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Changes to UK Trust Laws
(29/08/2006)
Further to our update last month on the changes to trust law in
the UK, the Finance Bill received Royal Assent on 19 July and is
now the Finance Act. As a result of this, all life assurance
policy trusts established on or after 22 March 2006, with a few
relatively minor exceptions (mainly bare trusts), will be within
the relevant property regime.
The inheritance tax consequences are as follows and are covered
in detail below:
* a chargeable transfer on the amount settled at the lifetime
rate (20%);
* a periodic charge on each tenth anniversary of the trust;
* an exit charge on property leaving the trust.
Please be aware that this is a complex issue so we have used
examples to illustrate the new charging structures. If your
total worldwide estate is worth (or is likely to be worth) over
£285,000, we would recommend you
speak to
a tax consultant or a financial planner
regarding your specific circumstances.
It is also important to realise that all the above consequences
are subject to available nil rate bands and exemptions. Under
the relevant property regime, the trustees effectively inherit
the settlor’s ‘nil rate band’ and it is thus essential
that there is a record of the settlor’s history of chargeable
transfers.
The Initial Chargeable Transfer
Adam (who had not previously made any transfers) gifted £341,000
to the trustees of a relevant property trust on 1 September
2006.
The only exemptions or reliefs available were the annual
exemptions for 2005-06 and 2006-07 totalling £6,000. This is a
chargeable transfer. The tax due is calculated as follows:
Transfer £335,000
Nil rate band 2006-07 £285,000
Taxable £50,000
Tax @20% £10,000
This assumes the trustees pay the tax. If the settlor
(Adam) pays the tax, the loss to his estate (the measure of
an inheritance tax transfer) is the gift plus the tax.
A process, known as 'grossing up’ determines the value
transferred (i.e. the loss to the estate); the amount on which
tax is payable is divided by 0.8 to give the value of the
transfer.
In Adam’s case the transfer is £12,500 + £335,000 = £347,500
(£10,000 / 0.8 = £12,500)
You can check the result by calculating the tax on £347,500 and
then deducting it. The difference should be the same as the
nominal amount of the gift. Thus:
£347,500 - £285,000 = £62,500.
£62,500 @ 20% = £12,500.
£347,500 - £12,500 = £335,000 (which was the nominal amount
transferred)
If Adam dies within seven years of making the gift, the tax is
recalculated using the ‘death rate’ (40%).
Inheritance tax taper relief will be available depending on the
precise circumstances of the transfer.
The Periodic Charge
There is an inheritance tax charge on the trust every ten years.
The charge is levied on the relevant property in the trust on
the day preceding the tenth anniversary and the maximum
rate of tax is 6%. (Grossing up never applies to the
calculation of the periodic charge.)
The rate is 3/10ths of the rate which would be charged if the
trust funds were subject to a hypothetical lifetime
Thus the maximum rate is: 3/10 x 20% = 6%
Consider the position where the settlor had made a chargeable
transfer before establishing a relevant property trust.
The settlor’s total cumulative chargeable transfers in the seven
years prior to establishing the trust must be added to the
relevant property.
Adam’s trust had grown in value to £900,000 by its tenth
anniversary. There had been no distributions to beneficiaries.
The nil rate band at that time was £400,000. The periodic charge
would be:
Relevant property £900,000
Nil rate band £400,000
Taxable £500,000
Tax at 6% £30,000
Tax as a percentage of fund value £30,000/£900,000 x 100 = 3.3%
Brenda established a trust on 1 September 2006 with a gift of
£341,000. She had not used her annual exemptions so the value
transferred was £335,000. Brenda had made a chargeable transfer
of £100,000 in 2003.
Brenda’s trust had grown to £900,000 by its tenth anniversary
and the nil rate band at that date was £400,000.
The periodic charge would be:
Relevant property £900,000
Settlor’s cumulative total £100,000
Assumed chargeable transfer £1,000,000
The relevant property (£900,000) is taxed at a rate based on an
assumed chargeable transfer of £1,000,000 as follows:
Assumed chargeable transfer £1,000,000
Nil rate band
£400,000
Taxable
£600,000
Tax @ 20% £120,000
Effective rate £120,000/£900,000 = 13.33%
Ten year rate is 30% of effective rate 13.33 x 30% = 3.99%
Tax (£900,000 @ 3.99%) £35,910
It is probably fair to say that in recent years most transfers
will have been potentially exempt
transfers (PETs) and therefore will not enter in to the
calculations but the introduction of the relevant property
regime will increase the number of chargeable transfers.
Carl established a trust on 1 September 2006 with a gift of
£341,000. He had no history of chargeable transfers. He had not
used his annual exemptions so the value transferred was
£335,000.
On 1 September 2009 the trustees advanced capital of £150,000 to
a beneficiary. Carl’s trust had grown to £700,000 by its tenth
anniversary and the nil rate band at that date was £400,000. The
periodic charge would be:
Relevant property £700,000
Amounts subject to exit charges £150,000
Assumed chargeable transfer £850,000
Nil rate band
£400,000
Taxable
£450,000
Tax @ 20% £90,000
Effective rate £90,000/£700,000 = 12.86%
Ten year rate is 30% of effective rate 12.86 x 30% = 3.86%
Tax (£700,000 @ 3.86%) £27,020
What happens if the trustees distribute some or all of the trust
fund? Distributions are taken into account (added back) in
determining the effective rate of tax.
Exit Charge
When there is a distribution of part or all of the trust fund,
an exit charge will be imposed.
The calculation is based on 3/10ths of the lifetime rate of
inheritance tax, giving a maximum rate of 6%. The rate
calculations depend on whether the exit charge arises before or
after the first ten-year anniversary.
The value transferred must be ‘grossed up’ if the tax is paid
from the trust fund. Again the settlor’s total cumulative
chargeable transfers in the seven years prior to establishing
the trust must be added to the relevant property.
The tax rate calculated is then reduced by a number of 40ths
(i.e. on a quarterly basis), to take into account the length of
time in quarter years that the property has been in the trust
since establishment, or the last ten-year anniversary.
Carl established a trust on 1 September 2006 with a gift of
£341,000. He had no history of chargeable transfers. He had not
used his annual exemptions so the value transferred was
£335,000.
On 2 September 2009 the trustees advanced capital of £150,000 to
a beneficiary.
Hypothetical chargeable transfer £150,000
Settlor’s cumulative total of chargeable transfers Nil
Total used to determine tax rate £150,000
Nil rate band £325,000
The rate is nil!! There is no tax to pay!!
Assume Carl had made chargeable transfers in 2002 and 2003
totalling £200,000. The calculation now becomes:
Hypothetical chargeable transfer
£150,000
Settlor’s cumulative total of chargeable transfers £200,000
Total used to determine tax rate
£350,000
Nil rate band
£325,000
Taxable
£25,000
Tax at lifetime rate
(20%)
£5,000
Effective rate £5,000/£150,000 x 100 = 3.3%
There are 12 complete quarters between 1 September 2006 and 2
September 2009.
The rate to be used is 12/40 x 3.3% = 0.99%
Therefore the tax due is £150,000 @0.99% = £1,485
There is no doubt that these calculations look daunting. However
it should be fairly clear that where the
settlor has not previously made chargeable transfers and where
the sums gifted are within the nil rate band, the inheritance
tax liabilities on establishment, distributions and ten-year
anniversaries would be a very small percentage of the trust
fund. In many cases there would be no charge.
How does the new regime affect the trusts offered by Candour
Consultancy?
Discounted Gift Trusts
The discounted gift trusts Candour Consultancy recommend are
based on a flexible interest in possession trust and is thus
within the relevant property regime.
The gift element (i.e. the discounted value) is a chargeable
transfer. The gift element needs to be determined at outset
(because of reporting requirements) and the advantage of this is
that the settlor (and his/her professional advisers) will know
precisely the value transferred shortly after inception. The
disadvantage is that there will be more formalities involved in
the establishment of discounted gift trusts generally.
These formalities will centre on the reporting and negotiating
of the value transferred. In order to determine the discount and
hence the value transferred, the settlor will need to be fully
underwritten
and this will include a requirement for a private medical
attendant’s report (PMAR).
Excerpt from HMRC letter to Scottish Life International dated 6
July 2006
“I would agree that in order to determine the gift value at the
outset, full underwriting will need to have taken place.”
The settlor’s retained interest is held by the trustees on bare
trusts and is therefore not subject to the relevant property
regime. The practical implication of this is that payments to
the settlor are not subject to the exit charge.
In theory there will be a periodic charge on every tenth
anniversary. This will be on the value of the relevant property
– the value of the trust fund less the value of the settlor’s
interest at that ten-year anniversary. This was initially
thought to pose significant administration issues. To value the
settlor’s interest (the repayment stream) at a ten-year
anniversary it would be necessary to re-underwrite at that date.
Fortunately HM Revenue & Customs have adopted a pragmatic and
generous approach and will only require underwriting once.
It could be argued that this will be particularly advantageous
to settlors whose health declines significantly between
establishing a Secure Estate Plan and the first ten-year
anniversary. However the overall amounts involved may not be
significant.
Excerpt from HMRC letter to Scottish Life International dated 6
July 2006
“The value required is the open market value of the fund as at
the ten-year anniversary. This will be the fund value at that
time shorn of the income stream (i.e. less the present value of
the income stream).
Scottish Life International’s thinking is that it will not be
necessary to underwrite again at the ten-year anniversary, this
being onerous in terms of cost on the industry and being an
unwelcome intrusion by settlors. That being so the best option
appears to be to add ten years to the settlor’s age at inception
(true or rated) and proceed on that basis.”
Loan Trusts
Where these arrangements are based on a loan (as are the loan
trusts Candour Consultancy recommend) there will be no transfer
of value (and thus no chargeable transfer).
Where there is an initial gift, the excess above available
exemptions (usually the annual exemption) will trigger a
chargeable lifetime transfer.
The value on which the periodic charge will be levied will be
the value of the trust fund (i.e. the bond value net of the
outstanding loan). Repayments of the loan to the settlor do not
trigger exit charges. Loan trusts will continue to offer a
significant degree of flexibility.
In practice it is likely that IHT charges on loan trusts will
only arise where the settlor has made significant lifetime
transfers and used up some or all of the available nil rate
band.
It would be possible to use loan trust arrangements using
underlying ’discretionary’ or ’bare’ trusts.
Probate Trusts
Probate trusts are designed primarily to avoid the costs of
probate and it is therefore essential that the settlor is a
beneficiary. With the probate trusts recommended by Candour
Consultancy, the settlor is entitled to both the income and
capital of the trust fund.
Probate trusts fall within the relevant property regime and
therefore the initial transfer by the settlor is a
chargeable transfer. As the settlor is a beneficiary, the gift
with reservation provisions apply. (There was a ’get out’ from
this double charge under the pre-22 March regime.)
There seems little point in a UK-domiciled individual using a
Probate Trust. Most life assurance and trust providers will
retain a draft Probate Trust for use by non-domiciled
individuals.
Nil Rate Band Trusts
Nil rate band trusts were designed to ensure that the
inheritance tax nil rate band was not ’wasted’ on the death of
the first of a married couple (or civil partnership).
Additionally there were further planning opportunities during
the lifetime of the surviving spouse or civil partner.
A transfer to a nil rate band trust will now be a chargeable
transfer. Additionally the planning opportunities previously
available after the first death have been blocked by changes to
the reservation of benefit rules.
Bare Trusts
The beneficiary/ies of a bare trust has/have the right to take
actual possession of trust property. Bare trustees hold the
capital and income for the absolute benefit of the beneficiary/ies.
A beneficiary has the right, on attaining the age of majority
and being of sound mind, to demand transfer of the trust fund.
Bare Trusts are not settlements and are therefore outside the
scope of the relevant property regime.
The beneficiary is treated as having the trust fund in his/her
estate for inheritance tax purposes.
Trustees are obliged to tell beneficiaries of their status!
The advantage in using a bare trust is the continuance of PET
treatment; the disadvantage is the complete lack of flexibility
and the fact that the beneficiaries can get the trust fund on
attaining the age of majority.
Potentially Exempt Transfers (PET)
The PET regime will continue to apply to transfers not involving
trusts.
Reporting chargeable transfers
Chargeable transfers must be reported to HMRC where the value
transferred is £10,000 or more or where the cumulative value of
transfers over the preceding 10 years (including the transfer in
question) is £40,000 or more.
On 31 July 2006 Alan gifted his daughter Emma a bond valued at
£100,000. This is a potentially exempt transfer and provided
Alan survives seven years (to 1 August 2013) this gift will be
inheritance tax exempt.
The information contained in this newsletter is based upon
Candour Consultancy’s current interpretation of HMRC practice
and tax legislation as at July 2006. Whilst great care has been
taken to ensure that the information is correct, you will
appreciate that Candour Consultancy does not and cannot give tax
advice and cannot accept liability for any loss suffered by any
person as a result of action taken or refrained from on the
basis of the above. Specialist tax and legal advice should be
taken before any investment is made or tax strategy implemented.
The value of tax benefits depends on individual circumstances
and can change. |
