4 September 2006
Significant changes to the tax treatment of trusts were announced in the 2006 Budget, presumably as the Government was becoming more and more concerned that accumulation and maintenance (A&M) trusts were being used instead of discretionary trusts, with a view to having the same advantages of greater flexibility but without the burden of the 6 per cent levy and having to make inheritance tax (IHT) returns.
The Paymaster General gave an example of a perceived abuse where a trust structure had been used as a tax shelter by several generations of a family. What she failed to mention was that this was attractive because a settlement of a reversionary interest onto new trusts was not a chargeable transfer, the reversion being excluded property. So a beneficiary under an A&M trust who had attained at age 18 but who would not take capital until, say, age 25 could settle the reversion on a discretionary trust without charge. An appointment from that trust on a new A&M trust before a 10-year anniversary need not attract an exit charge.
Was the problem of the perceived abuse the fact that the Inheritance Tax Act treats an asset of real world value as if it were not property at all? The new legislation makes no attempt to deal with the planning opportunities that this state of affairs presents.
The sweeping proposals, in the Finance Bill 2006 as first published, to impose a tax penalty on interest on possession trusts, which contained wide powers for trustees to terminate interests or resettle property, again suggests a concern that there has been a considerable growth in inter vivos and testamentary quasi-discretionary trusts, which fall outside the relevant property regime, and that this is unacceptable tax avoidance. The administration was clearly unaware that these powers are frequently included, in wills in particular, for sound practical reasons that have nothing to do with tax planning.
As a result of the changes that have been enacted, many existing family trusts will need to be reviewed to ascertain whether or not action should be taken and what the tax consequences of the new rules will be. This is the case whether the trust was made by a lifetime transfer into trust or created by the will of someone who has already died. The new legislation allows until 6 April 2008 as a 'transitional period', during which time it will be possible to reorganise some trusts on to a more favourable basis.
How have the tax rules changed?
In future, most new lifetime trusts will be subject to the same IHT regime as has applied to discretionary trusts for a number of years. There is potential for a tax charge when the trust is created, a charge every 10 years of the trust's lifetime and a charge when assets leave the trust.
Special rules will apply to certain types of trust established by will, but after the climbdown by the Government at committee stage the existence of a wide range of trustee powers will not of itself result in the denial of spouse exemption.
For trusts in existence before 22 March 2006 the future tax treatment is complex, not least because the 'old' rules will continue to apply to many existing trusts for some time.
Pre-22 March 2006 A&M trusts
The changes here are very significant. The current IHT treatment for A&M trusts for children or grandchildren will only continue where the terms of the trust are modified before 6 April 2008 to provide that trust assets will pass to a beneficiary absolutely at 18.
The current treatment will also continue, but in an altered form, in relation to those trusts where the terms of the trust are modified to provide that beneficiaries will take capital outright at age 25. It may also be necessary to amend certain other terms of such trusts. If trusts meet these requirements by 6 April 2008 a special regime will apply for the period while a beneficiary is aged between 18 and 25. A maximum tax charge of 4.2 per cent will arise if assets were held in trust until age 25. There will not be any 10-year anniversary charges while property is subject to this 18-25 age regime. As such, property is not relevant property, having regard to paragraph 18, Schedule 20 of the Finance Act 2006.
If existing A&M trusts are not amended they will become subject to the relevant property regime from 6 April 2008 and the 10-year and exit charges will apply in future. Trustees should be made aware that it is possible for the change to occur before then. If the beneficiary acquires an interest in possession at age 18 and that occurs before 6 April 2008, the new regime will apply from the birthday. Where the 10-year anniversary is before 6 April 2008 then a charge will arise, albeit at a low rate of tax, but with the compliance costs of making a return probably being in excess of the tax payable. Practitioners do need to ensure that trustees are aware now of the importance of these crucial birthdays and act accordingly.
Another factor for trustees to bear in mind when considering whether to advance capital where an A&M trust has become a relevant property trust after 6 April 2008 is the compliance cost of doing so before the trust has suffered its first 10-yearly charge. The trust will have been in existence for many years, but not previously have been the subject of charge under Section 64, so in order to find the rate of tax for the exit charge under Section 65 on a capital distribution it is necessary to consider the application of Section 69. Having regard to Section 69(3), this could well mean having to value the whole trust fund at 6 April 2008 with the costs that may entail.
Pre-22 March 2006 possession trusts
Under the old rules the life tenant is treated as the owner of the underlying trust assets for IHT purposes and, on their death, the trust property is included in their estate and subject to tax in the normal way.
These rules will continue to apply to interests in possession (IIP) that existed at 22 March 2006 until the interest comes to an end. They will also apply where the existing IIP is replaced by a new one in the transitional period.
After 5 April 2008, where a pre-Budget IIP terminates during the life-tenant's lifetime and the property remains on trust, the trust will generally be charged to tax at 20 per cent and will become subject to the discretionary trust tax regime. If a pre-Budget interest comes to an end on the life-tenant's death and the property remains on trust, this will be taxed as part of the life-tenant's estate for IHT purposes and the trust will then become subject to the discretionary trust regime, unless it qualifies for the exemption for spouses and civil partners.
How soon can trustees act?
Practioners should advise trustees to initiate their review in the coming months to be sure of meeting the deadline. In two situations an early review is essential to ensure that a tax planning opportunity is not missed. First, A&M trusts, where the interaction between the beneficiaries' dates of birth, the trust provisions and the new rules may produce some unexpected results. Second, IIP trusts, where the income beneficiary is seriously ill or elderly.
Trustees and settlors should also be aware that any addition of capital made now to most types of trust will potentially trigger an immediate charge to IHT.
There has been much criticism of the burdens involved in completion of the form IHT 100. It is overcomplicated in its attempt to deal with a wide variety of situations and is far less convenient in completing relevant property returns than the old form IHT 101.
Given that the changes given in the Finance Act are likely to result in more IHT returns, there is a feeling among practitioners that HM Revenue & Customs should improve the IHT return to reduce compliance costs for trusts. n
Peter Twiddy is the former head of HM Revenue & Customs' inheritance tax division and is a consultant at Bircham Dyson Bell