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TaxationWeb by Anthony Nixon

Anthony Nixon, Solicitor, Chartered Tax Adviser, Trust & Estate Practitioner and Partner with Lester Aldridge, considers some practical implications of the proposed new IHT regime for certain trusts.

The ‘attack on trusts’

Gordon Brown’s Budget Note 25 and Schedule 20 of the new Finance Bill have created great alarm and uncertainty.

This article aims to provide a brief practical overview of the consequences if these radical proposals come into effect.

I will consider:

• the implications for existing trusts;

• which wills need to be revised urgently; and

• how wills and trusts can still be used for IHT savings.

At the time of writing the Finance Bill has not become law. So far the government has vehemently defended its proposals. The optimistic still hope that the changes will be withdrawn. But it seems likely that most of the Finance Bill changes will find their way into the Finance Act.

Much detailed planning must wait until the final form of the new legislation is known. At this stage, I expect that:

• all existing trusts will have to be reviewed to minimise future IHT

• many wills will have to be changed to ensure that couples pay IHT only on the second, rather than on the first, death;

• flexible interest in possession trusts will no longer save IHT;

• accumulation and maintenance trusts will no longer provide a complete IHT shelter;

• detailed knowledge of the rules on ten-yearly and exit charges, which apply to ‘relevant property’ (the rules that used to apply just to discretionary trusts) will be essential for good IHT planning.

The major changes

Almost all lifetime gifts to trusts are now chargeable, rather than potentially exempt, transfers. So 20% IHT must now be paid at once on gifts of more than the threshold (£285,000 for 2006-07).

Where trusts are in the relevant property regime, there is 6% IHT on every tenth anniversary of the date the trust came into existence. Usually the 6% charge applies only to the extent the trust assets are worth more than the £285,000 threshold.

There is an “exit charge” when capital leaves trusts which are in the relevant property regime. This applies to any distributions, whether of cash or assets from the trust, as well as when the trust is finally wound up. The exit charge is always less than 6%. The exact rate depends on how long has passed since the last ten year anniversary, the total value of the trust assets and what other capital has been added to or has left the trust.

What to do with existing trusts

Discretionary trusts

There is no change to the IHT treatment of discretionary trusts.

Since interest in possession trusts will now be in the same IHT regime, it may be helpful to create interests in possession from existing discretionary trusts for tax or other reasons.

For example, trustees may want to give beneficiaries the right to some or all of the trust income so that the trust no longer pays 40% income tax.

Where a widow or widower is a beneficiary of a trust set up by their late spouse, the trust will often have remained discretionary, in order to keep the trust assets out of the IHT estate. This may have been combined with awkward loan arrangements. The surviving spouse may prefer to receive the trust income as of right.

Accumulation and maintenance trusts

The change to the IHT rules does not mean that beneficiaries of existing A&M trusts must receive the trust assets on their 18th birthdays. It will be up to the trustees of every A&M trust to consider what the trust’s tax position is likely to be from 2008 and take action accordingly.

The change is of no practical concern for most existing A&M trusts worth less than £312,000 (the 2008-09 IHT threshold) on 6 April 2008. These trusts will usually still pay no ten-yearly or exit charges.

On the other hand, A&M trusts worth more than the threshold will lose their IHT-free status from 6 April 2008. This is not necessarily a total disaster, but is clearly more expensive.

I think it unlikely that many trustees of A&M trusts worth more than £312,000 will want to take advantage of the ‘continuing A&M trust’ (provided for in the new legislation) under which beneficiaries must inherit on their 18th birthdays.

Where the trust is flexible, A&M trustees, like discretionary trustees, may decide to vary a continuing trust. Giving an earlier right to income may simplify the trust’s income tax affairs. On the other hand some trustees may want to arrange to defer the time when young adults become entitled to all the income; under the old rules, this had to happen on a beneficiary’s 25th birthday.

Interest in possession trusts

Assets subject to an interest in possession (IIP) on Budget Day (22 March) remain subject to the old IIP rules. So the beneficiary with the IIP is treated as owning the assets. This, of course, allows the Revenue still to take 40% IHT when the beneficiary dies.

The fact that the trustees have power to alter the trust does not affect the status of existing IIP trusts. For many IIP trusts, no changes will be needed.

If another IIP follows the existing IIP before 6 April 2008, the old rules apply to that IIP as well (this is a ‘transitional serial interest’). Once again, the old rules apply, whether or not the trustees have powers to vary the trust.

It may be better for some IIP trusts not to remain within the old regime, if a change can be made at no or little cost. For example, it may be useful to end an existing IIP over assets up to the value of the IHT threshold, moving those assets from 40% IHT to 6% or less.

What to do with existing wills

Outright gifts

There is no change to the IHT treatment of outright gifts by will. The exemptions and reliefs that applied before Budget Day apply today.

Nil-rate band discretionary trusts

Wills with trusts of the (£285,000 for 2006-07) nil-rate band remain ideal for married couples (and same-sex couples who have registered as civil partners) with combined assets worth more than the IHT threshold. Both spouses can make the maximum use of the tax-free amount and the potential saving is now £114,000.

Indeed the budget changes make these trusts simpler since, after the death of the first spouse, the survivor can receive all the trust income.

Wills creating trusts for the surviving spouse (or civil partner)

Interest in possession (IIP) trusts in the wills of those dying after Budget Day will be within the relevant property regime, rather than the old IIP regime, unless the trust falls within the (very tight) definition of an “immediate post-death interest” (IPDI).

Crucially, gifts to IIP trusts for spouses and civil partners that are not IPDIs are no longer IHT exempt.

IIP trusts were often used to plan for IHT. The trustees would be given power to end a spouse’s IIP, so that they could take assets out of the IHT estate without reservation of benefit problems. This IHT plan no longer works but there is no need to rush to amend these wills. The powers given to the trustees to help plan for IHT will almost always allow a variation within two years after death which is treated, for IHT purposes, as made by the deceased. So, even after the death of the first spouse to die, the trustees can put in place an absolute gift to the widow or widower and obtain the IHT exemption.

But major difficulties may arise with an IIP for a surviving spouse put in place for non-tax reasons. These wills may not give the trustees any power to vary. Tensions between step-parent and step-children may make it difficult to agree a variation after death. These wills must be reviewed now.

Trying to comply with the conditions for an IPDI will create inflexible trusts. Those inflexible trusts may give huge problems in the future.

Future IHT planning (1) - Married couples and civil partners

Wills

Couples with joint assets over the IHT threshold should still put trusts in their wills so that, on the death of the first of them to die, the extra IHT nil rate band is not wasted. As already noted, implementing these trusts should now be easier.

The same arrangement can still be put in place by deed of variation within two years after the death of the first to die.

Even if the couple have both died, a variation within two years after the first death will usually save the IHT

Business/agricultural relief

It is always an advantage for assets enjoying 100% business property relief or agricultural property relief to go to a trust in the will of the first spouse to die, particularly if there is any risk that relief will be lost after the first death. Where 100% relief is available, cash or other unrelieved assets up to the IHT threshold can be given as well.

If business or agricultural relief may be lost after the first death, consider making the gift in the will to one or more pilot trusts set up in the lifetime of the testator. Provided those pilot trusts are set up on separate days, and each is properly constituted with the transfer of an asset to them (my present suggestion is £100 worth of premium bonds to each) then even without business or agricultural relief, the trust assets will be significantly sheltered from ten-yearly and exit IHT charges.

Pension death benefits and life insurance

Substantial pension death benefits, or other insurance on the death of the first spouse to die, should be put into trust if this can be done without triggering lifetime IHT.

After the first death the maximum IHT is 6% every ten years rather than 40% in the estate of the surviving spouse.

As with business and agricultural assets, splitting funds between pilot trusts created on separate days may reduce future IHT, although this will not work in some cases.

Future IHT planning (2)

Lifetime gifts below the threshold

Where individuals can afford it, they should make gifts in their lifetime to trusts with a value below the IHT threshold. These will usually be free of IHT both on the transfer to the trust and on the dates of future ten-yearly and exit charges. After seven years the gift drops out of account and another gift can be made.

For example, a married couple who have not used this year’s or last year’s annual exemptions can give a jointly owned asset worth £582,000 to a trust without any IHT (Nil rate bands £285,000 x 2; two years’ annual exemptions for each £3,000 x 2 x 2). This could be an asset providing an income stream for grandchildren, for school, college or other expenses, on which the grandchildren pay little or no income tax.

Part shares of assets

A parent sharing their home with an adult child or children can make a gift of part of it to those children. There is no problem with reservation of benefit or pre-owned assets tax provided care is taken over payment of expenses. The more adventurous may want to give away more than 50% of the home in this way.

If a valuable home has surplus land or buildings, the surplus part can sometimes be given away without CGT. The donor should pay rent under a personal licence if they continue to use what they have given away.

Deeds of variation

As more individuals live well into their 90s and some reach 100, their family may already have IHT problems when they inherit additional assets.

If a deed of variation within two years of the date of death creates a trust, this is treated for all IHT purposes as made by the deceased. So the original beneficiary can remain the main beneficiary and retain control but with the assets outside their IHT estate. There is no reservation of benefit or pre-owned assets tax. There is no additional IHT to pay on the variation into the trust. 40% IHT will usually be saved on the death of the beneficiary.

Planning for ten-year charges

Trusts that invest in assets such as land and business assets can pay IHT by instalments. The 6% ten-yearly charge can then be spread over ten years and budgeted for on an annual basis.

Anthony Nixon
May 2006