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Monthly Tax Review by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP

Matthew Hutton MA, CTA (fellow), AIIT, TEP author and presenter of Monthly Tax Review, highlights possible consequences of the controversial proposed legislative changes to IHT and trusts.NOTE: Matthew Hutton is Chairing ‘Tax Planning With Trusts’, a LexisNexis Tolley Conference in central London on Wednesday 24th May 2006. Among the speakers will be James Kessler QC, Giles Clarke (Author of Offshore Tax Planning) and Nicholas Hughes (Director of Estate Planning and Trusts, Chiltern plc). Subjects will include the modernisation of trusts and the new residence rules, Income Tax and CGT for 2006/07 and beyond, IHT current issues and planning and pitfalls for UK resident trusts. For further information from the LexisNexis website, click here.

Context

Debate continues about the likelihood of any changes to the F(No 2)B regime. For example, will making a life interest trust on oneself (or one’s spouse) really be an immediately chargeable transfer? And is the qualifying age for children (to avoid an immediately chargeable transfer) going to stay at 18 – or might there be the outside chance of an increase to 25? And so on.

Specific causes of concern: (1) avoidance and (2) settlor control

Insofar as one can tell, the new regime proposed by Sch 20 to F(No 2)B 2006 seems to be prompted by HMRC perceptions that trusts continue to be used as a vehicle for IHT avoidance. There is the further point that, through the separation of legal and beneficial interests and typically through the appointment of the settlor as a trustee (even if not a beneficiary), he can continue to control the devolution of the settled property. Interestingly, page 5 of the newly issued IHT Newsletter for April 2006, in commenting on the operational consequences of the Budget changes, says ‘Most transfers into trust are now immediately chargeable to IHT when made … This means that the excepted transfer and termination regulations will have more purpose than previously and we will be reviewing the cash limits in those regulations. A&M trusts may now be subject to ten-year and exit charges.’ No mention of possible changes to Sch 20 during the Parliamentary process!

What is becoming clear from a detailed perusal of Sch 20 is that, if something like the original provisions are enacted, there will be a host of consequences, whether intended or not.

The spouse exemption

This is going to be restricted in future to trusts on intestacy and to Will Trusts which qualify as immediate post-death interests under new s49A of IHTA 1984. Interpreting the six conditions presents some difficulty, especially alongside the new s71A rule for trusts for bereaved minors. And what if, within s49B, the surviving spouse becomes incapable of giving consent? In particular, what happens in the event of failure of the conditions during the lifetime of the life tenant? The suggestion presented by Condition 6 and new s51A is that there is a transfer of value at that point (and to that extent). But this needs to be confirmed by HMRC.

Apart from the spouse exempt trusts under the new regime, a gift to a spouse will have to be absolute (whether inter vivos or on death) if it is to attract the s18 exemption. There is a host of applications, second marriages, trusts following divorce etc, when a view will have to be taken as to what structure to adopt in the light of the regime which finally emerges.

Self-settlements

Subject to any HMRC movement on this, it seems extraordinary that a settlement on oneself for life (not uncommon for a variety of non-tax reasons) will become an immediately chargeable transfer. The point has been put to HMRC that this will, in particular, impact adversely on situations where one of the spouses is a US citizen, in particular to ensure that there is a proper set-off as between US Estate Tax and IHT in the UK, typically so that on the first death the spouse exemption operates in both jurisdictions and any tax due is deferred until the second death (with the appropriate set-off). Where the first spouse to die is a US citizen and the survivor is not, the spouse exemption in the US will not apply unless the property is transferred to a qualifying domestic trust (QDOT). But that will not attract spouse relief in the UK. Such a QDOT is typically made by the surviving spouse in such a way as to attract the US spouse exemption. So either way, subject to any amendment of the rules, there would be a choice between paying UK or US tax on the first death with no set-off for tax payable in the other jurisdiction on the second.

Transitional serial interests (new s49C)

These are very restrictively drafted – and in particular do not give the protection of the current s49 regime either where (eg, under an A&M Trust) an interest in possession had not arisen before 22 March 2006 or where the interest following that in being at Budget Day did not arise until after 5 April 2008.

As to the first point, there could well be A&M Trusts where interests in possession had arisen to some but not all of the siblings before Budget Day. It would seem equitable, where such interests arise before 6 April 2008, to allow those to be transitional serial interests.

More significant perhaps is the 18-year age limit. Is there any scope of this being increased to age 25 (though even that would be too young in the case of particular beneficiaries or specific assets), consistent with the A&M regime introduced by a Labour Government in 1975? For HMRC to say that there was consultation on this, in the different context of income tax and CGT, when the age of 18 was simply ‘imposed’ by HMRC representatives on those attending the consultative committees, is simply mendacious.

Trusts for disabled persons (s89)

The definition of ‘disabled’ for these purposes, as amended under the new regime, remains overly restrictive. What about, for example, those who move in and out of a disabled condition or those suffering from a progressive illness, eg Alzheimer’s?

S71A trusts for bereaved minors

Apart from the restrictive age of 18, the scope of s71A trusts is very limited, not applying for example to gifts under the Will of a grandparent (illustrated by example Q.3 below), nor allowing the prospective shares to be varied under the age of 18.

Other types of trust

How are the new rules to apply in the case of, for example, trusts established by the equitable doctrine of estoppel – or secret or half secret trusts, indeed?

Related settlements

There is a concern that, on the drafting of the F(No 2)B 2006, under a Will structure of a discretionary nil-rate band trust plus a life interest for surviving spouse which satisfies the immediate post-death interest rule, the two settlements will be ‘related’ following an amendment to IHTA 1984 s80. This would have the disastrous effect of bringing into the calculation of the exit and ten-yearly charge in the discretionary trust the initial value of the spouse’s life interest (even if itself spouse exempt on the first death). If this unintended consequence is not rectified, the testator would have to choose between say (a) a nil-rate band trust plus an absolute gift to a spouse and (b) absolute gifts to chargeable beneficiaries taking up the nil-rate band, plus an immediate post-death life interest for the spouse.

Trusts of life policies

Amended explanatory notes published with the Finance Bill on 7 April indicate that all trusts of life policies put in place before Budget Day on 22 March are not affected by the new IHT regime for trusts in the Bill. The guidance note published by HMRC on 7 April goes further and says that ‘In particular, no one who wrote a life insurance policy into trust before Budget Day will have to pay an inheritance tax charge. All of these continue to be exempt from inheritance tax as they were before the Budget.’

However - for existing, pre-22 March life policy trusts - HMRC confirmed there is no blanket special treatment taking them outside the new IHT regime. The Law Society believes that this is a very
important and helpful clarification. It affects everyone owning a life policy in trust, all the insurance companies issuing the policies, and all those advising on the policies and the trusts.

The position on existing, pre 22 March, policy trusts is as follows:

1. The payment of ongoing premiums for life policies owned by trusts will not constitute ‘additions’ to those trusts so as to bring them within the new IHT regime. This is not because there is any provision in the Finance Bill, but because HMRC's view of the general law is that the payment of the premiums is a continuing contractual obligation between the policy holder and the life company in each case. [But is that correct? Surely there would have to be a contractual commitment by the settlor, which is somewhat unlikely?]

2. Any existing life policy trusts that are interest in
possession (or life interest) trusts will continue to have their existing IHT treatment accorded to them until the interest of the life tenant comes to an end. This is the same position as that for all
existing life interest trusts. But in many cases such life policy trusts will still need to be reviewed to take account of the new IHT regime that may apply when the life interest comes to an end.

3. Existing accumulation & maintenance trusts holding life policies are affected and will be within the new IHT regime and will need to be reviewed before the expiry of the 2 year transition period allowed by HMRC.’

Members of the Law Society's Tax Law and Wills & Equity committees met with officials from HMRC and the Treasury on Tuesday to discuss
the new IHT regime changes to the inheritance tax treatment of trusts in the Bill and to highlight the wide implications for many families of the measures.

(Posting on the Trusts Discussion Forum 20.4.06 by Anthony Nixon of Lester Aldridge)

Christopher Jarman added the following:

‘Essentially all the Treasury/HMRC believed they were saying, and apparently intended to say, was that the payment of ongoing premiums
under a regular premium policy, that is in a pre-Budget Day trust, will not result in additions being regarded as made to the trust such as to
trigger the rules for post-Budget Day trusts. They see that as a consequence of the general law, not requiring any special provision in the Finance Bill. But where the trust in question is within the
interest in possession or accumulation & maintenance trust rules, it will be affected to just the same extent as any other trust within those rules, as indeed follows from the Bill as published. There was
no indication of any intent to alter that aspect.’

HMRC view on additions to a settlement

For a settlement protected as a life interest at 22 March 2006 HMRC’s view, consistent with what they have been saying for the last ten years (though apparently at odds with the IHT regime, eg the added property rule in s67), is that each addition constitutes a separate settlement as a disposition of property within s43(2). However, the enhancement of value of property already within the settlement would seem to be protected under the transitional regime. Ingenious minds will be getting to work …

Immediate post death interests: examples

6 scenarios put to me last week by a delegate to my internet lecture for CPD for lawyers are as follows,

Husband (H) dies post 22.3.06 leaving Residuary Estate in trust for Wife (W) for life and subject to that for such of his 3 adult children (X, Y & Z) as survive him in equal shares with proviso that if any of X, Y, & Z predecease H leaving children of their own who attain 18, such children are to take their parent’s share.

Q.1. W, Y, & Z survive H but X predeceases leaving children under 18. It appears the new section 71A will not apply to what would have been X’s share because the trust arises under a grandparent’s Will (S.71A (2) (a)) and so to that extent W does not have an ‘immediate post-death interest’ because condition 4 in s.49A (5) is not met.

Does this mean all H’s Residuary Estate fails to qualify for the spouse exemption or just X’s share?

A.1 All the estate (though note the rules in s50 for part interests).

Q.2 W, X, Y, & Z all survive H but X dies before W and his share passes under his Will to his children at 18. It appears the new section 71A will apply to the provisions in X’s Will but is this sufficient to ensure W still has an ‘immediate post death interest’ in H’s Residuary Estate?

(In effect X’s share will then be held as in Q.1)

A.2 Yes.

Q.3 As in Q.2 but under X’s Will his share passes to his grandchildren at 18

Can it be argued the Trustees of X’s Will are absolutely entitled to X’s share of H’s Residuary Estate for the purposes of s.49A (5) ?

A.3 No.

Q.4 If after H’s death W ceases during her lifetime to have an ‘immediate post death interest’ in H’s Residuary Estate, (a) will the spouse exemption on H’s death be clawed back, &/or (b) will W be treated as making a chargeable transfer of all H’s Residuary Estate or (c) just the part in which she ceases to have an interest (if it ceases in part)?

A.4 (c) I think, given new s51A, though HMRC need to clarify the point.

Q.5 If the Trustees of H’s Will have power to advance capital to W (but no-one else) without W’s consent, does this prevent W having an ‘immediate post death interest’?

A.5 No: see s49B(3)(b).

Q.6 Mention has been made that s.32 Trustee Act could prevent W having an ‘immediate post death interest’ but does not proviso (c) in s.32 ‘save the day’ as W’s consent would be required to the advance?

A.6 An interesting suggestion – though I am hesitant: s32(c) does not require the consent to be ‘prior’, for example.

Advising clients

It may be dangerous to give any other than provisional advice to clients before Royal Assent. In some cases, however, eg Wills for critically ill clients, action has to be taken now. In anticipation of Royal Assent and subject to any changes to the regime:

1. Review all Wills made for clients:

(a) Where there is the traditional structure of nil-rate band discretionary trust followed by residue to surviving spouse for life with power to terminate, take instructions as to (i) whether this should be retained, accepting the consequences of the new regime, or (ii) whether it should be changed to a nil-rate band gift on trust either for a discretionary class or, perhaps more efficiently, for the surviving spouse for life under the traditional structure, with residue going to the survivor outright.

(b) Alternatively write the whole Will under a discretionary trust, relying on a clear letter of wishes and appointments under s144 within two years after the death (but see below).

(c) It could be worth accepting the new regime and paying IHT on the first death if the survivor has his/her own means and/or life assurance arises on the first death to pay inheritance tax and/or the assets concerned are likely to appreciate following the first death and the discretionary regime will prove more beneficial. Bear in mind, however, that the Government could always change the lifetime rate basis of taxation for discretionary trusts to the death rates (more logical in many ways).

In any event ensure that there is power to vary the Will or to make an s144 appointment before probate has been granted.

Meanwhile, watch for any amendments to s144 which (contrary to the apparent impression of HMRC) does not simply operate like a s142 variation! In particular, it needs to be confirmed that s144 appointments in Wills of those who died before Budget Day take effect from the date of death. And the effect of the Sch 20 revisions to s144 have to be clearly understood. And, in any case, not everyone can vary a Will under s142, minors in particular – and a Court, granted always the expense of proceedings, won’t necessarily grant the Order requested.

2. Existing trusts: review with effect from Royal Assent once we know the final shape of the regime. Consider whether advantage can be taken of the transitional rules.

3. For new trusts, bear in mind the new regime for CGT as well as IHT.

4. Warn clients that further changes to the IHT regime may arise in the remaining years of this Government, for example: (a) complete abolition of the PET regime; (b) increases in the rates of IHT charged within the discretionary trust regime; (c) reduction in the rates of APR and BPR; and/or (d) re-introduction of FB 1989 on restricting the scope for post-death re-arrangements.

May 2006

Matthew Hutton MA, CTA (fellow), AIIT, TEP

About Monthly Tax Review (MTR)

MTR is a 90 minute monthly training course, held in London, Ipswich and Norwich – as well as a reference work. Each Issue records the most significant tax developments over a wide range of subjects (see below) during the previous month, containing 30 to 40 items. The aim is not necessarily to take the place of the journals, but rather to provide an easily digestible summary of them and, through the six-monthly Indexes, to build up, over the years, a useful reference work.

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