Memorandum submitted by the Law Society
CHANGES ANNOUNCED TO THE INHERITANCE TAX
TREATMENT OF INTEREST IN POSSESSION AND ACCUMULATION AND MAINTENANCE
TRUSTS (BUDGET NOTE BN25)
BN25 headed "aligning the inheritance
tax treatment for trusts" contains some entirely unexpected
changes in the way the inheritance tax regime applies to trusts.
The Chancellor has introduced measures that,
will give rise to a number of issues, including:
— taxpayers with assets in excess of
the Nil Rate Band will have to review their wills and in many
cases change them to probably a less flexible structure. They
may not be capable of doing so—the elderly and those covered
by the Mental Health Act, who may not have the requisite mental
capacity to change their wills, may be prejudiced;
— all divorced wives and children with
existing court orders establishing trusts in their favour will
need to take advice, which in many cases is likely to involve
the need to make expensive court applications to rectify the traditional,
legal planning;
— all who have recovered damages (eg
personal injury, criminal injuries compensation) that have been
placed in trust may also be affected;
— additional hurdles for those wishing
to protect their children against the risk that a surviving spouse
(especially in second marriages) will defeat their interests;
— parents will have to leave assets
to their children at an age which may be in individual circumstances
inappropriate because of the maturity of the beneficiary, (for
example, settlements for children who have difficulties coping
with the world at large and their financial affairs but whose
parents would baulk at the thought of having to claim that the
child was disabled within the section 89 IHTA and Mental Health
Act definitions); and
— anyone proposing to leave assets
on modern protective (essentially anti-bankruptcy) trusts[34]
will either have to put the family's entire wealth at risk of
creditor claims or to leave a surviving spouse destitute to protect
the children. This will particularly impact on Lloyd's members
and the self-employed.
There is the additional issue that it is not
clear for inheritance tax purposes which trusts fall within the
definition of settlement and whether IHT extends to commercial
trusts. The intended changes have a potentially far reaching effect
as a result.
MISCELLANEOUS OBSERVATIONS
(A SUMMARY
OF THE
PRE-22/03 POSITION
IS SET
OUT AT
THE END
OF THE
PAPER)
1. BN25 does not indicate what mischief
it is aimed at addressing, yet the manner of its introduction
would suggest it is seen as an anti-avoidance measure: there is
a reference on page 118 of HC 968 issued by the Treasury with
the Budget papers (at para 5.102) which refers to "preventing
these trusts from being used to shelter wealth from inheritance
tax". As discussed below, trusts of any substance are
of dubious tax advantage and generally neutral; furthermore, they
have some fundamental and unobjectionable non-tax objectives which
will now become prohibitively expensive. In our view, there is
no tax-avoidance special status of trusts.
2. Trust structures either made in lifetime
or on death are typically used for a variety of non-tax reasons
and are largely tax neutral. Some of the reasons are:
— concentration of assets for management
reasons;
— the protection of family assets from
the impact of a divorce in future generations. Any abuses of this
are already easily tackled by the divorce courts;
— the laudable and responsible objective
of protection of vulnerable beneficiaries, who under the historic
regime have been the deemed owners for tax purposes and therefore
subject to inheritance tax, but have been insulated from spendthrift
behaviour and protected from creditor claims which might make
them a burden on the State; and
— the protection of first families
where there has been a second or subsequent marriage—again
this typically has no greater tax benefits than handing over the
assets outright, but in a country which has in most cases no automatic
succession rights for children, this means they can still inherit
family money, while at the same time the surviving spouse is looked
after.
3. A common use of accumulation and maintenance
trusts is as school fees planning vehicles: an earlier generation
sets aside funds for the maintenance of children/grandchildren,
who pay their own fees through the trust, to the advantage of
the Treasury in two ways. First there is the risk (as with an
outright gift—which you would not make to a minor) of the
donor not surviving seven years, which yields an inheritance tax
charge. Second, the trustees, parents or children pay income tax
and capital gains tax at normal rates on income and gains, though
note that trusts have a reduced gains tax allowance (which makes
trusts marginally less attractive in pure tax terms than outright
ownership.
4. The original rationale for the discretionary
charge regime was to ensure that there was no loss of revenue
in a trust where the assets would never otherwise be deemed to
be part of a taxpayer's estate. The idea has traditionally been
explained to be that the charge on the way in and the periodic
6% charges on exits of assets or at least on 10-year anniversaries
was designed to ensure the equivalent of a once a generation (approximately
every 30 years) full charge to inheritance tax at 40% (which you
have the same chance of getting in a life interest trust as with
outright ownership). In the case of life interest trusts or of
most A & M trusts (which mostly metamorphose into life interest
trusts), either (a) the potentially exempt charge regime applies
and the Treasury sees tax on a donor or beneficiary not surviving
seven years or (b) the donor or beneficiary survives legitimately
and the Treasury has the same chance of seeing tax in relation
to the recipient's estate as it did in relation to the donor or
(c) the Treasury sees the tax on the life tenant's death because
he hasn't tried to avail himself of the potentially exempt charge
regime in favour of the next rank of beneficiary.
5. Significant problems are likely to arise
with reducing the age at which beneficiaries must acquire assets
to 18. Most agree that an 18-year old is still young and lacking
experience, while a 21-year old has at least some experience.
By 25, children have had the opportunity to join the job market
and establish themselves and prove their ability to manage money.
6. The reasons why testators or settlors
choose a vesting age over 18 include:
— to allow the child time to make a
will, to avoid the inheritance passing under the intestacy rules
back to an absent, estranged, unknown, unsuitable, incapable,
imprisoned, improvident or immensely rich surviving parent or
on to an absent, estranged, unknown, unsuitable, incapable, imprisoned,
improvident or immensely rich sibling, or an aged, absent, estranged,
unknown, unsuitable, incapable, imprisoned, improvident or immensely
rich grandparent;
— so that the first child to reach
18 cannot insist on the house being sold to get their share, resulting
in younger siblings being made homeless;
— to ensure that a surviving parent
remains responsible for maintenance until the child leaves fulltime
education;
— to ensure that a child has sufficient
maturity to resist pressure to hand money over to an improvident
parent, sibling or spouse; and
— to allow the trustees the flexibility
to put younger children through university, in addition to their
share of the estate rather than out of their share, so that younger
children are not prejudiced by the fact their parents have died
before they graduated.
7. These changes made by BN25 run contrary
to the Revenue's avowed intent (expressed in the consultation
process which has led to the reform of the tax treatment of trusts
for capital gains and income tax purposes) to create "a tax
system for trusts that does not provide artificial incentives
to set up a trust but, equally, avoids artificial obstacles to
using trusts where they would bring significant non-tax benefits".
8. Until enactment of the Finance Bill (whose
publication date is not known), it is not clear what steps should
be taken by taxpayers in relation to their wills, done under the
old, tried and tested system: a taxpayer who dies in the limbo
period may find there is no spouse exemption available for his
surviving spouse and a cut in the children's inheritance. Civil
partners, new to this regime, will also be hit.
SUMMARY OF
HISTORICAL POSITION
The following is a brief summary of the existing
(pre-22 March 2006) treatment of trusts.
LIFE INTEREST
At present, where the terms of a trust provide
that an individual is entitled to the income of the trust property
(an "interest in possession trust") the inheritance
tax treatment of that individual (the "Life Tenant")
is as follows:
— the Life Tenant is treated as the
owner of the underlying trust assets for inheritance tax purposes;
— if the Life Tenant dies the trust
property will be included in his estate (and taxed accordingly);
and
— if his interest is terminated during
his lifetime, he will be treated as making a gift of the trust
property; if the property passes outright to another individual
or continues to be held on interest in possession trust for another
individual, tax will only be payable if the Life Tenant (as donor)
fails to survive the termination of his interest by seven years
(this is a potentially exempt transfer) always assuming
no other exemptions are available (such as the spouse exemption).
A gift into an interest in possession trust
is treated in the same way as a gift to another individual—so
where an interest in possession trust is created by an individual
during his lifetime inheritance tax will only be payable if he
fails to survive the gift by seven years. If the donor fails to
survive, the fact that the property is in trust confers no benefit.
If the donor does survive, the trust is no better off than if
the donee had been an individual. The assets in the trust are
expressly deemed to form part of the donee Life Tenant's estate
and tax will be due on the same basis as described above on any
gifts by the Life Tenant.
DISCRETIONARY
Very different rules apply to trusts under which
no individual is entitled to the income of the trust property—ie
a trust under which distributions of income and capital are made
at the discretion of the trustee (commonly referred to as "discretionary
trusts").
— A transfer of assets into a discretionary
trust results in an immediate inheritance tax charge for the settlor
at 20% (insofar as the value transferred exceeds the settlor's
available nil-rate band) with additional tax chargeable if the
settlor dies within seven years.
— During the life of the trust, periodic
inheritance tax charges are imposed every 10 years at a rate of
6% on the value of the trust assets insofar as they exceed the
inheritance tax threshold.
— An exit charge is payable when capital
is distributed from the trust at any stage between 10-year anniversaries
(basically a fraction of the 10-yearly charge apportioned by reference
to the time which has passed since the last 10-year anniversary).
CHILDREN'S
TRUSTS/GRANDCHILDREN'S
TRUSTS
The discretionary trust charging regime does
not apply to children's "accumulation and maintenance"
trusts (aka A & M trusts), which in many ways are hybrids
of discretionary and life interest trusts. These are (broadly
speaking) trusts under which:
— the beneficiaries (normally grandchildren
of a common grandparent) will become entitled either to the trust
property itself or to its income;
— on or before attaining an age not
exceeding 25 (typical ages are 18, 21, 23 and 25);
— the trust income is to be accumulated
(ie added to capital) insofar as it is not used for the maintenance,
education or benefit of any of the beneficiaries.
Although without trustee action no individual
will be entitled to the income of property held on A & M trusts
(at least until the beneficiaries attain the relevant age), so
that an A & M trust is indistinguishable in practice from
a discretionary trust while the children are under the relevant
age, the discretionary trust charging provisions described above
are suspended; there are no periodic or exit charges. Furthermore,
a gift into an A & M trust is a potentially exempt transfer
which will not be chargeable if the creator survives by seven
years.
Discretionary trusts offer a great deal of flexibility
in terms of how the trust property is distributed; however the
inheritance tax treatment described above makes them relatively
unattractive in many cases.
By contrast, interest in possession and A &
M trusts have been commonly created in lifetime and on death (by
the inclusion of suitably drafted trusts in wills). Both forms
of trust allow assets to be made available for the benefit of
children or other dependents without handing over direct control
of these assets to them. The current regime has been in place
for over 20 years and is well understood and accepted by taxpayers
and their advisers.
The changes proposed are far reaching and will
have significant impact on existing trusts. Given the breadth
of inheritance tax the changes could also affect trusts established
for commercial purposes which may not fit within the existing
narrow IHT exemptions. It is considered that the start date of
the legislation should be postponed and safe harbours consulted
upon.
27 March 2006
34 Protective trusts typically exist under section
33 Trustee Act 1925, although their pedigree is older. They are
life interest trusts under which the life tenant has the right
to income/enjoyment of the assets, but in the event he attempts
to deal with the life interest, eg by assigning the benefit of
it to creditors or by trying to give up part or all in favour
of the next rank of beneficiaries, the interest evaporates. A
discretionary trust over income arises. Under the "old"
rules, it had no tax advantage as the assets would be taxed on
the life tenant's death (having possibly also suffered a charge
on creation) and the life tenant paid income tax each year. They
have typically been used by the spouses of the self-employed and
investors in Lloyd's of London, to try to guard half the family
wealth against potential creditor claims against their spouses
(to the benefit of the state and the succeeding generation). Back
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