Inheritance Tax

Far-Reaching Changing to trust taxation

Everyone with an existing trust or who is contemplating setting up a new trust, whether in their lifetime or in their Will, should seek advice in the light of these changes.

There are fundamental changes to the inheritance tax (IHT) treatment of two types of widely used trusts, namely:

Accumulation and maintenance trusts (A&M trusts), set up for children and grandchildren under the age of 25; and

Life interest or “interest in possession” trusts, under which one or more beneficiaries – the life tenant(s) – is (or are) entitled as of right to receive the income.

Before Budget Day 2006, it was possible to add cash and property to new and existing A&M trusts and life interest trusts without an immediate IHT charge, provided the donor survived for seven years from the date of the gift.

Thereafter, in relation to life interest trusts, there was no IHT charge until the death of the life tenant(s).

Subject to the narrow exceptions, A&M trusts and interest in possession trusts, whether established during the settlor’s lifetime or by Will, now come under the existing regime for discretionary trusts. This means:

From 22 March 2006 there is an up-front inheritance tax charge on the value of assets settled in new A&M trusts and life interest trusts, and on adding assets to existing such trusts. The rate of IHT will be 20 per cent on the excess of the donor's available IHT "nil rate band", with a further charge of up to 20 per cent payable if the donor dies within seven years of the gift.

There will be IHT charges on every tenth anniversary of the creation of such trusts, payable at up to 6 per cent of the value of the trust assets, and also “exit” charges of up to 6 per cent on the value of capital distributions to beneficiaries.

New trusts that are excluded from the new tax regime

These are:

• Trusts created on death by a parent for their minor child, who will be fully entitled to the assets at 18. In the legislation these are called “trusts for bereaved minors”.
• So-called “immediate post-death interests” or IPDIs, that is life interest trusts arising on death for the benefit of a life tenant whose interest cannot be altered or overridden except by or with the consent of the life tenant him/herself, or by distribution of capital to the life tenant. There are also strict requirements about the terms of any gifts taking effect after the surviving spouse's death. A Will leaving a life interest to a surviving spouse will only get the IHT spouse exemption if it falls within the above description of an IPDI.
• Life interests which were already in existence on 22 March 2006: if the life tenant dies before 6 April 2008 there is provision for successor life tenants who become entitled to so-called “transitional serial interests”.
• Trusts created for disabled individuals (defined narrowly in the legislation) either during lifetime or on death.

The only existing A&M trusts that will not become subject to the discretionary trust regime from 6 April 2008 are those under which the children are entitled to the trust assets outright at 18.

In order to stay outside the new tax regime, it will be permissible to exercise trust powers of appointment during the transitional period, that is before 6 April 2008, to provide for such outright entitlement. Where, however, under the terms of the trust a beneficiary becomes entitled to an income interest after 22 March 2006 but before 6 April 2008, it may be necessary to act before the child attains his/her income entitlement. This is because an appointment thereafter could trigger an exit charge at 6 per cent of the value appointed.

Existing life interest trusts will run on under the pre-Budget inheritance tax regime until the current life tenant’s interest ends. Thereafter, however, if the property remains in trust the IHT discretionary trust regime will apply.

Prior to publication of the Bill there was widespread concern that life policies written in trust would be caught by the new rules. There was, therefore some relief that the explanatory notes accompanying the Bill indicated that they would be outside the scope of the changes. In reality, however, the position is still not straightforward since there is no express provision in the Bill itself dealing with life policy trusts and it will still be necessary to look separately at each life policy trust to check whether or not it is affected.

Transfers into trusts that come within the new rules will be eligible for a capital gains tax (CGT) holdover election.

If an individual becomes entitled to a life interest on or after Budget Day, the capital gains tax-free uplift on death of that life tenant that used to apply will no longer be available, unless the trust is excepted from the new regime as an immediate post-death interest (IPDI), a serial transitional interest or a trust for a bereaved minor.

For new trusts, if on the death of the life tenant the trust comes to an end, then there will be an IHT exit charge and any gain liable to CGT should be eligible to be held over. If the trust is ongoing following the life tenant’s death, then there should be no exit charge and no CGT, but no CGT uplift either.

Until it is known whether the Government will agree to ameliorate the changes, the following points are relevant:

• Everyone with an existing trust will need to review it before the transitional period ends on 6 April 2008 (and earlier if it is an accumulation and maintenance trust under which a beneficiary attains a life interest before 6 April 2008).
• Existing Wills which incorporate trusts will need to be reviewed.
• Anyone setting up a new trust needs to take account of the changes.
• From an inheritance tax perspective, one possibility is for new Wills to be made in a fully discretionary form. Following death, the executors can make the best arrangements for the longer term, in the light of the legislation as it then stands.
• Existing life policy trust arrangements still need to be checked and great care is required in setting up any new trust arrangements for life assurance based products.
• Entering a post-death variation of a Will, particularly where the aim is to establish a trust, should be deferred if possible until the IHT implications are clear.
• Trusts set up by non-UK domiciled settlors appear not to be directly affected by the changes – to the extent that they do not directly own assets located in the UK.
• Trusts owning business and agricultural property qualifying for 100 per cent IHT relief will largely avoid the worst implications of the changes.

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