Finance Act Inheritance Tax and Trusts - August 2006
Following recent changes to Trust Legislation, Diana Davidson of Farrer & Co provides an update on the rules:
Executive Summary
This year's Finance Act has introduced far-reaching changes to the inheritance tax (IHT) treatment of trusts.
- Broadly, all trusts created on or after Budget Day (22nd March 2006) will be subject to the discretionary trust IHT rules unless:
- they qualify for one of the exclusions set out below or
- they were created on death and qualify as a bereaved minor's trust (BMT), an 18-25 trust or an immediate post-death interest trust (IPDI). (See below.)
- For Trusts falling within the discretionary trust IHT rules IHT charges are as follows:
- 20% on lifetime transfers of assets into trust over the nil-rate band (£285,000 for 2006/7); and
- a maximum of 6% on each ten year anniversary and when assets are distributed from the trust.
- Amendments made to the original proposals mean that the IHT spouse exemption will continue to be available on death transfers where property passes to a spouse outright or the spouse receives a life interest in trust assets (even where the trustees have power to revoke that interest.)
- Assets left by a parent by Will on trust for a child who will take an outright interest at 18 will not be subject to the dicretionary trust IHT rules. If instead the Will provides for an outright interest to be taken no later than the age of 25 and this is received after the child's 18th birthday there will be an IHT charge when the interest is received at a maximum of 4.2%
- Assets may be left by WIll on immediate life interest trusts to anyone including a child without falling within the discretionary trust IHT rules.
1, Exclusions from discretionary trust IHT rules
Irrespective of the new rules, the following arrangements will remain outside the discretionary trust IHT rules:
- Trusts of assets qualifying for 100% business property relief (e.g. stocks and shares listed on the Alternative Investment Market which have been held for at least two years.);
- Trusts of assets qualifying for 100% agricultural property relief;
- Trusts qualifying as disabled persons' trusts;
- Trusts of conditionally exempt heritage assets (so long as the conditional exemption is not lost);
- Charitable trusts;
- Excluded property (i.e. non-UK property transferred into trust by non-UK domiciliaries who are not deemed to be UK domiciled for IHT purposes) and certain reversionary interests in trusts;
- Bare trusts (i.e. property held by a nominee); and
- Life interest and A&M trusts which fall within the nil-rate band of the settlor(s)
2, Pre-Budget Day Trusts
2.1 Life Interest Trust
A trust where the beneficiary (life tenant) has the right to receive the trust income.
A Life Interest Trust established before Budget Day will continue to be taxed under the previous IHT rules for a transitional period which will continue:
- until the death of the tenant; or
- until the death of a successor life tenant where the successor life interest (of a person who was not the spouse or civil partner of the first life tenant) arises between Budget Day and 5th April 2008 and which follows on from a pre-Budget Day life interest, or
- until the death of a successor life tenant where the successor life interest follows at any time after a pre-Budger Day life interest and belongs to the spouse or civil partner of the original life tenant.
On a lifetime termination of the successor interest, the trust will become subject to the discretionary trust IHT rules resulting in a 20% IHT liability unless the trust terminates at this time.
IHT Rules for Pre-Budget Day Life Interest Trusts
Before Budget Day, a life tenant was broadly treated as the owner of the trust assets for IHT purposes so that:
- no IHT charge arose on a lifetime transfer of assets to a life interest trust, provided the transferor survived for seven years;
- no IHT charge arose when a life tenant received trust assets; and
- there was an IHT charge on the death of the life tenant or on a lifetime termination of the interest if the life tenant died within the following seven years.
Note, therefore, that a pre-Budget Day life interest trust can be wound-up free of IHT by a transfer of assets to the life tenant or, if the life tenant survives seven years, to anyone else.
2.2 Life Interest Trust
A trust for beneficiaries under 25 where:
- the trust terms give one or more of the beneficiaries a right to the income from the trust assets, or the trust assets themselves, no later than 25; and
- until then the trust income is either used for the beneficiaries' maintenance, or is accumulated.
A&M trusts established before Budget Day will continue to be taxed under the previous A&M trust IHT rules until 6 April 2008.
On 6 April 2008, such trusts will become subject to the discretionary trust IHT rules unless, by then, the trust terms provide that each beneficiary will receive an outright interest in his share of the trust assets on or before the age of 25. In such a case there will be an IHT charge when each beneficiary receives his interest (at a maximum rate of 4.2%) unless this occurs no later than the beneficiary's 18th birthday.
IHT Rules for Pre-Budget Day A&M Trusts
The IHT rules were broadly as follows:
- no IHT charge arose on a lifetime transfer of assets to an A&M trust, provided the transferor survived seven years; and
- there was no IHT charge in the course of the A&M trust's existence.
3, Post-Budget Day Trusts
All lifetime trusts established on or after Budget Day will be subject to the discretionary trust IHT rules unless they qualify for one of the exclusions listed above.
Will trusts coming into effect on or after Budget Day, which do not fall within any of those exclusions, will nevertheless escape the discretionary trust IHT rules if they fall within one of the following categories:
Immediate post-death interest trust (IPDI)
This is a trust where a beneficiary is entitled to the trust income immediately following the testator's death. The pre-Budget Day life interest trust IHT rules will apply until the beneficiary's right to income terminates. Note that this type of trust can be established for a child.
Bereaved minor's trust (BMT)
This is broadly a trust created by a parent in his Will for his children (including step-children and children for whom he has parental responsibility) on terms that the children receive the trust assets outright at 18. In addition, while a child is under 18 any income or capital payments made from his share may only be made to that child. The pre-Budget Day A&M trust rules will apply to such trusts.
18-25 Trust
This is similar to a BMT but the trust terms instead provide for the children to receive the trust assets at an age greater than 18 but no later than 25. The pre-Budget Day A&M trust IHT rules will apply to a child's share until he reaches 18. However, there will be an IHT charge at a maximum rate of 4.2% if he receives an outright interest in the trust assets after his 18th birthday.
The Appendix sets out the impact of the legislation on some common forms of Will.
4, Other Points to Note
4.1 Life Policy Trusts
Policy effected in trust before Budget Day
- Where policy premiums are paid on or after Budget Day, the whole value of the policy will still qualify as an asset of a pre-Budget Day trust as regards the application of the new IHT rules.
- The terms of a policy can be varied from Budget Day without impacting on it's status as property of a pre-Budget Day trust, provided that such variation is permitted under the original terms of the policy.
- Where an individual is entitled to a life interest, the trust remains outside the discretionary trust IHT rules if it pre-dated Budget Day or forms part of a chain of life interests in the policy which began with a pre-Budget Day life interest and consists of life interests which terminated on the life tenants' deaths.
Policies effected in trust from Budget Day
These will fall within the discretionary trust IHT rules, subject to the application of any of the exclusions listed.
4.2 Capital Gains Tax
Before Budget Day, hold-over relief mainly applied in relation to trusts to defer the capital gains tax (CGT) liability which would otherwise arise on transfers into and out of discretionary trusts. It will now apply to all trusts within the discretionary trust IHT rules so that CGT and IHT should not be payable simultaneously on transfers into and out of such trusts (except in certain cases where the settlor or his immediate family may benefit from the trust).
However, where as a result of the new IHT rules, a life interest trust now falls within the discretionary trust IHT rules, the death of the life tenant will no longer give rise to an uplift to market value in the purchase cost of trustee assets for CGT purposes. (in that event, though, there will no longer be a charge to IHT on the whole of the trust assets.)
4.3 Revocable Life Interests
The IHT gift with reservation of benefit (GROB) rules provide that, where property is gifted but the donor continues to benefit from the property, it is deemed to remain in the donor's estate for IHT purposes. Before Budget Day, it was generally accepted that if, for example, an individual provided by Will for his spouse to have a life interest in his house and following his death, the trustees terminated the spouses's interest but the spouse continued to live in the property, this would not be a GROB. Consequently, the property would not be part of the spouse's estate for IHT purposes provided he or she survived for seven years from the date of the termination.
From Budget Day this will no longer be the case and the termination of a life interest by trustees will be treated as a gift by the life tenant for the purposes of the GROB rules.
Conclusion
It is advisable for all existing Wills and trusts to be reviewed in the context of the new rules to ascertain the impact of the changes and to consider and action which should be taken in this connection. In addition, those considering establishing a trust or making a Will should take advice as to how the new rules will impact on them.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
Appendix
THE POSSIBLE IMPACT OF THE NEW LAW ON SOME COMMON FORMS OF WILL
Terms of Will |
Post-Budget Day |
|
Married with children 1, Residue to spouse outright. If spouse predeceases testator, to children outright or on trust for children at 18. |
No Change. | |
2, Residue to spouse outright. If spouse predeceases testator, on trust for children at an age greater than 18 but not over 25. |
No change if spouse survives testator. Otherwise, charge on death of testator as before; no IHT charge on distribution to children at 18. If children receive outright interest after 18 there will be an IHT charge at a maximum of 4.2% at that point. |
|
3, As for 2, but if spouse predeceases testator on trust for children at an age greater than 25. |
No change if spouse survives testator. Otherwise, charge on death of testator as before; children's trust taxed under discretionary trust IHT rules, unless children have an immediate right to income on testator's death. |
|
4, Residue on trust for spouse for life. After spouse's death on trust for children at 25. |
No change during spouse's life; charge on death of spouse as before. No IHT charge on distribution to children at 18. If children receive outright interest after 18 there will be an IHT charge at a maximum rate of 4.2% at that point. |
|
No spouse, but children 5, Residue to children outright or on trust for children at 18. |
No Change. | |
| 6, Residue on trust for children at an age greater than 18, but not over 25. | Charge on death as before. No IHT on distribution to children at 18. If children receive outright interest after 18 there will be an IHT charge at a maximum rate of 4.2% unless children have an immediate right to income on testator's death. |
|
7, Residue on trust for children for life. After children's death on trust for grandchildren. |
Charge on death as before. No change during children's lives or on their deaths. Grandchildren's trust taxed under discretionary trust IHT rules. |
|
No spouse, no children 8, Residue trust for grandchildren. |
Tax on death as before. Trust taxed under discretionary trust IHT rules. |
|
| 9, Residue to charity. | No Change. |
Assumptions:-
(A) The testator has not died pre-Budget Day.
(B) The reference to "children"
is to children of the testator (including step-children and children for whom the testator has parental responsibility). The impact of the legislation may differ where other children are beneficiaries of the estate.
(C) The reference to "spouse" includes civil partner.
(D) None of the exclusions from the discretionary trust IHT rules listed above apply.
| Credit: | Diana Davidson of Farrer & Co |
| www.farrer.co.uk |
