has made a significant
difference in so far as the notional tax credit on dividends does not
enter the tax pool, although the additional 22.5% making it up to the
dividend trust rate does go into the pool.
Trusts for vulnerable persons
FA 2005 established a special regime, with effect from 2004/05, for
trusts for vulnerable persons. These are defined as either a disabled
person or a minor, at least one of whose parents has died. By election
the normal rate applicable to trusts can be disapplied and the income
and gains of the trust taxed as if they had risen directly to the
beneficiary. Note, however, that an election does not disapply the s
687 mechanism. That is, the trustees must be able to show on making
any payments of income to the beneficiary that that payment is franked
by income which has borne 40% income tax in the hands of the trust.
This is a curious anomaly.
Trust management expenses
An expense may be deducted from trust income if:
=B6 it is under trust law properly chargeable against income, eg
management expenses of a property within a property business; and
=B6 it is actually paid out of income for the year.
HMRC published revised guidance on deductible trust expenses on 2
February 2006. The general rule, applying the 1985 House of Lords'
decision in Carver v Duncan, is that while a deduction against income
may be given for expenses of a revenue nature or which are recurrent,
this will not apply if the expenses are incurred for the benefit of
the whole estate or are otherwise attributable to capital. Only in the
case of certain accountancy and audit charges is ap****tionment allowed
by HMRC. Otherwise, in a way which will represent a dramatic change
from previous common practice, an expense will not be deductible. Most
contentious is the treatment of trustee management fees which HMRC say
are not ap****tionable in any cir***stances except where they clearly
relate wholly to income. A test case is anticipated on this latter
point.
Life interest trusts
Subject to specific deductions in calculating taxable income, eg for
trade or property purposes, trust management expenses are deducted
from the life tenant's net share of income which is then grossed up to
produce the statutory taxable income.
Discretionary or ac***ulation trusts
Trust management expenses may be deducted from the income taxed at the
RAT or the dividend trust rate. However, such expenses cannot be
deducted in calculating the income taxed only at the 10% dividend
rate, the 20% lower rate or the 22% basic rate.
Expenses are deducted in order (which is most useful to the
beneficiary), viz:
=B6 UK dividend or scrip dividends which carry a non-repayable
10% tax credit;
=B6 Foreign dividends;
=B6 20% savings income; and
=B6 22% rate income, eg rents.
Capital gains tax
Actual and deemed disposals
CGT is payable on actual disposals, which include a gift. CGT is
charged also on deemed disposals, eg where one or more beneficiaries
becomes absolutely entitled to the property against the trustees
(except on death of the life tenant treated as owning the property for
IHT purposes).
Computing the gain
The gain has to be calculated. In simple terms the gain is the sale
proceeds less the cost of acquisition (or 31 March 1982 value if
later), with a deduction for professional and other incidental costs
of acquisition and disposal. Indexation allowance was 'frozen' at
April 1998. In the case of a gift, the market value of the date of the
gift is taken. The same 'market value' rule (under TCGA 1992, s 17)
applies where the trustees make a disposal, even by way of sale, to a
'connected person', eg the settlor or anyone related with him.
Various reliefs
Trustees benefit from certain reliefs, some of which depend upon a
claim:
=B6 Main residence relief (TCGA 1992, s 225): in parallel to the
relief given to individuals, trustees making a gain on disposing of a
house which has been used as the only or main residence of a
beneficiary may have the gain wholly or partly relieved.
=B6 Taper relief was introduced in 1998 (TCGA 1992, Sch A1). It
is designed to relieve the impact of CGT according to the length of
time the particular asset has been owned, with very significant favour
being given to business assets.
=B6 Roll-over relief (TCGA 1992, s 152) is a relief given to
trustees who trade, whether by themselves or in partner****p, in
allowing a claim for deferral of a gain realised on the sale of one
qualifying business asset into the acquisition cost of another.
=B6 Enterprise investment scheme (TCGA 1992, Sch 5B para 17)
allows trustees of certain settlements to claim to defer a gain
realised on any asset by making an investment in a qualifying EIS
company. Venture capital relief is not available to trustees.
=B6 Hold-over relief (TCGA 1992, s 165 and s 260). The trustees
may claim to defer CGT which accrues on a gain when they dispose of
certain assets to a UK resident beneficiary, whether under s 165 for
business assets or under s 260 where there is a chargeable transfer
for IHT purposes. The in-built gain is charged to tax when the
beneficiary comes to sell the asset.
Settlor-interested trusts
There is a similar rule for CGT to ITTOIA 2005, s 624 for income tax
discussed above. The CGT rule is found in TCGA 1992, s 77, as extended
by FA 2006. A trust will be settlor-interested not only if (subject to
certain limited exceptions) the settlor or spouse can benefit, but
also where (from 2006/07) the settlor's minor unmarried children not
in a civil partner****p can benefit. Gains of a trust which are settlor-
interested are treated as those of the settlor and not of the
trustees. In certain cir***stances this rule could be advantageous, if
for example the effect is to *****s the settlor to tax at 20% rather
than 40% and to have the benefit of the settlor's annual exemption of
=A38,800 for 2006/07 rather than say the trustees' exemption of =A34,400
(and see below) -- or indeed if the settlor has allowable losses.
Losses
If the trustees realise a loss by making a disposal to a 'connected
person' eg the settlor or a relative or a settlor, they cannot offset
that loss generally against their gains (TCGA 1992, s 18(3)). The loss
must be carried for forward for use only against a gain which arises
from the trustees disposing of another asset to that same connected
person.
Rate of tax
Trustees are *****sed on their gains at 40%.
The annual exemption
The annual exemption, ie within which gains will be tax free, is
=A34,400 for most trusts for 2006/07. This is one half of the
individual's exemption.
The anti-fragmentation rule
An anti-avoidance rule operates in cir***stances where the same
settlor has made more than one 'qualifying settlement' since 6 June
1978. This is to prevent a person making a number of settlements, each
benefiting from the =A34,400 annual exemption (2006/07). If there is
more than one qualifying settlement in a group, the annual exemption
is divided between them, up to a maximum of five. That is, the annual
exemption for a trust can never be less than =A3880 (=A34,400 =F7 5 or
=A38,800 =F7 10).
'Qualifying settlement'
The expression does not include charitable trusts, or trust death
benefits of certain pension policies. The 'certain pension policies'
extends to old style retirement annuity policies, but not to personal
pension schemes. Otherwise, the expression will include almost every
type of settlement, even settlements which do not realise a gain and
indeed settler-interested trusts. This means that there could be a
total of five qualifying settlements, only one of which is making a
gain in the tax year, but it gets the benefit of an annual exemption
of only =A3880, ie in 2006/07 =A33,520 of annual exemption is wasted
forfeiting =A31,408 in tax potentially saved and now payable @[EMAIL PROTECTED]
40%.
The trust and estate tax return
The form for returning chargeable gains is supplementary page SA 905
(to be included within the main trust and estate return SA 900).
The only cir***stances in which SA 905 need not be completed are:
=B6 The assets disposed of say in 2005/06 realise net proceeds
of =A334,000 or less in total (ignoring exempt assets), and
=B6 The total chargeable gains were less than, or equal to the
annual exempt amount.
Form SA 905 is used:
=B6 To claim allowable losses which may be deducted from future
gains; or
=B6 To make other claims or elections which require reference
to, and completion of, other HMRC forms.
(See SDTS Division C4.2)
Simon's Tax Briefing
STB 4 September 2006, 1
A matter of trust Part 2
Taxation Of Trusts
Matthew Hutton
Matthew Hutton describes the taxation of trusts following Finance Act
2006
Matthew Hutton continues his series of articles on trusts by dealing
with their inheritance tax implications.
The first in our three part series (published in the Newsletter of 18
August 2006) considered the income tax and capital gains tax (CGT)
treatment of different types of trust. This article moves on to
inheritance tax (IHT). These articles assume both that the settlor is
domiciled in the UK and that the trustees are resident in the UK for
tax purposes.
Starting a trust
A gift of property to the trustees of a settlement is a transfer of
value by the settlor (measured on the basis of the loss to his estate)
for IHT purposes. The implications of that transfer of value will
depend upon the type of trust concerned.
Chargeable transfers
A lifetime gift to a discretionary trust or, after 21 March 2006, a
life interest trust (other than a disabled person's trust) is an
immediately chargeable transfer. Subject to the =A33,000 annual
exemption, the value of the chargeable transfer will be taxed at nil
%, provided that its value combined with the amount of any other
chargeable transfers made by the settlor in the preceding seven years
does not exceed the nil-rate band threshold for the tax year in
question (=A3285,000 for 2006/07). To the extent that it does exceed
that threshold, IHT is charged at 20%. If the settlor dies within
seven years of the gift, a further 20% (to make a total of 40%) will
be payable. Any IHT should generally be paid by the trustees, to avoid
the need to 'gross up' the value of the gift.
'Potentially exempt transfers' (PET's) before 22 March 2006
By contrast, a gift to the trustees of a qualifying ac***ulation and
maintenance settlement or a life interest settlement was a PET which,
whatever its amount, is taken to be exempt unless the settlor dies
within seven years (in which case it is treated as a chargeable
transfer).
Re****ting
Remember that, with a chargeable transfer (even at the nil-rate),
notice should be given to HMRC Capital Taxes within twelve months
after the end of the month in which the gift was made (subject to a de
minimis provision of no more than =A310,000 chargeable transfers made in
the relevant tax year plus no more than =A340,000 in the preceding ten
years). Because a PET is assumed to be exempt, no notice of a PET need
be given for IHT purposes except in the event that it becomes
chargeable by reason of the transferor's death within seven years.
'Relevant property' trusts
The current regime was introduced for discretionary trusts with the
advent of capital transfer tax in 1975. Because, since 22 March 2006
it applies also to practically every lifetime trust, it is referred to
as the 'relevant property' regime. The rules treat a discretionary
trust as a separate taxpayer for IHT purposes, although one which (in
family terms) is treated as the 'child' of its 'parent' settlor. That
is, the chargeable gifts history of the settlor in the seven years
preceding the date of the settlement is always taken into account in
fixing the tax charge on the settlement. The trust is subjected to two
forms of taxation: on each ten-year anniversary of the making of the
trust and in addition whenever any capital leaves the discretionary
regime (the 'exit charge').
The ten-year anniversary charge
The thinking behind the legislation is to subject a relevant property
trust to IHT as if the property in the settlement had been the subject
of a lifetime gift made every generation. The rate of IHT on death is
40%, whereas the rate on chargeable lifetime gifts (which the donor
survives by more than seven years) is 20%. A generation is assumed to
be 33 1/3 years. HMRC want to collect the money rather more regularly
than three times every 100 years, so the charge on property in the
settlement is collected every ten years at a maximum rate of 6%, which
equates to 20% every 33 1/3 years. However, 6% is a maximum rate and
in most cases the effective rate will be much less than this, given
the effect of the nil-rate band. There is of course no guarantee that
this basis of calculation will not be changed in the future, eg. to
apply the death rates of IHT.
There are two elements in calculating the charge:
=B6 the chargeable amount. This is the value of all 'relevant
property' in the settlement immediately before the ten-year
anniversary. Reliefs for business and agricultural property are
available to reduce the amount chargeable to tax; and
=B6 the rate of tax, which is 30% of the 'effective rate'
applicable to a lifetime charge made by a hypothetical transferor with
a gifts history equal to that of the settlor in the seven years before
he made the settlement (excluding the date of settlement, though see
below for 'related settlements'). The hypothetical transfer is
subjected to the lifetime rate of 20% to find the appropriate tax
rate, having made any adjustments required in the cir***stances as
summarised under 'other matters' below. This rate divided by the
deemed chargeable transfer produces the 'effective rate', which is
multiplied by 30% to discover the actual rate payable on the ten year
anniversary; this is then applied to the chargeable property to find
the tax payable.
The exit charge
This charge arises when property leaves the relevant property regime,
by way of gift. There is no exit charge if the event happens in the
first quarter (three months) following either creation of the
settlement or the last ten-year anniversary. If the trust was
established by Will, there is no exit charge if the event happens
within two years, but at least three months, after the death (IHTA
1984, s 144).
There is a distinction between calculation of the exit charge in (a)
the first ten years of the life of the settlement and (b) the ten year
period following the first or subsequent ten-year anniversaries. The
exit charge in the first ten years is related back to the
cir***stances at the date of settlement (subject to scaling down to
reflect the number of three month periods -- or quarters -- which have
elapsed since then). If there was no positive charge to IHT at outset,
there will generally be no charge on an exit within the first ten
years, whatever the then value of the property. However, in
calculating the rate of tax on an exit within the first ten years in a
case where business or agricultural property went into the settlement,
note that the initial deemed chargeable transfer is the gross and not
the net value. The exit charge following the first ten year
anniversary adopts the rate charged on the last anniversary, again
scaled down by reference to the number of completed quarters which
have elapsed since then.
Other matters affecting the calculation of charge
In order to create equity both for the taxpayer trust and for HMRC,
adjustments are made to the calculation of both charges for:
=B6 related settlements, that is other settlements made by the
settlor on the same day as the discretionary (or other 'relevant
property') settlement commenced;
=B6 property within the trust at any time which is not 'relevant
property' (ie subject to the relevant property regime);
=B6 additions of property to the settlement at any time
thereafter;
=B6 property changing character within the settlement; and
=B6 property moving between settlements.
Ac***ulation and Maintenance (A&M) trusts (created before 22 March
2006)
These are a 'privileged' type of discretionary trust introduced in
1975. While the qualifying conditions (defined in IHTA 1984, s 71) are
satisfied, the privilege consists in a freedom from the exit and ten-
yearly charges imposed on discretionary trusts. The A&M trust is a
type of discretionary trust primarily designed to benefit children or
grandchildren under the age of 25. For CGT and income tax purposes, an
A&M trust is treated exactly like any other discretionary trust (as
was described in article one of this series).
The s 71 conditions
The conditions are strict. They fall into two parts, which are broadly
as follows:
=B6 There is no interest in possession, the income is to be
ac***ulated insofar as not paid out for maintenance, education or
benefit of the beneficiaries and one or more beneficiaries will become
entitled to income or capital at a specified age not exceeding 25.
=B6 Either no more than 25 years have passed since the
settlement was created or, more commonly, all those who are or have
been beneficiaries are or were grandchildren of a common grandparent.
If there is any possibility of either set of conditions being
breached, the settlement will not have A&M status and will therefore
be treated as an ordinary discretionary trust with its exit and ten-
yearly charges.
Ending the A&M regime
An A&M settlement will typically have prospective shares in capital
owned by one of a number of qualifying beneficiaries. As and when each
beneficiary reaches the specified age, or otherwise has a right to
income, the capital underlying that share will fall outside the A&M
regime.
That said, there will typically be in the trust deed power for the
trustees to vary the shares, so that a particular beneficiary may be
deprived of his share before attaining the specified age (in which
case that capital will continue within the A&M regime for the benefit
of the other beneficiaries). Subject to that point, on or before
attaining the specified age, the capital will either become subject to
an interest in possession or will vest outright. On outright vesting
there will be CGT implications to consider. If the assets have grown
in value in the trustees' owner****p there will be a deemed disposal as
described in article one of the series. It may be possible to hold
over the gain either under TCGA 1992, s 260 if capital vests with no
prior right to income or under s 165 if the assets are defined
business assets.
FA 2006 transitional rules
No new A&M trust can be created on or after 22 March 2006. For trusts
already in being at that date, there will be no IHT penalty if capital
is advanced outright on or before the beneficiaries attain age 18 --
or the trusts are changed before 6 April 2008 to provide that. Failing
this, the trust will on 6 April 2008 enter the 'relevant property'
regime, with the effects described above. If, before 6 April 2008, the
trusts are changed (if necessary) to provide that capital vests at 25
(and income at 18), the trust will not enter the 'relevant property'
regime in relation to a presumptive share before the beneficiary
attains age 18 and the relevant property regime will apply up to a
maximum of seven years between those ages (that is, there will be an
exit charge when capital is advanced outright).
Interest in possession (or life interest) trusts
For IHT purposes, someone entitled to an interest in possession
arising (generally) before 22 March 2006 is treated by IHTA 1984, s
49(1) as beneficially entitled to the underlying property in the trust
fund. This means that, so long as the beneficiary is alive and the
interest continues, there is no chargeable event for IHT purposes.
When the beneficiary dies, there will be a chargeable transfer. The
value in the life interest trust is aggregated with the free estate
and the combined total is subjected to IHT at the appropriate rate,
known as the 'estate rate'. The trustees are liable for the IHT in
respect of the trust fund and the executors for IHT on the free
estate.
If the interest comes to an end during the beneficiary's lifetime
(other than by outright advance to him), he will be treated as having
made a transfer of value. This will be either:
=B6 a PET if the capital is advanced to an individual or p*****
on life interest or A&M trusts before 22 March 2005 (and will become
exempt if the life tenant survives for seven years); or
=B6 a chargeable transfer by the life tenant if the capital
becomes subject to discretionary trusts or (after 21 March 2005) on
life interest trusts.
There is a further exemption on the termination of an interest in
possession if the capital reverts to the settlor (or in certain
cir***stances his spouse or widow), whether absolutely or on a further
life interest trust. Any planning op****tunities presented by this are
of course gone for trusts created on or after 22 March 2006. For
trusts in being at that day, the exemption will still apply, so as to
remove the IHT charge on death of the life tenant. However if the
capital does not then vest outright, the trust fund will otherwise
enter the 'relevant property' regime.
FA 2006 transitional rules
A life interest trust made on or after 22 March 2006 triggers the
'relevant property' regime, even if the primary beneficiary is the
settlor or the settlor's spouse. Interests in possession in being at
22 March 2006 continue to fall within IHTA 1984, s 49(1). There will
be a chargeable transfer when that interest comes to an end, whether
during life or on death, unless the capital is appointed to the life
tenant or his spouse absolutely. Any continuing settlement falls
within the 'relevant property' regime. The benefit of this
transitional rule is extended to 'transitional serial
interests' (TSIs): where an interest in being is created before 6
April 2008 which replaces an interest in possession in existence at 22
March 2006, that replacement interest is treated as if it were itself
in existence at 22 March 2006. A life interest ending after 5 April
2008 will also be a TSI if it ends on the death of the life tenant's
spouse who was entitled to a life interest in the same property on 22
March 2006.
Will trusts
An interest in possession trust for a surviving spouse will generally
be spouse exempt as an 'immediate post-death interest' (IPDI). In
broad terms, the four conditions set out in IHTA 1984, s 49A require
the income to be paid to the spouse until death or earlier
termination, typically by capital payment whether to the spouse or to
eg. one of the children (which would be a PET by the spouse).
Similarly, there can be an IPDI for a non-spouse beneficiary. Any
continuing trust would fall within the 'relevant property' regime,
unless it is either a 'disabled person's trust' or a 'bereaved minors
trust'.
Bereaved minors trusts
These are trusts defined by IHTA 1984, s 71A under which, broadly,
under the Will or intestacy, a parent, step-parent or person with
parental responsibility for the minor leaves assets which he or she
inherits at the age of 18. Separately, there is a regime under s 71D
called an 'age 18-to-25 trust' under which income arises at 18 and
capital at 25, when the 'relevant property' regime applies to the
share in the capital at, but not before, the time the minor attains
18.
Anti-avoidance
Gifts with reservation of benefit (GWR)
Unless the settlor is irrevocably excluded from benefit under the
settlement, he will be treated by FA 1986, s 102 (as amended) as
continuing to be beneficially entitled to the trust property. While
both settlor and spouse will usually be irrevocably excluded from
benefit, settlements from which the settlor but not his spouse is
excluded are not caught for IHT purposes (although the anti-avoidance
CGT and income tax rules will apply to such a 'settlor-interested'
trust, as described in article one of this series).
Effects
=B6 If the reservation of benefit continues until death, the
settlor is treated as if the trust property were comprised in his
estate at its then market value.
=B6 If the benefit was released within the seven years before
his death, the settlor is treated as having made a PET at that time at
its then value.
=B6 If the benefit was released more than seven years before the
settlor's death, the notional PET will become exempt, with no IHT
implications.
There is the possibility of double taxation insofar as a gift to
discretionary trustees from which the settlor is not excluded from
benefit will be both the chargeable transfer and a gift with
reservation of benefit. This problem is addressed by the IHT (Double
Charges Relief) Regulations 1987 which generally ensure that there is
no double taxation.
The pre-owned assets regime
These rules, found in FA 2004, Sch 15 applying from 2005/06, affect
trustees indirectly rather than directly. They impose a charge to
income tax on a person who in broad terms and in certain cir***stances
has disposed of land and chattels (or other property with which land
or chattels are purchased) and he now occupies that land or enjoys
possession of those chattels without their forming part of his estate
for IHT purposes. A third charge applies where a person is or would be
subject to income tax on any income arising under a settler-interested
trust to the extent that the trust fund includes 'intangibles' (ie,
property other than land or chattels) following such a disposal or
contribution by him. These rules are aimed at various arrangements
adopted since 18 March 1986 designed to avoid the GWR regime. While
such arrangements typically involve trusts, the pre-owned assets
charge is primarily a problem for the settlor, though of course the
trustees will typically need to be involved in deciding how to respond
to them.
Planning
The third article in this series, to appear in the next issue of TPT,
will consider planning op****tunities, pitfalls and suggestions of
cir***stances in which trusts of one type or another might sensibly be
used in practice.
(See SDTS Divisions I5.2, I5.5)
Simon's Tax Briefing
STB 11 September 2006, 1
A matter of trust Part 3
Taxation Of Trusts
Matthew Hutton
Matthew Hutton concludes his series of articles on trusts by
considering the cir***stances in which trusts of one type or another
might be used tax efficiently.
This is the final article in our three part series. The first part
(published in the Newsletter of 21 August 2006) considered the income
tax and capital gains tax (CGT) treatment of different types of trust.
Part two (published in the Newsletter of 4 September 2006) reviewed
the inheritance tax (IHT) implications of the three main types of
trust. This final part aims to pull the threads together by suggesting
various cir***stances in the office in which trusts might usefully be
used -- and highlights certain pitfalls.
The FA 2006 IHT regime for trusts, described in article two of this
series, constitutes a sea change in the way that trusts are taxed and
therefore in the way that one might regard them in the context of
estate planning. The Government's intention is that for trusts created
on or after 22 March 2006 there will be an IHT cost if capital vests
absolutely at an age greater than 18. This is subject to the
transitional rules for interest in possession trusts in existence at
22 March 2006. Generally, this article looks to the future rather than
the past.
General considerations
The overriding advantage of any gift into trust, especially if the
beneficiaries are minors or are for some reason not considered able to
manage their own finances, is that the capital is protected and that
its management can be put in the hands of the trustees (whether or not
one or more of these is a 'professional'). If the settlor has in mind
the benefit of one of or a few specified children, grandchildren,
nephews or nieces, certainly if they are generally over the age of 18,
he may well plump for a life interest trust, for reasons of income tax
efficiency. The beneficiaries would under such a trust have the right
to income, though the trustees should always have power to advance
capital to them (subject to tax and other implications).
Where the settlor has a wider class of beneficiaries in mind (and
especially if he might wish further beneficiaries to be added in
future), the flexibility offered by a discretionary trust may well
suit his purposes.
The two previous articles have proceeded on a tax by tax basis. This
last article looks at each type of trust in turn, starting with the
life interest trust.
Life interest trusts
Income tax
Where capital of the trust was settled before 9 March 1999, a life
interest trust on the settlor's minor children could be used to
overcome the disadvantage of the parental settlement rules in ITTOIA
2005, s 629. So long as the income belongs absolutely to each child
and is not paid out or applied for his or her benefit, and is retained
by the trustees pending attainment of the age of 18, the income is not
*****sed on the parent for tax purposes and is treated as that of the
child, in other words carrying the benefit of the child's personal
allowance, starting, lower and basic rates of tax. That treatment
continues for such settlements (though not for income from capital
added to them since 9 March 1999). For settlements made since that
date, however, income from such settlements will be taxed on the
parent whether or not it is paid out (given that the income from that
parent for that child exceeds =A3100 per tax year).
Dividend income
The FA 1999 changes to dividend taxation can produce an adverse effect
on discretionary settlements. That is, where there is no brought
forward tax pool and the income of the trust comprises dividend income
all of which is effectively distributed to one or more higher rate
beneficiaries, their effective rate of tax is 46% rather than 40%.
With a life interest settlement, on the other hand, the beneficiaries
are in the same net position as if they had owned the shares
beneficially, ie a maximum rate of 40%.
Estate planning
The settlor may wish to ensure that his assets go to his children even
if his wife remarries following his death. This result could be
achieved though an interest in possession in his Will for his
surviving spouse (now known as an 'IPDI' as defined in IHTA 1984, s
49A) and, following her death, capital for the children. If by
contrast he were to make an outright gift to his wife, there is no
guarantee that she would not leave her property away from the
children.
Inheritance tax: questions of valuation
Where an interest in possession comes to an end during the
beneficiary's life rather than on his death, a special rule applies
which displaces the general 'estate before less estate after'
principle (under which the amount of the transfer of value is the
difference between the value of the taxpayer's estate before the
transfer and again after the transfer -- not necessarily the same as
the value of what is received by the donee). Since 1990 HMRC Capital
Taxes accept that, to measure the transfer of value, the settled
property is valued in isolation. This may bring advantages. However,
the principle is subject to the application of the anti-avoidance
'associated operations' rules in IHTA 1984, s 268.
This is a point which continues to apply to those interests in
possession which continue to be treated under IHTA 1984 s 49(1), that
is, not within the 'relevant property' regime.
Reverter to settlor trusts
Advantage cannot be taken of the IHT exemption for new trusts created
on or after 22 March 2006, as they will enter the 'relevant property'
regime. For existing trusts set up to take advantage of the exemption
in IHTA 1984, s 53(2) note that they will typically have been drafted
to provide a continuing life interest for the settlor, so as to secure
the CGT-free up lift on death under TCGA 1992, s 73. But that will now
forfeit the IHT exemption as the property remains settled. If the IHT
exemption is more im****tant than the CGT-free uplift, (unless of
course the settlor's interest arises before 6 April 2008 as a
transitional serial interest), consider changing the trust to provide
that the capital vests outright following the termination of the
present life interest.
Bare trusts for minor children
While bare trusts have not yet been mentioned in this series of
articles, they carry an im****tant CGT advantage. The anti-avoidance
income tax rule in ITTOIA 2005, s 629 does not apply to CGT.
Regardless therefore of when the bare trust is made for the settlor's
minor unmarried children, the capital is the child's and so any
chargeable gains can take advantage of the child's annual exemption of
=A38,800 for 2006/07 and lower and basic rates of tax -- even though any
income is *****sed on the settlor (subject to the de minimis limit and
the rule which applied before 9 March 1999).
It seems somewhat curious that in extending the definition of 'settlor-
interested trusts' for CGT, FA 2006 did not also conform the CGT
treatment of bare trusts with income tax. Of course, when the child
attains 18 the capital is his and must be paid to him on demand -- and
of course will be treated as his in the event of insolvency,
matrimonial breakdown etc.
Maximising the advantage of the transitional regime
If it is generally advantageous to be treated under the s 49(1)
regime, rather than the 'relevant property' regime (and that may not
be a foregone conclusion), one will generally want to maximise the
advantage of the transitional rules introduced by FA 2006. In
particular, if within a settlement the life tenant enjoying an
interest in possession at 22 March 2006 can be replaced before 6 April
2008 with a younger and fitter life tenant with a greater life
expectancy, this could prove advantageous in postponing the charge to
IHT on death. Only when a person succeeds to a life interest on the
death of her spouse, need this replacement life interest not pre-date
6 April 2008.
Hold-over relief
Under general principles, where capital leaves a trust the trustees
are treated as disposing of and immediately reacquiring the asset at
current market value (TCGA 1992, s 71(1)). If a gain results, it may
be 'held over' either under s 260 in respect of certain types of
transfer or, if it is a defined business asset, s 165. S165 relief
will apply to any type of trust. S 260 relief can apply only to
ac***ulation and maintenance (A&M) trusts if a beneficiary becomes
entitled to capital without a prior right to income. To achieve this
result, it may be necessary for the trustees to change the beneficial
interests in the trust deed. However, from 6 April 2008 all old A&M
trusts will fall within the 'relevant property' regime unless capital
vests at age 18 -- and so will be eligible for s 260 hold-over.
'Relevant property' Settlements
In extending the range of trusts which fall within the 'relevant
property' regime, FA 2006 has considerably extended the number of
settlements which can benefit from s 260 hold-over (as mentioned above
with an A&M trust in being at 22 March 2006 where an interest in
possession arises thereafter and capital subsequent to that, but after
5 April 2008). Generally, one must remember that where s 260 hold-over
is or could be applied, there can be no hold-over under s 165 (TCGA
1992, s 165(3)(d)).
Hold-over relief
This is the respect in which discretionary and other 'relevant
property' trusts come into their own. Assume that the asset in
question is not a defined business asset which attracts hold-over
relief under s 165 (see above). It is possible under s 260 to hold
over a gain which for IHT purposes is a 'chargeable transfer'. This
expression will include a transfer within the nil-rate band.
Accordingly, if a settlor wishes to put into trust non-business
assets, eg quoted stocks and shares, which stand at a gain when
compared to historic base cost, he can do so with a discretionary
trust, so that the trustees broadly speaking step into the settlor's
shoes. The trustees may hold over a gain when they advance capital out
of trust (whether the rate of IHT on exit within the nil-rate band or
alternatively a positive charge to IHT arises, as explained in article
two). These principles assume that the trust is not 'settlor-
interested' (see below).
Bear in mind that, even where an asset is acquired under a hold-over
election, the date of acquisition of that asset by the trustees for
tax purposes cannot predate the actual date. This used to be an
im****tant point where a secondary residence is transferred into trust
under hold-over. Provided that during the trustees' period of
owner****p the property was occupied by one or more beneficiaries
entitled to do so as their only or main residence under the terms of
the settlement, it was, before 10 December 2003, possible to 'wash'
the whole of the historic gain under TCGA 1992, s 225.
However, significant restrictions on hold-over relief were introduced
by FA 2004, with effect from 10 December 2003. First, whether the hold-
over election is under s 165 or under s 260, no election is possible
if the trust is 'settlor-interested'. Further, if a gift effective for
hold-over is made and then within broadly six years thereafter the
settlement becomes settlor-interested, the relief given is clawed
back. Second, for disposals on or after 9 December 2003 it is not
possible to combine the benefits of s 260 hold-over into a
discretionary trust and s 225 relief for the trustees on disposal of a
residence occupied by a beneficiary. If the disposal was already made
by that date, the benefit of accrued s 225 relief is preserved.
Broadly, the choice is between s 260 relief on 'going in' and s 225
relief on 'coming out'.
And of course, following FA 2006, any trust under which during the tax
year the minor unmarried children of the settlor can benefit will be
'settlor-interested'.
Don't add!
In calculating the ten year charge, the settlor's history of
chargeable transfers in the seven years in preceding the making of the
settlement is taken into account when computing the rate (see article
two). If a person adds to a settlement, the effect of IHTA 1984, s 67
is that the seven year ***ulative total prior to the addition is then
substituted in any future calculation of the ten yearly charge, if
that is greater than the seven year ***ulative total on making the
settlement. One should therefore be wary of adding to a settlement
unless quite sure of the implications.
More generally, HMRC Capital Taxes tend to argue that, the definition
of 'settlement' in IHTA 1984, s 43(2) including a 'disposition of
property', any addition of property to a settlement constitutes a
separate settlement.
Will trusts
Everyone (including the readers of this article) should have a Will,
which is regularly reviewed. Where the testator is married or has a
registered civil partner, it will generally be im****tant to secure the
spouse exemption on the first death for immediate post-death interests
(IPDI's) found in IHTA 1984, s 49A as introduced by FA 2006 explained
in Part 2. The Committee Stage amendments have helped considerably,
both in removing the need for large number of Wills executed before 22
March 2006 (where the testator is still alive) to be changed but also
providing greater flexibility in Will structuring for the future. If
following the second death, the capital does not vest outright (or
pass into a 'disabled person's trust' or a 'bereaved minors trust')
the trust fund will then enter the 'relevant property' regime.
A further point to watch with Will trusts is the effect of the
'related settlements' provisions of IHTA 1984, s 62. If on the day
that a discretionary trust is created (and a Will speaks from death)
the settlor makes some other trust, the initial value of that other
trust is always taken into account in completing the rate of the ten
yearly charge. Only if that other trust is a life interest for the
surviving spouse will this rule not apply. However, if that life
interest for the surviving spouse is followed by a discretionary
trust, the discretionary trust is treated as made by the survivor on
her death (under IHTA 1984, s 80) and therefore related to it will be
any trust made by her under her Will. The traditional way to avoid the
related settlement problem is for a lifetime 'pilot' trust to be made
with a normal trust fund and for the Will to add property to that pre-
existing trust.
All types of trust: capital gains tax
The gains of all trusts are now charged at 40%. There are some
planning points that should be watched.
Hold-over relief
If the trustees advance an asset out of trust and elect for hold-over,
whether under s 260 or under s 165, they should be wary. To attract
the relief, the beneficiary must be UK resident. If within six years
after the end of the tax year of the advance the beneficiary becomes
non-UK resident the gain is treated as immediately arising. If the
beneficiary does not pay the tax within twelve months the trustees can
be *****sed. They should therefore protect their position, ideally by
retaining legal owner****p of sufficient of the assets concerned.
The annual exemption
The rules here and the effect of the anti-fragmentation principles
were explained at STB 178 page 4 of article one. These need to be
watched. Bear in mind, however, that a settlement made by a husband
and a settlement made by a wife may each attract its own annual
exemption of up to =A34,400 (for 2006/07), subject to other settlements
made by that spouse. This is worth =A31,760 in tax-free gains each year,
as against a single settlement made by both spouses.
Losses
The connected party rules in TCGA 1992, s 18(3) were explained at STB
178 page 4 of article one. Subject to general anti-avoidance rules the
use of a family trust to 'warehouse' assets might be considered. For
example, current year losses must always be set off against current
year gains, even if the effect is to waste the individual's annual
exemption. If by contrast he were to transfer those loss-making assets
into a family trust, which then itself made the sale, the loss would
be 'warehoused' under s 18(3) until such time in the future as that
individual made a disposal at a gain to the same set of trustees.
Looking ahead
One should bear in mind that advice can be given only on the basis of
the regime as it is. The introduction of the new IHT regime by FA 2006
may not be the last IHT reform introduced by the present Government.
What about, for example:
* (a) a reduction in the rates of relief for agricultural
and business property to 50%;
* (b) either further restriction or complete abolition of
the PET regime;
* (c) reintroduction of the Finance Bill 1989 measures
generally prohibiting IHT efficient post-death rearrangements and
appointments out of discretionary trusts; and
* (d) revision of the IHT calculation on the ten year
anniversary to apply the death rather than the lifetime rates of IHT,
so producing a maximum of 12%, every six years, equivalent to 40% of
every generation of 33 1/3 years?
It is hoped that this series of articles will have cleared away
something of the mystique of settlements and will have illustrated
ways in which they can be used in family tax planning. That said, the
tax tail should never be allowed to wag the more im****tant family dog.
Anyone thinking of doing something purely for tax purposes should be
dissuaded, as it may well be vulnerable to future HMRC attack.
(See SDTS Divisions I5.2, I5.5)
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