Tech talk

Trusts and Inheritance Tax Changes - Budget 2006 - TT18/06

In the immediate aftermath of the Budget, we issued Tech Talk TT16/06 which outlined the proposed changes to the Inheritance Tax treatment of trusts and in particular how these changes affect the trust range we offer for investments. We also recently issued TT17/06 on the same topic which explained how the new IHT regime may work in practice and provided examples of the calculations involved.

The main aim of this Tech Talk is to discuss how the proposals may affect other trust arrangements such as life policies under trust, will trusts and existing lifetime trusts which may need to be reviewed as a result of the changes.

The Finance (No 2) Bill 2006 was published on 7 April 2006 and further clarification was provided in the guidance notes and Q&A which appeared on the HMRC website. Discussions are however still ongoing between the professional bodies and HMRC on some of the aspects of the new rules which are currently unclear and it may be that changes will be required to the Bill as it progresses through Parliament.

Re-cap on Proposals

We do not intend to repeat the content of TechTalk 16/06 however here's a quick reminder of the main changes proposed in the Budget:

Prior to 22 March 2006, any lifetime gift to an Interest in Possession (IIP) trust or an Accumulation & Maintenance (A & M) trust would have been treated as a Potentially Exempt Transfer (PET). Any beneficiary with an interest in possession (i.e. entitlement to income under the trust, would have the value (or a share of it) as part

of their own estate for IHT purposes. This was a special treatment which meant that these trusts were not subject to the mainstream IHT regime for trusts. In practice, only discretionary trusts were subject to this regime, otherwise known as the "relevant property" regime.

Under the proposals in the Budget, most trusts created on or after 22 March 2006 will now be subject to the "relevant property regime". The IHT treatment for trusts is therefore being streamlined so that all trusts are treated in the same way with some limited exceptions.

What does this mean in practice?

This means that:

• When a trust is created, there will be an immediate charge to IHT at 20% on lifetime transfers that exceed the available IHT threshold (£285,000 for the tax year 2006/07).
  
• A "periodic" charge (a maximum of 6%) will apply at every 10th anniversary on the value of the trust assets over the nil rate band at the time.
  
• An "exit" charge will apply where capital is distributed to beneficiaries between 10 year anniversaries. This is known as the "proportionate" charge since it is calculated by reference to the periodic charge.

Does this mean that PETs have gone altogether?

PETs can still be made if the lifetime gift is made outright to another individual. If the gift is being made to a trust after 22 March 2006, it will still be treated as a PET if the trust is for an Absolute/Bare Trust or a trust for a disabled person (as defined under section 89(4) IHTA 1984).

PETs made to IIP and A&M trusts prior to 22 March would have been PETs at the time the gift was made and these will not be affected retrospectively.

Can existing trusts in place at 22 March 2006 be affected at all?

Yes. Although as detailed above, earlier gifts to the trust will not be affected by the change, in certain circumstances the trust could fall into the new regime. Before we look at the details on this, the first point to consider is whether the trust was actually in place before 22 March. For the trust to be "created", the asset must have been transferred to the legal ownership of the trustees. In the case of cash, or a life assurance policy, the cheque must have been encashed. Simply dating the trust prior to 22 March is not sufficient.

Any additional gifts made to an existing trust arrangement will be subject to the new regime.

Existing Interest in Possession Trusts

Interest in possession trusts which were in place prior to 22 March 2006 will not suffer any exit or periodic charges unless the existing interest comes to an end. If this interest ends on the death of the beneficiary, the value of the trust will be part of the beneficiary's estate for IHT purposes. If the interest comes to an end because the beneficiary (or any other beneficiary) becomes absolutely entitled to the assets, no exit charge will apply.

If the interest ends after 6 April 2008 and the asset stays in trust, for example where trustees of a flexible trust alter the beneficiary of the trust, this will be regarded as a new trust for the purposes of the new regime and exit and periodic charges will apply thereafter. There is an exception however where the new beneficiary is a charity.

The period from 22 March 2006 to 6 April 2008 is therefore a transitional period in which trustees have the opportunity to vary the original beneficiary without bringing the trust into the new regime.

Another change under the new rules relates to the gift with reservation of benefit provisions. Take the example of a flexible trust where the children are "default" (or named) beneficiaries. In the past their interest could be terminated (say in order to skip a generation in favour of the grandchildren) and the children could still benefit as a discretionary beneficiary without the Gift with Reservation provisions applying. Now if interest is terminated and that person is still able to benefit from the trust, this will be treated as a gift with reservation of benefit for the beneficiary being removed. Trustees may then need to consider removing that beneficiary from the classes of potential beneficiaries.

Existing Accumulation & Maintenance Trusts

In the past, Accumulation & Maintenance trusts have been popular where clients wish to provide funds for children or grandchildren and are often used in conjunction with funding for school or university fees. Typically this kind of trust would give beneficiaries an income entitlement at age 21 or 25 and capital would often be deferred until some point in the future.

Under the Budget proposals such trusts will only remain outside of the new regime if the trust terms state that the assets will pass to a beneficiary at age 18. Trustees have until 6 April 2008 to amend the terms of the trust to allow for this, otherwise periodic and exit charges will apply. Of course careful thought must be given before allowing a beneficiary to access their share of the trust at 18.

In practice, what will the consequences be for IHT Planning Schemes offered by the life industry?

TechTalk 16/06 already covered in detail the implications for our own trust range. Given that most lifetime gifts for small to medium sized estates fall within the nil rate band, in practice lifetime IHT planning using trusts can still be carried out in many cases without an immediate IHT charge of 20% arising. Provided the donor survives for seven years, the full nil rate band will be available again. On the face of it this does not appear to be much different from a PET, however chargeable lifetime transfers can in practice affect the tax payable on gifts over a 14 year period prior to death(see attached appendix for an example of this).

In order to avoid this complication, one planning strategy would be for clients to make a lifetime gift up to the value of the nil rate band every seven years and any gifts in between should be simply to use exemptions such as the annual exemption or normal expenditure out of income exemption.

Should trusts still be considered for lifetime gifts?

Trusts will still have an advantage over an outright gift since the donor can still exercise a degree of control and can still have access to income in some cases. Discounted gifts arrangements will also still form an important part of estate planning and the discount may be more important than ever before. The value of the gift for the purposes of calculating whether a lifetime charge will arise will be the amount after the discount and therefore the discount could be the difference between an immediate IHT liability or not. Furthermore, since chargeable transfers will now require to be reported to HMRC, any potential challenge on the level of discount will be at the time of the gift rather than on death within seven years as before. This means it will be essential that life offices underwrite the plans they offer.

There is however no doubt that the new rules may deter clients from making large lifetime gifts into trust in excess of the available nil rate band since this could result in a significant IHT liability. Rather than incurring a liability clients may be more likely to fund a whole of life policy instead to meet the potential IHT liability on their estate on death.

How will the new regime affect life policies written under trust?

Life assurance protection policies written under flexible trusts prior to 22 March 2006 will not be subject to the new regime even though premiums will continue to be paid on the policy after this date. This view was confirmed in the HM Revenue and Customs Guidance Note Clause 157, Sch 20 - Rules for Trusts and the supplementary Q & A guide (www.hmrc.gov.uk/finance_bill2006) although in fact there is no specific exemption for existing life policies in the Finance Bill as it stands at the moment. It is therefore anticipated that changes will be made to the draft legislation in due course.

The guidance note explains that unless premiums are increased or the benefit term extended after 22 March 2006, the new provisions will not apply to the trust (although it is not yet clear how indexation options affect this).

It follows that if these policies already written in trust are outside the scope of the changes, it should be possible to change the beneficiaries after 5 April, 2008 without bringing the trust within the new rules. However, the guidance notes fail to cover this point therefore we cannot at this stage be certain of this.

Life policies written into trust after Budget Day will however be within the new regime. We will now examine in detail how the provisions will impact.

On creation

In general, where a trust is created by a regular premium life policy, there will be no 20% lifetime tax charge since the value of the gift made is simply the premiums paid on the policy. Such premiums are usually exempt from IHT either because they fall within the annual exemption (currently £3,000 per annum) or because the premiums qualify as normal expenditure out of income based on the proposer's spendable income.

Even where large premiums are paid and none of the exemptions apply, provided the policy owner has not used his/her nil rate band, no tax charge should arise provided that the premiums over a seven year period do not exceed the available nil rate band.

Where an existing policy is placed into trust now the value of the gift is the open market value of the policy (usually this is the greater of the surrender value or the premiums paid to date). Again provided this is within the available nil rate band, no tax charge will arise.

Ongoing periodic & exit charges

Periodic and exit charges apply where there is a value within the trust. Consequently as long as the life assured is in good health, or the policy has no significant surrender value, there will be no value in the trust, therefore no charges will arise. HMRC have confirmed that they do not expect individuals to have medicals every 10 years for the purposes of the new legislation. Provided the individual is not seriously ill to the best of their knowledge and belief, no further action would be needed. They also indicated that for the purposes of the 10 yearly charge, generally they will accept the surrender value of the policy.

If however the surrender value is significant or the life assured is in poor health, the value of the trust at the 10th anniversary (and each subsequent 10th anniversary) may be subject to IHT at 6% on the excess above the nil rate band at that time.

More commonly charges may arise if a claim is made on policy and the proceeds remain in the trust for a period of time. An exit charge should not arise where proceeds are paid out within the first ten years if the value of the initial gift (including the cumulative total of the settlor's chargeable transfers in the seven years prior to the gift) plus any added property is below the nil rate band. If funds continue to be held in trust beyond the tenth anniversary any exit charges will depend on the rate of the previous periodic charge.

Example

In May 2006 David and Sally do not want to make any lifetime gifts. Instead they take out a joint life second death policy with a sum assured of £400,000 which is intended to meet the IHT liability on their estate and they write this in a flexible trust for the benefit of their three children. The monthly premiums qualify as normal expenditure out of income and therefore no immediate IHT charge will arise on setting up the trust. Assuming the second death arises 15 years later the IHT implications for the trust will be as follows:

May 2016 (Year 10)	No periodic charge assuming the surrender value is below the nil rate band at the time.
2nd Death 2021	Claim is made. If funds are paid out immediately no IHT implications.
	If held in trust beyond the following 10th anniversary - IHT charge possible. 6% x (value of trust less NRB)

In the vast majority of cases, no IHT liabilities will arise in connection with life policies in trust.

Business Protection Policies

Although, in theory business trusts are also affected, in practice IHT charges would be unlikely to arise. Payment of the premiums are not treated as gifts since they are in connection with a commercial arrangement. In the event of a death claim the funds would normally be paid immediately to the other shareholder in order that they can purchase the shares of the deceased.

In the event of a critical illness the shareholder could of course choose not to sell his/her shares in which case if the proceeds remain in trust beyond the 10th anniversary of the trust's creation, periodic and exit charges could arise. The solution would be to release the funds from the trust and for the other shareholders to hold on to the cash personally.

How are Will trusts affected?

Many trusts created in client's wills are discretionary trusts anyway (e.g. nil rate tax planning trusts). Since discretionary trusts have always been subject to the "relevant property regime" nothing has changed.

However, it is still recommended that clients' wills should be reviewed to ensure that any trusts created are still appropriate. For example, until now a popular planning tool used by clients is to leave the residual estate on a flexible interest in possession trust for the benefit of the spouse as a default beneficiary. This would have qualified for the spouse exemption and the main advantage of using the trust is that the spouse could later be removed as a default beneficiary, thus creating a PET, yet still able to benefit from the trust a discretionary beneficiary. This would not be treated as a gift with reservation.

However, under the new rules, these trusts would no longer qualify for the spouse exemption because of the flexibility of the trust. The spouse exemption will only be available in future where the trust gives a fixed life interest to the spouse (or civil partner) and someone then becomes absolutely entitled to the trust assets (e.g. the children) on the death of the spouse.

Trusts for children should also be reviewed if the existing will includes provisions for income or capital to be withheld beyond age 18. As noted earlier, if the child does not become absolutely entitled to both income and capital at 18, the new provisions will apply.

One piece of good news with regard to will planning is that nil rate tax planning with the family home may become simpler. In the past the difficulty with leaving a half share in the family home to discretionary trust was to ensure that the spouse was

not deemed to have an interest in possession in the trust by having a right to live there. In this case the value of the trust fund would be deemed to have been part of the spouse's estate. To combat this various schemes based on an IOU or charge were developed. However, it must therefore be assumed that since having an interest in possession in a flexible or discretionary trust no longer means that the value is included in the beneficiary's estate under the new rules, presumably these schemes will become less popular particularly if the value of the share of the house is within the nil rate band.

Comment

Although there is no doubt that the announcement in the Budget will be an added complication for advisers recommending the use of trusts to their clients, the impact of the new regime will be far less dramatic than first thought.

The Government estimate that additional IHT of approximately £15M will be raised from these measures which emphasises how few people will actually be affected. Given that most life policies and lump sum gifts within the nil rate band will largely be unaffected, the extra tax raised will mainly come from large lump sum gifts in excess of the nil rate band being placed into trust. Clients with large estates may well decide to use absolute or bare trusts for their lifetime IHT planning although this lacks flexibility. Rather than incurring an immediate IHT charge at 20%, many clients contemplating large gifts may well choose to fund a whole of life policy instead.

Further clarification of certain aspects of the draft legislation is currently being sought by the ABI, and other professional bodies. Updates will be issued in due course.

Liz Henderson - May 2006

Appendix 1 - Example of the "14 year" rule

Andrew has made the following gifts

1 June 1998 - £150,000 to a discretionary trust
2 August 2000 - £200,000 to his son David

Andrew dies on 31 May 2006 with an estate of £500,000, what IHT is payable as a result of his death?

The chargeable lifetime transfer on 1 June 1998 was made more than seven years ago and therefore is not added back into his estate. No tax is due on that gift.

However, the PET made in August 2000 is now chargeable as he has died within seven years. Normally where a PET is within the available nil rate band, no tax would be payable on death. However, when calculating the tax due on the failed PET, the chargeable transfer made in the seven years prior to that gift affects the amount of tax payable on the gift as follows:

Nil rate band on death	£285,000
Less previous chargeable transfer
£150,000 less £6,000 annual exemptions	£144,000
Nil rate band available for use against PET	£141,000

The tax on the PET will therefore be as follows:

Gift 2 Aug 2000	£200,000
Less 2 x annual exemption	6,000
	194,000
Less nil rate band	141,000
	53,000
Tax @ 40%	21,200
Less taper relief 60%	12,720
IHT payable	8,480

This tax will be payable by Andrew's son David. The gift made 8 years before death has therefore affected the amount of tax payable on the failed PET but not the estate which will suffer tax as follows:

Estate		£500,000
Nil rate band	£285,000
Less failed PET in 2000	£194,000
		91,000
Taxable estate		409,000
Tax @ 40%		163,600