Introduction

Under the “old rules” the inheritance tax treatment of trusts was, in concept at least, straightforward – a beneficiary of a trust was treated as the owner of the underlying capital for inheritance tax (IHT) purposes and the trust fund was subject to IHT accordingly. Much the same applied for its predecessor taxes, capital transfer tax and estate duty. Where there was no defined beneficiary of a trust then the trust – usually a discretionary trust – was subject to a special taxation regime and a charge to tax was levied every 10 years. This was necessary because there was no defined beneficiary who was treated, for taxation purposes, as the owner.

All this changed in 2006. The new rules bring all trusts within the ambit of the old discretionary trust charging regime – now the “mainstream trust regime” – but with a plethora of complicated and confusing exemption and transitional provisions. Some of these transitional provisions may last for a generation or more. And because all trusts are now treated as discretionary this has a knock on effect on their capital gains (CGT) treatment.

These changes mean that it is more important than ever to review your Will and any family trusts – delay could be costly.

This note seeks to summarise the main changes and outline the effect of the new provisions.

The Mainstream Trust Regime

This is the old “discretionary trust regime” and provides that every 10 years trusts are subject to IHT at 6% on the excess over the nil rate band (currently £325,000) with proportionate exit charges on property coming out of trust in between 10 yearly anniversaries. The actual details of the charging regime are, of course, much more complicated than this but this note is not the place to cover them.

The 6% rate of tax is 30% of the current lifetime inheritance tax rates of 20% and although may at present seem relatively manageable it is not impossible that this rate might be increased – 50% of the existing lifetime rate would produce a 10 yearly charge of 10%, or 30% of the existing death rate of 40% would produce a 10 yearly charge of 12%.

Any lifetime gifts into a trust will now be an immediately chargeable transfer for IHT, and subject to tax at 20% on the excess over the nil rate band with further tax payable on death within 5 years. Contrast this with the position still relating to gifts to individuals – these are “potentially exempt transfers” and no IHT is payable unless the donor dies within 7 years.

These changes impact on the CGT treatment of trusts. Because new life interest trusts are, in effect, taxed the same way as discretionary trusts it will in most cases be possible to defer gains on a gift into trust, but there will be no uplift in CGT base costs on the death of the life tenant.

These new provisions are all embracing – even a gift into a trust for the benefit of oneself or one’s spouse is caught by the new rules. Trusts were also frequently used in divorce settlements, and even trusts made as a way of securing an equitable divorce settlement and protecting the interests of the children of the marriage are caught by these provisions.

Exemptions

The most important exemptions relate to the trusts that can be created by Will (not by lifetime gift) and the new rules create three new types of Will trust that avoid the mainstream trust regime.

Exemptions – Will Trusts – Immediate Post Death Interest

It is still possible by Will to leave one’s surviving spouse a life interest (with or without flexible powers of appointment) and for that to be eligible for the surviving spouse relief. There will be no 10 yearly charges to tax during the surviving spouse’s lifetime and on their death the trust fund will be subject to IHT as if it had belonged to them. If the surviving spouse’s life interest comes to an end during their lifetime then that may or may not be a potentially exempt transfer by the surviving spouse depending on whether the trust property leaves the trust or remains in trust.

There will, for CGT purposes, be an uplift in base costs on the death of the surviving spouse.

Although these provisions are primarily designed for surviving spouses, they are not restricted to them and it would therefore appear possible to use them for children or grandchildren, so creating a life interest trust that would be outside the mainstream trust regime and the restrictions affecting “bereaved minors trusts” and “18 – to – 25 trusts” (see below).

Exemptions – Will Trusts – Trusts for “Bereaved Minors”

These can only be established by a parent under their Will for their children. IHT will be payable in the usual way on the parent’s death, but no periodic charges will arise provided that when the child is 18 they become absolutely entitled to all the capital and any accumulations of income. There can be no flexibility between children as to the shares of income and capital they receive but the existence of an s.32 Trustee Act power of advancement will not bring it within the mainstream trust regime and does allow the possibility to vary the children’s entitlement through a resettlement by way of advancement, but that would bring the property within the mainstream trust regime for the future.

No charge to CGT arises on the child becoming entitled at 18 as any gain can be held over.

These provisions do not apply to Will trusts established by grandparents (including substitutional trusts for the children of predeceased children) which will find themselves within the mainstream trust regime even if the Will provides that they are to inherit at 18. But this is perhaps a distinction without significant difference in that if, for example, a grandparent leaves property equally to their grandchildren, but without specifying an age contingency, then under the general law grandchildren would anyway only inherit at 18. The difference is that if the grandchildren die before 18 their prospective inheritance passes under their intestacy provisions and not in accordance with the grandparent’s Will. On the plus side, each grandchild would have available their own personal CGT allowance.

Exemptions – Will Trust – Age 18-to-25 Trusts

This is a “bolt on” to the trust for bereaved minors provisions. If instead of inheriting at age 18, a bereaved minor inherits absolutely at 25 then the mainstream trust regime will apply but only for the period between 18 and 25 (if the minor only inherits a life interest at 25 then the mainstream trust regime will apply throughout the period of the trust). As the maximum rate of IHT upon a 10 yearly charge is 6% and so, for a 7 year period, the maximum rate of tax will be 4.2% on the excess over the nil rate band. So, if parents wish their children to inherit at 25, not 18 (commonly done for reasons of prudence), they will be faced with this extra tax charge.

As with a bereaved minor’s trust, no CGT arises on the beneficiary becoming absolutely entitled as any gain can be held over. In fact, the ability to hold over gains upon a beneficiary becoming absolutely entitled is slightly wider for an old style accumulation and maintenance trust.

This option is not open to grandparents (or in substitutional provisions) – so if property is left to grandchildren at 25 then it may be within the mainstream trust regime for up to 25 years, incurring a maximum cumulative inheritance tax charge of 15%.

Exemptions – Disabled Beneficiaries

Life interest trusts made for disabled beneficiaries are still taxed under the old rules – that is, as if the beneficiary owned the underlying capital – and so a lifetime gift to such a trust is still a potentially exempt transfer and such trusts (whether arising by lifetime gift or by Will) are outside the mainstream trust regime.

This new trust regime for disabled beneficiaries operates alongside and in addition to the previous disabled beneficiaries trust regime, which deemed certain trusts that would otherwise have been discretionary trusts for IHT purposes to be taxed as life interest trusts.

Transitional Provisions

Although no new life interest trusts (subject to the above exemptions) or accumulation and maintenance trusts, as understood under the old rules, can be created, there are transitional provisions to cover those life interest and accumulation and maintenance trusts in existence at 22 March 2006.

Life interest trusts extant at 22 March 2006 continue unaffected during the life tenant’s life and there are transitional provisions relating to what happens on the life tenant’s death; accumulation and maintenance trusts cease for tax purposes come 5th April 2008 but there are provisions regarding their reorganisation in the meantime.

Transitional Provisions – Life Interests – Transitional Serial Interest

If a life interest that existed on 22 March 2006 came to an end before 5 April 2008 – whether during lifetime or upon death – and another person (be it their spouse or someone else) takes a life interest then that will be a “transitional serial interest”, outside the mainstream trust regime and taxable under the old rules. So, spouse relief will be available between husband and wife and if, for example, the life tenant surrenders their life interest in favour of (say) the next generation on life interest trusts, that will be a potentially exempt transfer.

CGT uplift on death continues to be available on pre-existing life interest trusts and on transitional serial interests.

Transitional Provisions – Life Interest – Successive Life Interest to Surviving Spouse

If a life interest that existed on 22 March 2006 comes to an end on the life tenant’s death after 6th April 2008 and their surviving spouse takes a life interest then that will also count as a transitional serial interest. Surviving spouse relief will then be available, and the surviving spouse’s life interest will also be outside the mainstream trust regime. Such life interests under which the surviving spouse of an existing life tenant has a successive life interest could therefore be with us for very many years indeed. CGT uplift on death continues to be available for these.

Transitional Provisions – Accumulation and Maintenance Trusts

Those transitional provisions that apply to accumulation and maintenance trusts are far more limited than those applying to life interest trusts.

Come 6th April 2008 all accumulation and maintenance trusts – whether capital vests in children outright at 25 or whether they take a life interest – will be within the mainstream trust regime.

The only complete exception is for accumulation and maintenance trusts where capital vests in children at 18.

In the case of accumulation and maintenance trusts in existence at 22nd March 2006, where capital vests absolutely at the age of 25 or below, then the trust will only be subject to the mainstream trust regime from the beneficiary’s 18th birthday, in much the same way as the age 18-to-25 trusts described earlier. But if a beneficiary takes a life interest at 25 it will be within the mainstream trust regime from 2008.

CGT holdover relief will be available on children becoming absolutely entitled and – post 2008 – because that will be a chargeable event for IHT purposes, there may be instances where gains can be held over under the new regime when they could not under the old regime.

Extension of Gift With Reservation of Benefit Rules to Settlements

It was previously the case that the gift with reservation of benefit rules did not apply to settled property where the life tenant had their interest in it appointed away from them by the trustees – the life tenant had not themselves actually made a gift and so the rules did not apply. This was often used in tax planning involving the family home, especially in Will trusts.

The 2006 legislation, however, extended the gift with reservation of benefit rules to settled property, so, for example, it is no longer possible for trustees to revoke the life tenant’s interest in the family home, but with the life tenant continuing to live there on an “unofficial” basis without the value of the family home being in their estate for IHT purposes.

For further advice contact our team direct or talk to your contact in the firm.

This article is not intended to be a comprehensive review of all developments within the law, or to cover all aspects of the chosen topic. You should take legal advice before applying information contained herein to any specific issue.