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In the first part of a series of notes on the inheritance tax (IHT) treatment of trusts after Finance Act 2006, Matthew Hutton MA, CTA (fellow), AIIT, TEP sets the scene and considers the position for interest in possession trusts existing at 22 March 2006.

Setting the Scene

Budget Notice 25 issued on 22 March 2006 sent shockwaves through both the professions and, following press coverage, the informed public at large.  Although, at both Committee Stage and Report Stage of Finance (No 2) Bill 2006, there was some watering down of the original proposals – especially in relation to ‘immediate post-death interests’ (‘IPDIs’) - the essential rigour of the new regime remains.  And everyone advising private clients needs to be aware of the implications.

This Note can be regarded as an introduction only and by no means the last word on the subject, nor indeed can it deal with more than a very few basic eventualities.  It now takes in a number (though by no means all) of HMRC’s generally helpful responses (‘the HMRC Responses’) on 3 November 2006, as revised 12 December 2006 and in effect on 23 March 2007, to the 43 Questions put to them in September by STEP and CIOT.  As a matter of interest, Schedule 20 is the subject of two published new books, the first written by Chris Jarman for Tolley published in October (IHT Trusts Alignment: A Guide to the New Regime) and the second by Emma Chamberlain and Chris Whitehouse published by Sweet & Maxwell in December (Trust Taxation – Planning After the Finance Act 2006), both of which are surely rapidly proving to be, in the traditional publishers’ language, ‘must have’ additions to one’s library.  Further, in order to put some bounds on the scope of this Note, I decided to impose on myself the constraint of 17,500 words.  I have had to be selective in terms of the number of technical points currently being raised on the new regime and confine myself to what I consider to be the most important.

The Regime on and After 22 March 2006

The FA 1975 regime for discretionary trusts as revised in 1982 (called variously the ‘relevant property’ or the ‘mainstream trust’ regime) has become the norm for all lifetime settlements and for some Will trusts, subject to certain exceptions.  It is no longer possible to create a favoured accumulation and maintenance (‘A & M’) trust to avoid the ten-yearly and exit charges.  Any interest in possession trust, other than in favour of a disabled person, is an immediately chargeable transfer, including a trust for the settlor or the settlor’s spouse.  A life interest arising under a Will as an IPDI will generally be treated as hitherto under IHTA 1984, s 49(1) as though the life tenant were entitled to the underlying assets.  This means that the spouse exemption will be available for an IPDI for a surviving spouse.  But a settlement which follows such an IPDI will, even if life interest in form, fall into the relevant property regime, unless it is (a) a disabled person’s interest; (b) a ‘trust for a bereaved minor’ under which the child gets capital under a Will or intestacy at 18; (c) an 18-to-25 trust which is specifically excluded from the definition of ‘relevant property’ and has its own charging regime on exit (see 5.6 and 7.5 below); or (d) a ‘transitional serial interest’ where the IPDI was in existence (as is possible) at 22 March 2006 (see below).

Transitional Rules

(a) Interests in possession

Section 49(1) treatment continues for interests in possession at being at 22 March 2006 and, under s 49(1A), for:

(i)  IPDIs:
(ii) disabled person’s interests (see below);
(iii) interests in possession which before 6 April 2008 replace interests in possession at being at 22 March 2006;
(iv) interests in possession arising on death for a surviving spouse of the beneficiary of the previous interest where that death occurs on or after 6 April 2008; and
(v) replacement interests in possession of Budget Day 2006 interest in possession trusts of life assurance policies in cases corresponding to (iii) and (iv) above.

Cases (iii), (iv) and (v) are called ‘transitional serial interests’ (TSIs) under IHTA 1984, ss 49B and C respectively (see below).    Otherwise, within an existing trust, a new interest arising will (even if life interest or ‘A & M’ in form) fall within the relevant property regime. 

(b)  A & M trusts

For trusts within the A & M regime at 22 March 2006, s 71 protection from the relevant property regime continues until the earlier of 5 April 2008 and the commencement of an interest in possession (or other type of trust outside s 71).   At that date, the trust property will fall into the relevant property regime unless (i) the trusts have been converted (if necessary) to provide that capital vests at age 18 or (ii) the trusts have been changed (if necessary) to provide that capital vests on or before age 25, in which case a presumptive share in capital will not enter the special charging regime under s71E until the beneficiary attains 18 (an ‘age 18-to-25 trust’).

Capital Gains Tax Consequentials

To the extent that property is given to or advanced out of a trust within the ‘relevant property’ regime, hold-over relief will be available under TCGA 1992 s 260, unless with a transfer of property into trust the trust is ‘settlor-interested’.  Section 260 hold-over is available also for exits of property from trusts within (i) or (ii) of 1.2(b) above: see 11.3 below.  Following FA 2006 a settlor-interested trust includes the case where a minor unmarried child of the settlor not in a civil partnership can benefit.  Section 165 hold-over relief for business assets is relevant only in a case where s 260 relief is not available, that is in an increasingly limited set of circumstances.  Generally, see below.

The corollary is that the CGT-free uplift to market value on death of the life tenant is available only where on that death the trust property is treated under s 49(1) and not as ‘relevant property’.

Action Required

The new rules must be taken on board on the making of any settlement on or after 22 March 2006.   In particular, as an immediately chargeable transfer and not capable of falling within the PET regime, any value which exceeds the transferor’s nil-rate band (£285,000 for 2006/07 and £300,000 for 2007/08) will attract an immediate IHT charge at 20%, to increase to 40% if death follows within seven years.

The terms of any interest in possession and A & M trusts in being at 22 March 2006 should be reviewed: 

(a) so far as interest in possession trusts are concerned, to confirm what will happen on the termination of the current interest in possession and in particular whether it might be worth before 6 April 2008 advancing  a subsequent interest in possession or appointing a new interest in possession, in either case as a TSI, to prolong the effect of the s 49(1) regime; and

(b) in relation to A & M trusts, to decide whether:

(i) to bring the trust to an end before 6 April 2008;
(ii) the terms of the trust should be changed before 6 April 2008, either to advance capital at 18 or to create an age 18-to-25 trust; or
(iii) things should be left as they are.

But bear in mind that an interest in possession arising in an A & M trust on or after 22 March 2006 will (subject to (ii) above having been effected beforehand) constitute a new ‘relevant property’ settlement, leaving behind the protected A & M regime.

Pre-Budget Day 2006 Wills where the testator has not yet died are unlikely to be immediately affected.  However, any trusts in such Wills should be reviewed to ensure that IHT efficiency is maintained, especially where it is desired to create either an age 18 or an age 18-to-25 trust within the context of the testator’s wishes.  See below for further details.

Generally, any action taken now on IHT mitigation should reckon on the possibility of further changes to the regime during the remainder of the lifetime of this Government (albeit not proposed at Budget 2007), for example:

(a) a change in the method of calculating the ten-yearly charge for discretionary trusts, for example moving from the lifetime rates to the death rates, so making the ten-yearly charge a maximum of 12%.  This would have an impact on the balance of advantage as between the s 49(1) and the relevant property regimes (see below);
(b) a reduction in the rates of relief for qualifying business property and agricultural property;
(c) a reintroduction of the Finance Bill 1989 proposals effectively removing the IHT efficiency of post-death rearrangements; and
(d) further restriction of the PET regime, whether complete abolition or an extension of the seven year risk period to say ten years.

This Note now proceeds to consider the new regime in further detail.

Trusts Made on or after 22 March 2006

PETs Restricted

IHTA 1984 s 3A (potentially exempt transfers) is amended, so that: 

(a) a gift to another individual (which includes a gift to a life interest trust, given IHTA 1984 s49(1)) or a gift to an A & M trust will be a PET under s 3A(1) only where made before 22 March 2006. 

(b) New s 3A(1) provides that a PET will be a transfer of value made by an individual on or after 22 March 2006 which would otherwise be a chargeable transfer and is:
(i) a gift to another individual (which will not now include a life interest trust except where a TSI);
(ii) a gift to a disabled person’s trust; or
(iii) a gift to a bereaved minors trust on the termination of an IPDI.  The category of gift to a bereaved minors trust is expanded by new s 3A(3B) which envisages that the bereaved minors trust follows an IPDI which comes to an end during the life tenant’s lifetime.

No new A & M trust within the favourable IHTA 1984 s 71 regime can be made on or after 22 March 2006 (FA 2006 Sch 20 para 2).

There are two further categories of PET:

• the lifetime cessation of a reservation of benefit, which has always been treated as a deemed PET under FA 1986 s 102(4), even when (interestingly) made out of a discretionary trust.  That remains the case.  Of course, such a PET cannot be made ‘in favour of’ anyone, but merely has the result that the donor’s estate is ‘on risk’ in the event of his death within seven years; and
  
• under FA 2006, premiums paid on life policies held in either a life interest trust or an A & M trust as at 22 March 2006. 

Accordingly, any lifetime non-charitable settlement, other than in favour of a disabled person’s trust (see below), will be an immediately chargeable transfer.  This means in particular that: 

(a) to the extent that after any available £3,000 annual exemption(s) the transfer of value exceeds the transferor’s available nil-rate band, there will be an immediate charge to IHT at 20%, to increase to 40% on death within seven years.  Of course 100% or 50% relief for agricultural or business property may be available to reduce the chargeable transfer.  But, subject to the restrictive de minimis provisions (the chargeable transfer not to exceed £10,000 and all chargeable transfers, including this one, in the previous ten years not exceeding £40,000), form IHT 100 should be submitted to HMRC Inheritance Tax even if within the nil-rate band.

(b) The system of ten-yearly and exit charges found in Chapter III of IHTA 1984 Part III will apply.

(c) Unless the settlement is settlor-interested (which following FA 2006 includes the case where the minor unmarried children of the settlor not in a civil partnership can benefit), any gain arising on transfer (whether or not of business assets) may be held over under TCGA 1992 s 260. 

Disabled Persons Trusts

FA 2006 expands on the regime hitherto provided in IHTA 1984 s89 ‘Trusts for Disabled Persons’.  A settlement which falls within s 89, necessarily a discretionary trust, is kept out of the ‘relevant property’ regime so long as the conditions remain satisfied.  These are that during the life of a disabled person no interest in possession exists and not less than half of the settled property which is applied during his lifetime is applied for his benefit.  For IHT purposes the trust property is treated as if the disabled person were beneficially entitled to an interest in possession.

(a) The four categories

As from 22 March 2006, there is both a slight expansion of the definition of ‘disabled person’ and, to the deemed interest in possession under s 89, the addition of three further types of trust to constitute what is now called a ‘disabled person’s interest’ (IHTA 1984 s 89B):

(i) an actual interest in possession made for a disabled person on or after 22 March 2006;

(ii) a trust falling within new s 89A ‘Self-settlement by person with condition expected to lead to disability’.  Among the qualifying conditions in s 89A, the settlor must satisfy HMRC that at the date of settlement he had a condition which it was then reasonable to expect would have such an effect as to lead him to become a ‘disabled person’ within the meaning of s 89(4) as amended by new s 89(5) and (6).  However, under s 89A, there must be no interest in possession during the settlor’s lifetime - if any of the settled property is applied during his life for the benefit of the beneficiary it is applied for his benefit; and any power to bring the trust to an end during his lifetime must ensure either that the beneficiary or someone else will become absolutely entitled or a qualifying disabled person’s interest must exist; and

(iii) an actual interest in possession trust made on or after 22 March 2006 by a person on himself with the same reasonable expectation of disability. 

However, somewhat curiously, it is not open for a person to create a disabled person’s interest trust on another who has a reasonable expectation of disability.  Such a trust would qualify as a disabled person’s interest only if at the time of making it the individual was a disabled person as defined: otherwise, the trust would fall within the ‘relevant property’ regime.

Note also that, whichever one of the four categories above is selected, the trust must satisfy the statutory conditions at outset if it is to qualify.  That is, it is no good if at some time after commencement the primary beneficiary first becomes a disabled person or, within (ii) and (iii) above, first acquires the reasonable expectation of disability: the trust will be, and will remain, relevant property.

Example

Katie, severely disabled since birth, is in receipt of a disability living allowance under the care component at the highest rate.  On 1 September 2006 her mother makes an interest in possession settlement for Katie.  That constitutes a ‘disabled person’s interest’ and so the £500,000 transferred into trust is a PET.

(b) Capital Gains Tax

FA 2006 provides that a qualifying life interest for a person who is disabled or a self-settlement on a life interest by a person with a condition expected to lead to disability will attract the CGT-free uplift to market value on death.  However, the anomaly with traditional s 89 trusts continues, that is they are treated for IHT purposes as if the beneficiary were entitled to the underlying capital under s 49(1), though for CGT purposes they are treated as the discretionary settlements they are, that is with no CGT-free uplift on the death of the beneficiary. 

Interests in Possession Existing at 22 March 2006

Overview

There is no change to the treatment under IHTA 1984 s 49(1), treating the interest as if the beneficiary beneficially owned the underlying assets.  What will happen when it comes to an end?  Then, as now, s 52 ‘Charge on termination on interest in possession’ will apply, though as amended by FA 2006 (see below).  There are also amendments to s 51 ‘Disposal of interest in possession’, s 53 ‘Exceptions from charge under section 52’ and s 54 ‘Exceptions from charge on death’.  This Note looks at each of these sections as amended in turn.

Section 51:  Disposal of Interest in Possession

The disposal of an interest in possession is not a transfer of value, but is treated as the coming to an end of the interest, with IHT charged under s 52.  This does not apply to a disposition which is not a transfer of value by virtue of s 11 ‘Dispositions for maintenance of family’. 

Where the interest is one to which the beneficiary became entitled on or after 22 March 2006, that rule will apply (under new s 51(1A)) only if the interest is an IPDI, a disabled person’s interest under s89B(1)(c) or (d), or a TSI.  If the interest is one to which the beneficiary became entitled before 22 March 2006, the rule in s 51 will not ap ply if the property concerned satisfies the conditions for either a bereaved minor’s trust (s 71A) or a bereaved minor age 18-to-25 trust (s 71D): see below for these. 

Section 52:  Charge on Termination of Interest in Possession

The traditional rule is that the beneficiary is treated as if (subject to the s 53 exceptions) he had made a transfer of value.  If he disposes of his life interest for a consideration in money or money’s worth, s 52(2) treats the value of the property as reduced by the amount of the consideration.  Under FA 2006, the s 52 rule applies to an interest arising on or after 22 March 2006 only if the interest is an IPDI, a disabled person’s interest or a TSI.  A similar provision qualifies the rule under s 52(3) where there is a transaction between the trustees and a person who is, or who is connected with, the life tenant or another beneficiary. 

Section 53:  Exceptions from Charge under Section 52

The exceptions are broadly as follows:

(a) excluded property;
(b) life tenant becoming absolutely entitled;
(c) reverter to settlor; and
(d) absolute entitlement of a UK domiciled spouse of the settlor or, if within two years of the settlor’s death, the widow or widower,

(though (c) and (d) above do not apply where the settlor, spouse or widow/widower had acquired a reversionary interest for a consideration in money or money’s worth).

Amendments to s 53 provide that:

(i) tax will not be charged under s 52 if the beneficiary became entitled before 22 March 2006 and the interest comes to an end on or after that day and immediately beforehand the property is subject either to a bereaved minors trust or a bereaved minor age 18-to-25 trust; and

(ii) where a person becomes beneficially entitled to an interest in possession on or after 22 March 2006 and the interest is not a disabled person’s trust, there will be no occasion of charge under s 53(2) only if the beneficiary becomes absolutely entitled.  That is, if he becomes entitled to a succeeding interest in possession in the property, there will be a chargeable transfer by him.

Section 54: Exceptions from Charge on Death

The exception from IHT under s 53(3) (Reverter to settlor during the lifetime of the beneficiary) is replicated under s 54 where the interest reverts on the death of the beneficiary.  There is a similar exclusion from IHT corresponding to s 53(4) where the settlor’s spouse, widow or widower becomes entitled.

The qualification introduced by FA 2006 is that the s 54 exception will apply only if the interest which reverts to the settlor is a disabled person’s interest or a TSI.

New s 54(2B) applies where a person dies with an IPDI within two years after the death of the testator and on that person’s death a UK domiciled widow or widower becomes beneficially entitled.  In such a case the trust assets are not brought into account for IHT purposes on the person’s death.

Summary

Apart from the general exception to the s 52 rule (in particular, the beneficiary becoming absolutely entitled to the settled property and the specified exceptions as restricted by FA 2006, eg in the case of reverter to settlor), there will generally be a chargeable transfer by the beneficiary on termination of the interest in possession.  Specifically, if there is a successive settlement of whatever description, it will enter the relevant property regime unless it is either a disabled person’s trust or a TSI.

NOTE: While I have taken every care in writing this Summary Note to reflect the provisions of FA 2006 Schedule 20 and to analyse those provisions in the Worked Examples, I can accept no responsibility for any loss occasioned to any person acting or refraining from action as a result of the material in this Note.  Specialist advice should be taken as necessary in all cases.

Inheritance Tax 2007/08: Practical Solutions

New Connaught Rooms, London WC2

Wednesday 20th June 2007

Only £350 plus VAT per delegate (with 10% discount for those coming to one of Matthew Hutton’s Estate Planning Conferences in Autumn 2007) 

Inheritance Tax Mitigation continues to be at the forefront of the priorities of many individuals and families. And, especially following the FA 2006 'Alignment of IHT for Trusts', the issues do not get any easier. At least Budget 2007 has given us all some respite from last year’s pace of change.  This full-day Conference has been designed to give an up-to-date and cutting edge analysis of the options open to your clients and the practical steps they should take - or indeed avoid. To this end Matthew Hutton has assembled a first class panel of Speakers. This Conference is designed as a prelude to Matthew’s more general Estate Planning Conferences to be held (this year, only) in the Autumn.

• Business Property Relief - John Tallon QC, Pump Court Tax Chambers

• Trusts - Chris Jarman, Thirteen Old Square

• The Family Home - Nick Hughes, Director of Estate Planning & Trusts, Chiltern plc

• Agricultural Property Relief- Adrian Baird, Chief Taxation Adviser, CLA

• The Use of Insurance Products in IHT Mitigation - Penny Bates, Partner, Menzies & Co

• Wills and Post-Death Arrangements - Matthew Hutton, Chartered Tax Adviser

Matthew Hutton Conferences 2007

On 20 June Matthew has organised an all-day Conference in London on Inheritance Tax Planning 2007/08 at which the Speakers will be John Tallon QC (Pump Court Tax Chambers), Chris Jarman (Thirteen Old Square), Nick Hughes (Director of Estate Planning & Trusts, Chiltern plc), Adrian Baird (Chief Taxation Adviser CLA), Penny Bates (Partner, Menzies & Co) and Matthew himself.

The cost is £350 plus VAT per delegate or, for those coming to one of Matthew’s Estate Planning Conferences in the Autumn, £315 plus VAT per delegate.

Matthew’s six round the country Estate Planning Conferences in September and October 2007 will be held on the following dates and at the following venues:

East - Thursday 6 September: Cambridge Belfry Hotel, Cambourne CB3 6BW           

North - Wednesday 19 September: Tankersley Manor, South Yorkshire S75 3DQ          

Midlands - Tuesday 25 September: Woodland Grange, Leamington Spa CV32 6RN            
West - Thursday 4 October: Hilton Bristol Hotel BS32 4JF                   

South - Wednesday 17 October: Norton Manor Hotel, Sutton Scotney, nr Winchester SO21 3NB

London - Wednesday 31 October: New Connaught Rooms, London WC2               

The subject matter has yet to be finalised, although brochures will be available in June.  The cost is £295 plus VAT per delegate or for those who have attended a previous Matthew Hutton Estate Planning Conference £270 plus VAT per delegate.

Enquiries for all these Conferences should be made to Matthew on mhutton@paston.co.uk.