The UK trust regime was radically changed in 2006 and in its wake, increased tax liabilities followed for many trusts. Despite these changes, trusts continue to be an important tool to a well advised family.

The reasons a person may have for setting up a trust may vary, but trusts can offer tax efficiency, retention of control and protection of family assets. The Perpetuities and Accumulations Act 2009 provides that trusts executed after 6 April 2010 may not exceed 125 years (previously 80 years). Trusts can offer flexibility in relation to inclusion of future classes of beneficiary, for effective bloodline planning.

This article is an overview of the current trust regime, and upcoming amendments to the taxation of trusts. The various IHT reliefs and exemptions which may be available have not been covered in detail here. In this regard, I would refer you to the UK feature article in the August edition of tax.point, ‘UK Inheritance Tax Reliefs’.

Settlor-interested trusts have also been ignored for the purposes of this article.

Discretionary Trusts

Beneficiaries of a discretionary trust are not guaranteed an annual income or capital distribution. A discretionary trust may therefore offer further protection to family assets from issues affecting the beneficiaries, such as divorce or bankruptcy.

Discretionary trusts are subject to the relevant property regime. Thus, there are IHT events when capital is distributed, and also every ten years. This is, known as the principal or periodic charge. With a maximum IHT charge of 6%, trusts can offer valuable protection from the IHT charges of direct ownership on death.

On Gift

A gift to a relevant property trust during a settlor’s life is called a chargeable lifetime transfer (CLT), and is subject to a 20% inheritance tax (IHT) charge, being half the death rate. An individual may have reliefs and a nil rate band (NRB) to utilise, prior to calculating the tax charge.

Business property relief (BPR) is also used in trust planning. However the wider tax issues, such as capital gains tax (CGT) on a future sale of the assets, should not be ignored. The settlor and trustees should have a clear understanding of the tax position, should different transactions occur.

As noted previously, the gift to the trust is a CLT and will remain within the settlor’s estate for a period of seven years. If the gift exceeds the settlors available NRB, IHT will be payable. The IHT charge will be subject to taper relief after three years post gift.

For CGT purposes, gifts to discretionary trusts are deemed to be a disposal at market value by the settlor, as the settlor and trustees are connected persons. Gift relief may be available to defer the gain, providing it meets the conditions for either business assets (s.165 TCGA1992), or holdover relief which is available for assets subject to IHT (section 260 IHTA 1984). As relevant property trusts are subject to IHT calculations, section 260 should be available (some exclusions apply). Consent of the trustees is not required for section 260; unlike other gift relief claims which require a joint election.

The life of a Discretionary Trust

There is a small basic rate income threshold of £1,000, after which discretionary trusts are exposed to the highest rates of income tax. Some relief may be available for trust expenses.

The trustees also report any CGT transactions undertaken by the trust. Trustees normally have a CGT annual exemption of half of the ‘individual rate’, after which the higher CGT rate of 28% is applicable.

A discretionary trust is also subject to IHT every ten years. The standard approach to calculating the periodic charge is to look at the value of the assets immediately prior to the 10 year anniversary, and deduct the NRB that would be available to the settlor at that time, taking in to account the settlor’s CLTs in the 7 years pre-trust creation, and any capital distributions made by the trustees in the last 10 years. Notional tax on the above value is calculated at 20%.

The effective rate must then be calculated on the notional transfer, which is equal to the (net) current value of the trust and the initial value of any related trust, even though the assets in the related trusts are not themselves subject to tax. Finally, the actual rate is the effective rate × 30%. The maximum charge every ten years is thus 6%.

A little over-complicated? The Government thought so. Read further under the heading ‘Simplification’ below.

On distribution

It is recommended that undistributed income is clearly identifiable.

All income tax is recorded in the tax pool. This is a running total of tax liabilities, credits etc. and is important when you come to make income distributions to beneficiaries. The tax pool ensures that the Trustees have paid sufficient tax to HMRC for the beneficiary to be entitled to the tax credit attached to their income distribution. If tax credits on distribution are in excess of the tax pool, then the trustees will have an additional income tax liability. Depending on the beneficiaries own position, a refund of tax may be due to the beneficiary.

If capital is appointed to one or more beneficiaries, there is both IHT and CGT exposure. The same holdover conditions as discussed above can be considered for CGT purposes.

For IHT purposes, an exit charge computation must be prepared to calculate whether IHT is payable. This too has quite a lengthy calculation process, but is being changed under a simplification measure. It is worth also noting that the computation for calculating an exit charge is valued at different tax-points pre and post the first periodic charge.

Planning point

Discretionary trusts provide the opportunity for non-business assets to be passed to beneficiaries without CGT crystallisation. There are wider tax issues to consider in addition to the IHT and CGT position, depending on the asset distributed. Stamp Duty Land Tax, VAT and other taxes all may play their part.

Life Interest Trusts (Interest in Possession)

Under the terms of a life interest trust, the trustees do not have the power to accumulate income and must pay out the income to the qualifying beneficiaries (the life tenants), with the appropriate tax credit. Life interest trusts are taxed at the basic rate of income tax. Higher rate beneficiaries may have additional taxes due, whereas those with no income may be entitled to a refund.

After the life tenant’s death, the capital in the trust will pass to the ‘remainderman’ – the beneficiary entitled to the capital. Trustees therefore have a duty to both generate income and protect the capital of the trust.

It is important with life interest trusts to establish whether they are ‘relevant property trusts’.

On 22 March 2006 the trust regime was overhauled, and many trusts within the meaning of s49(1) IHTA 1984 known as ‘qualifying interest in possession trusts’ disappeared. Currently these types of trust are not subject to the relevant property regime.

Historically, a gift to these types of trust had been a potentially exempt transfer. On the life tenant’s death, the life interest would form part of their estate.

The remainderman receives the capital with a CGT-free uplift in the value of the assets, following the life tenant’s death.

Trusts in existence at 22 March 2006 which fell within s49, may now be within the relevant property regime, due to changes to beneficiaries after 6 October 2008, and so these types of trusts should be reviewed. Those now subject to the relevant property regime should confirm when the first periodic charge calculation is due.

Although, some life interest trusts can still be created under s49, including a disabled persons trust and a life interest set up under a will, most life interest trusts set up post 22 March 2006 are caught by the relevant property regime. This means the capital is subject to anniversary and exit charges as explained above. In turn however, the value of the life interest is excluded from the life tenant’s death estate.

For disposals of assets within the trust, the trustees normally have a CGT annual exemption equal to one half of the ‘individual rate’. CGT is payable at 28%. If more than one trust is in existence, the annual exemption could be divisible, although a minimum 1/10 of the full trustee’s annual exemption, will be available.

CGT could be payable on the appointment of capital to beneficiaries. Whether a capital gain can be held over under s260 will generally depend on whether the relevant property regime applies or not.

Planning Point

The trustees of a life interest trust can take advantage of a beneficiary’s unutilised entrepreneurs’ relief, providing the beneficiary also qualifies in their own right. This type of planning must be executed effectively or may become costly, but can achieve significant value qualifying for entrepreneurs’ relief, under the control of the trustees.

Additionally, carefully structured life interest trusts can be useful to hold family company shares, in order to provide income to family members (life tenants) who may have their own basic rate band available. The cash provided could help to finance a house deposit or university costs for example, whilst avoiding the parent’s higher rates of tax when extracting income to finance these expenses. There are various aspects of anti-avoidance and settlements legislation to consider before implementing such planning.

Accumulation and Maintenance Trusts

An A & M trust is a ‘hybrid’ of both a discretionary trust and a life interest trust, although many of the tax advantages of these structures pre 22 March 2006 have been removed. Many of these trusts are now caught under the relevant property regime.

Simplification

Following the changes in 2006 which brought many trusts within the relevant property regime, all was quiet for a while. Then in 2012 HMRC published a consultation document ‘Inheritance Tax: Simplifying charges on trusts’, followed by a further consultation document in 2013. There were consultation documents released in June 2014, draft legislation released in December 2014 with the Autumn Statement, and further provisions in the Finance Act 2015 and Summer Finance Bill 2015. Some proposals were retained, some dropped, and some revised.

So what are some of the key points which will now be implemented? The Summer Budget provides the most direction.

1. Periodic (10 year) and exit charge computations will change. Legislation was released to enable exclusion of non-relevant property for the purpose of the calculation of the periodic and exit charges. This measure will be in place for charges arising with effect from Royal Assent.
2. Settlements created before 22 March 2006 which gave an interest in possession to the settlor or surviving spouse, or widow (equally applicable to civil partners), will now be brought into the relevant property regime where a spouse succeeds a life interest after Royal Assent.
3. Legislation has also been amended so that provisions which previously prevented a tax charge being levied on appointment out of a trust to a surviving spouse (within three months) which was settled by will, no longer apply. This will mean that where appointment is made within three months after the date of death in favour of the surviving spouse or civil partner, it can be read back to the will and spouse exemption can be attributed. This measure will be effective from 10 December 2014, once Royal Assent is passed.
4. Pilot Trust planning will no longer offer the benefits it once did. This involved setting up a number of different trusts over a period of time, with a notional sum of money. The trusts would typically receive pension or insurance policy proceeds on death, having been written into trust to bypass the settlor’s estate. Due to the way in the trust regime worked, each pilot trust worked in isolation, and had a NRB. Pilot trusts were aimed at keeping each trust value within the NRB exemption, and thus avoiding the higher IHT charges that would be the case if all policy proceeds were settled upon one trust.

The Government will introduce new rules which will mean that ‘same day additions’ in two or more settlements will be considered as part of the periodic and exit charge computations of each relevant property trust. This will include not only same day additions of that trust, but the historic value of assets in other trusts that had also received same day additions. Thus, even if two trusts were set up 20 years apart, if they each receive insurance policy proceeds on the settlor’s death (for example), both trusts will be caught in the periodic and exit charge computations. This applies to both relevant property trusts created on or after 10 December 2014, as well as those created before this date but which receive additions after this date. Transitional measures mean that changes will not apply to wills executed before 10 December 2014, where death occurs before 6 April 2017.

Whilst the above changes are not law yet, they soon will be, so advisers should familiarise themselves with the legislation surrounding the simplification of Trusts, as well as those rules which have been retained from 2006.

Non-UK Domiciled

Whilst the Government has made a concerted effort to limit the tax planning opportunities available to non-UK domiciled individuals in recent Budgets, there remain some key planning opportunities available to them, depending on their circumstances. For those nearing the deemed-UK domicile threshold of 17 of the last 20 years, there may be some key planning opportunities, such as the use of an excluded property trust to shelter offshore assets from UK IHT. There are complicated provisions surrounding tax planning for non-domiciled individuals, and as such, specialist advice should be sought.

Trusts are often thought of as useful tax vehicles, and whilst this is true, they can also offer a flexible structure which can be used for family asset preservation and succession planning.

Sherena Deveney is Head of Private Client Services for EY in Northern Ireland.

Email: sdeveney@uk.ey.com

Website: http://www.ey.com